In July 2018, the International Swaps and Derivatives Association, Inc. ("ISDA") published a consultation (the "ISDA Consultation") on options for calculating adjusted risk-free rates ("RFRs") and spread adjustments to be used as fallbacks in derivatives contracts referencing various interbank offered rates ("IBORs"). Although the ISDA Consultation focused on non-USD IBORS, it solicited preliminary feedback for derivatives fallbacks relating to USD LIBOR, EUR LIBOR and EURIBOR, which will be specifically covered in a separate consultation. In late December 2018, ISDA published a report (the "Report") summarizing responses by market participants to the questions raised in the ISDA Consultation.1


LIBOR may cease to be published in 2021. Issuers of floating rate notes and other market participants are now including new fallback replacement rate provisions in their floating rate note documents, with guidance from USD LIBOR and Sterling LIBOR, the Alternative Rates Reference Committee (the "ARRC") and the Bank of England's Working Group on Sterling Risk Free Rates (the "BOA Working Group"), respectively. The next step in this process will be developing an agreed-upon industry standard replacement rate for USD and Sterling LIBOR for relevant LIBOR floating rate notes. As we previously have reported, the replacement rate for USD LIBOR will be based on the secured overnight financing rate ("SOFR"), which is a secured, overnight, backward-looking rate published by the Federal Reserve Bank of New York. The replacement rate for Sterling LIBOR will be based on the Sterling Over Night Interest Average ("SONIA"), which is a measure of the rate at which interest is paid on sterling short-term (overnight) wholesale funds. Unlike SOFR, SONIA is an unsecured rate in the same manner as LIBOR. However, because SONIA is a measure of overnight borrowing costs, it does not, unlike LIBOR, incorporate bank credit risk so it operates as a near proxy for a risk-free rate.

Similar to the way in which ISDA proposed a number of options for calculating replacement adjusted RFRs, ARRC also, in its most recent publication, set forth a number of choices for an adjusted RFR based on SOFR. Because the market participants responding to the ARRC solicitation will most likely be the same ones that responded to the Report with the same concerns, we can expect that the adjusted RFR chosen in response to the ISDA Consultation will be the same in the responses to the ARRC Consultation. Indeed, some market participants in their responses pointed to the need for consistency across instruments, including cash instruments such as floating rate notes, that are hedged by derivatives.

The BOA Working Group has also acknowledged the need for consistency across derivatives and cash instruments, including floating rate notes hedged by derivatives, and the need for triggers and fallbacks to be aligned where possible. The BOA Working Group also acknowledges that cash product markets (including loans, mortgages and, to a lesser extent, the bond and securitization markets) have a preference for the development of term SONIA reference rates ("TSRR") that can provide cash flow, certainty, the simplicity of forward-looking rates, and consistency with current market practice for the cash product markets.


(Drum roll/cymbal crash) Not surprisingly, the compounded setting in arrears SOFR rate was the overwhelming choice of respondents to the ARRC Consultation. Why is this not surprising? This is, essentially, the same rate that recent SOFR floating rate note offerings have used. Under this method, the daily SOFR rate is compounded over the interest period (one month, three months, etc.) and averaged to determine, at the end of the period, the rate for that period.

Similarly, in the United Kingdom there has been, in the absence of TSRRs, twelve issues of SONIA-linked floating rate notes (totaling over £6bn in principal amount), a market that was kicked off in earnest in June 2018 by the European Investment Bank and swiftly followed by the issuances from the private sector by Lloyds Bank plc, the Royal Bank of Canada, Santander UK plc and others. The interest payable on these floating rate notes for any period is based upon the compounding of the interest rate observed on each London business day during an observation period. At present, an agent bank takes the daily published SONIA rate and applies a formula to compound the rate over the relevant period, adding the relevant margin to the compounded rate. It is anticipated, however, that this manual calculation of the rate may be simplified in the future by publication of a compounded rate on a screen that can be referred to directly in the interest rate calculation provisions of the floating rate notes.

So what are the differences between these rates and LIBOR rates? First, the new rates are not term rates. USD LIBOR and Sterling LIBOR are term rates that are published at several different maturities (for example, 3-month, 6-month and one year), are known prior to the beginning of the relevant interest period, and are fixed and applicable for the whole interest period. These rates are forward-looking. The SOFR and SONIA rates are, on the other hand, "assembled" from overnight fixings during the relevant interest period and are not known until the end of the interest rate period, which creates some interesting settlement mechanics (more on that below). Therefore, the new rates are backward-looking; but also take into account daily variations in the overnight rates during the interest period.

