With December 31, 2021, in plain sight, preparation for the transition from the London Interbank Offered Rate ("LIBOR") and similar interbank offered rates ("IBORs") to replacement benchmark interest rates is accelerating rapidly. In this article, we explore a number of recent core developments affecting structured finance products.

ISDA IBOR Fallbacks Protocol and Supplement

The International Swaps and Derivatives Association ("ISDA") launched the long-awaited IBOR Fallbacks Protocol and related IBOR Fallbacks Supplement on October 23, 2020.1

The IBOR Fallbacks Protocol2 allows market participants that choose to adhere to it to incorporate fallback language into existing non-cleared derivatives with no further action. Derivatives contracts involving a counterparty that has not adhered to the Protocol will require a bilateral amendment to address IBOR cessation. The fallbacks in the Protocol apply upon a permanent cessation of an applicable IBOR. In addition, for LIBOR only, the fallback will become operative upon the occurrence of a pre-cessation trigger; that is, upon a determination by the UK Financial Conduct Authority ("FCA") that a particular LIBOR no longer is representative of its underlying market. ISDA reports that during the two-week period prior to official launch of the Protocol, 257 market participants elected to adhere to it.

Supplement No. 70 to the 2006 ISDA Definitions,3 which also takes effect on January 25, 2021, amends ISDA's standard definitions to incorporate appropriate fallbacks for GBP (United Kingdom), CHF (Switzerland), USD (United States), EUR (Europe) and JPY (Japan) LIBOR, as well as EURIBOR (Europe), TIBOR (Japan), BBSW (Australia), CDOR (Canada), HIBOR (Hong Kong), SOR (Singapore) and THBFIX (Thailand). These fallback rates are deemed robust and follow the recommendations of applicable governmental working groups. They will apply to new cleared and non-cleared interest rate derivatives that reference the 2006 Definitions from the effective date. The Supplement also addresses the treatment of discontinued rate maturities.

ARRC Recommendations and Resources

The US Alternative Reference Rates Committee (the "ARRC"), convened by the Federal Reserve Board and New York Federal Reserve Bank, has been very active in producing tools, across numerous product categories, to ease the transition from LIBOR to its recommended replacement: the Secured Overnight Financing Rate ("SOFR").

FALLBACK LANGUAGE AND SPREAD ADJUSTMENT

After conducting product-specific consultations, and refreshing its loan recommendations based on market evolution, the ARRC has produced final recommendations for key product categories that incorporate a "hardwired" approach to LIBOR fallback rate language. While the rate waterfall within the hardwired approach varies somewhat by product,4 the essence of falling back to Term SOFR is constant.

Separately, the ARRC published its recommendation for a spread adjustment to recognize the difference between LIBOR and SOFR resulting from the fact that SOFR is a secured rate while LIBOR is not. In response to global market preference to align product fallbacks with potentially linked derivative product fallbacks, the ARRC's recommendation mirrors that of ISDA: a spread adjustment methodology based on a historical median over a five-year lookback period calculating the difference between USD LIBOR and SOFR.

It should be noted that many financial institutions still are considering whether SOFR is the appropriate fallback rate for them based on their funding models and loan activity structures, and specifically whether a more creditsensitive rate might be more suitable. For the structured finance market, there would be obvious implications for securitization and hedged transactions that are SOFRbased. In a statement5 released on November 6, 2020, US prudential banking regulators reiterated that banks should choose a robust replacement rate that is appropriate for their needs and include fallback language in their loan agreements providing for the use of such chosen rate if LIBOR were to be discontinued.

BEST PRACTICES

To assist market participants in preparing for LIBOR cessation, the ARRC released a set of recommended best practices in May 2020, which it updated in September.6 Included in these best practices are timelines and intermediate steps that market participants should consider to accelerate their transition to a replacement benchmark interest rate. Key recommendations include:

  • New USD LIBOR cash products should include ARRC-recommended (or substantially similar) fallback language as soon as possible;
  • Institutions should implement clear and rigorous internal programs to assess and address their LIBOR exposure across all relevant activities;
  • Third-party technology and operations vendors relevant to the transition should complete all necessary enhancements to support SOFR by the end of 2020;
  • For contracts specifying that a party will select a replacement rate at their discretion following a LIBOR transition event, the determining party should disclose their planned selection to relevant parties at least six months prior to the date that a replacement rate would become effective; and
  • New use of USD LIBOR should stop, with timing depending on specific circumstances in each cash product market.

Footnotes

1 ISDA Launches IBOR Fallbacks Supplement and Protocol, October 23, 2020.

2 ISDA 2020 IBOR Fallbacks Protocol, published on October 23, 2020.

3 Amendments to the 2006 ISDA Definitions to include new IBOR fallbacks - Supplement number 70 to the 2006 ISDA Definitions, Final on October 23, 2020, and published and effective on January 25, 2021.

4 For example, the recommended waterfall of replacement benchmark rates for securitization transactions, set forth in the ARRC's May 2019 Recommendations, is (a) Term SOFR, (b) Compounded SOFR, (c) the rate recommended by the Relevant Governmental Body, (d) the ISDA Fallback Rate and, optionally, (e) the rate chosen by a party designated with that responsibility in the transaction documents. The ARRC Recommendations for Floating Rate Notes, issued in April 2019, are slightly different in that they recommend the calculation of an interpolated LIBOR rate before resorting to the waterfall (which is substantially identical to the securitization waterfall). In contrast, the refreshed Syndicated Loan Recommendations and Bilateral Loan Recommendations offer a simpler recommended hardwired waterfall that starts with Term SOFR but then prefers Daily Simple SOFR and ends with a rate selected by the administrative agent and borrower, for syndicated loans, or lender, for bilateral loans (i.e., an amendment approach, which was removed as an alternate first-step approach in the refreshed recommendations).

5 Statement on Reference Rates for Loans, Federal Reserve Board, Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency, November 6, 2020.

6 ARRC Recommended Best Practices for Completing the Transition from LIBOR, Alternative Reference Rates Committee, September 3, 2020, which includes links to numerous additional tools.

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