Another effect of using a rate derived from a backward-looking rate is how to manage the last day of the interest period. For any floating rate note, the last day of the interest period is an interest payment date, and interest accrues up to and including that interest payment date (or maturity date). The interest accrued on that last day is known and paid. For a SOFR- or SONIA-derived rate, the daily rate published on the last day of the interest period, which is also an interest payment date (or maturity date), is the rate that was used on the prior day. For example, if Friday is the interest payment date, the SOFR or SONIA rate published on Friday morning is Thursday's rate, and Friday's rate would not be available until Monday, after the interest payment date. Consequently, on Friday, the agent bank will not have enough data to determine the rate for the just completed interest period and also will not know the correct amount of interest to be paid. This suggests that payment date conventions may need to be changed in the future.

To address this problem, recent floating rate notes linked to SOFR and SONIA have developed a short mismatch (or lag) between the period for which the rate is observed and used to calculate the payment (known as the observation period) and the interest period itself. Recent floating rate notes linked to SOFR have used a four-day lockout period pursuant to which the SOFR rate in effect on the fourth business day prior to the interest payment date remains unchanged for the rest of the interest period. Similarly, SONIA-linked issuances to date have been based upon an observation period commencing five London business days before the start of the relevant interest period and ending five London business days before the end of the relevant interest period. Adding this certainty as to the actual interest payment also eases any burdens with settlement systems, which need a certain amount of advance notice for payments.

In selecting the new rate, market participants in the United States have noted the following positive characteristics:

  • it has the aforementioned ability to reflect daily interest-rate movements during the relevant interest period;
  • it is less volatile than the spot overnight rate;
  • it mirrors the structure of the overnight index swaps that reference the RFRs; and
  • it is understandable to market participants.

The fact that the rate could not be determined until the end of the period was not considered to be a significant issue.

As mentioned above, momentum is also building in the United Kingdom for SONIA FRNs using overnight SONIA as a reference (with the characteristics described above also viewed as positive in the London markets). However, the BOA Working Group has acknowledged that there are some users (issuers and investors alike) for whom a forward-looking term rate may better meet their needs and is consulting rapidly with commercial providers and market participants on how TSRRs that are robust and transparent can be created.


When structuring a transaction that will reference an IBOR but will continue past 2021, one must not only include an agreed upon replacement rate but also a spread/margin adjustment. That is because although everyone may agree on the replacement rate, the risk-free replacement rate will not be, and will not behave in the same manner as, the IBOR. As noted by ISDA, IBORs are available in multiple tenors while the RFRs are overnight rates. The IBORs also incorporate a bank credit risk premium and a variety of other factors (such as liquidity and fluctuations in supply and demand) while RFRs do not. The spread adjustments to the RFR are intended to ensure that legacy derivatives contracts referencing an IBOR continue to function as closely as possible to what was intended when the contracts were entered in the event that a fallback takes effect (i.e., the IBOR transitions to RFR).

The ISDA Consultation's criteria for a spread adjustment methodology was "(i) eliminating or minimizing value transfer at the time the fallback is applied, (ii) eliminating or minimizing any potential for manipulation and (iii) eliminating or mitigating against the impact of market disruption at the time the fallback is applied."

According to ISDA, the historical mean/median approach could be based on the mean or median spot-spread between the IBOR and the adjusted RFR calculated over a significant, static look-back period (e.g., 5 or 10 years) prior to the announcement of the relevant triggering event. This spread adjustment could then be used from the end of a one-year transition period from when the fallback took effect. During the one-year transition period, the spread would be calculated using linear interpolations between the spot IBOR/adjusted RFR spread at the time the fallback took effect and the spread that would apply at the end of the one-year transition period.

The historical mean/median approach was chosen by the majority of respondents primarily because of its robustness, simplicity, and resistance to manipulation. This spread adjustment was also chosen by the most respondents to be used with the compounded-setting-in-arrears rate. The majority of respondents also preferred the median spot-spread to the mean approach as it removes the impact of outliers in the calculation.

In response to feedback from market participants, ISDA will develop specific fallbacks to include in its standard definitions and also work to determine the appropriate parameters for the historical mean/ median spread adjustment (whether to use a mean or median calculation and the length of the historical look-back period).


Because very similar questions were asked by ARRC of market participants with respect to the replacement RFR and spread adjustment for USD LIBOR floating rate notes, we can expect that the responses from these market participants will likely mirror those provided to ISDA. This will help clarify how to draft workable fallbacks for USD LIBOR floating rate notes with maturities that extend past 2021 (or any earlier LIBOR cessation). We can also expect a similar response from the BOA Working Group and will look to update you as the group's mandate to develop workable fallback provisions for Sterling LIBOR progresses in the next few months.

Originally published in REVERSEinquiries, Volume 2, Issue 1.


1. The Report is available at: See also: REVERSEinquiries, Volume 1, Issue 7, available at:

Originally published 22 January 2019

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