On July 12, the International Swaps and Derivatives Association, Inc. ("ISDA") initiated a market-wide consultation (the "Consultation")[1] on technical issues related to new benchmark fallbacks for derivatives referencing certain interbank offered rates, or IBORs, in response to the expected discontinuance of the publication of those IBORs at the end of 2021.[2] The purpose of the Consultation is to ease the transition of the derivatives market from referencing existing IBOR rates to alternative risk-free-rates ("RFRs") that have been identified as part of the global benchmark reforms. These RFRs are intended to be based on robust and highly liquid underlying markets that, unlike the relevant IBORs, do not require and are not based on submissions from panel banks or others.
Pursuant to the 2006 ISDA Definitions (the "Definitions") governing most interest rate derivatives, if an IBOR is not available (including as a result of a permanent discontinuance), current fallbacks require that the designated calculation agent obtain quotations of what the rate should be from major dealers in the interdealer market.[3] This approach is not a viable long-term solution in the case of a permanent discontinuance of an IBOR, where quotations would be solicited for each rate reset date for thousands of transactions, including long-dated contracts. Therefore, ISDA is planning to amend the Definitions through the publication of a Supplement to incorporate fallbacks for "floating rate options" referencing certain key IBORs, which will apply if the relevant IBOR is permanently discontinued, based on specific triggers (discussed below). Transactions incorporating the Definitions that are entered into prior to publication of the Supplement would not automatically be subject to the amended floating rate options with the fallbacks. However, ISDA is also contemplating one or more voluntary protocols to facilitate multilateral amendments among protocols "adherents" to include the amended floating rate options in legacy transactions.
These fallbacks will be the RFRs identified for each relevant IBOR as part of the global benchmark reforms. However, there are significant inherent differences between the RFRs and IBORs. The Consultation seeks market input on the approach for addressing certain technical issues associated with adjustments to the RFRs if the fallbacks are triggered to deal with those differences.
A. IBOR Discontinuance Trigger
The Consultation first recommends that certain floating rate options listed in the Definitions include "a statement identifying the objective triggers that would activate the selected fallbacks."[4] The Consultation contemplates two circumstances under which the fallbacks would be triggered in the following circumstances:
(i) a public statement or publication of information by or on behalf of the administrator of the relevant IBOR announcing that it has ceased or will cease to provide the relevant IBOR permanently or indefinitely (provided that, at that time, there is no successor administrator that will continue to provide the relevant IBOR); or
(ii) a public statement or publication of information by the regulatory supervisor for the administrator of the relevant IBOR, the central bank for the currency of the relevant IBOR, an insolvency official or a resolution authority with jurisdiction over the administrator of the relevant IBOR, or a court or entity with similar insolvency or resolution authority over the administrator for the relevant IBOR, which states that the administrator has ceased or will cease to provide the relevant IBOR permanently or indefinitely (provided that, at that time, there is no successor administrator that will continue to provide the relevant IBOR).
Upon amendment of the Definitions by the contemplated Supplement, once a relevant IBOR has been permanently discontinued, the applicable RFR will apply. For example, the fallback RFR for GBP LIBOR is currently expected to be SONIA, the fallback RFR for JPY LIBOR is currently expected to be TONA, and the fallback RFR for USD LIBOR is currently expected to be SOFR.
B. RFR Adjustments
Unlike IBOR rates, which are determined for various tenors and take into account credit and other risks, RFRs are overnight rates and do not take into account such risks. Therefore, they must be adjusted to be comparable to the permanently discontinued IBORs.
1. Adjustment for Tenor
The Consultation discusses four options for adjusting RFRs to account for tenor differences, each with its own advantages and disadvantages:
(i) the Spot Overnight Rate (i.e., the RFR that sets on the date that is 1-2 business days (depending on the relevant IBOR) prior to the beginning of the relevant IBOR tenor), which, among other things, would be widely accessible but ignores the inherent variation in risk-free interest rates over different tenors;
(ii) the Convexity-Adjusted Overnight Rate (i.e., calculated the same way as the Spot Overnight Rate, except with a first-order modification to adjust for "convexity," which attempts to account for the difference between flat overnight rates at the spot overnight rate versus the realized rate of interest that would be delivered by daily compounding of the RFR over the IBOR's term), which, among other things, is a closer match for the term structure of risk-free interest rates but increases the complexity of the adjustments;
(iii) the Compounded Setting in Arrears Rate (i.e., the relevant RFR observed over the relevant IBOR tenor and compounded daily during that period) which, among other things, is understandable and reflects the actual daily interest rate movements during the relevant period, but the information required to determine the rate is not available at the start of the period; and
(iv) the Compounded Setting in Advance Rate (i.e., calculated the same way as the Compounded Setting in Arrears Rate, but with the observation period being equal in length to the relevant IBOR tenor but ending immediately prior to the start of the relevant IBOR tenor) which, among other things, would be available at the beginning of the relevant IBOR tenor because it is set in advance, but is inherently backward-looking.
2. Spread Adjustment
The Consultation proposes three options for a spread adjustment to RFRs as a "rough proxy" to account for the fact that RFRs are risk-free (or nearly risk-free), whereas IBORs incorporate a bank credit risk premium,[5] as well as a variety of other factors (e.g., liquidity fluctuations in supply and demand). The spread adjustment would be calculated as of the business day before the fallback is triggered to avoid distortions due to market disruption during the period between the fallback being triggered and the actual permanent discontinuation of the relevant IBOR. The adjustment would be set (and not be subject to change) and would apply beginning on the first day the relevant IBOR is not published following a permanent discontinuance.
The Consultation discusses three options for spread adjustment to the RFRs:
(i) the Forward Approach, under which, generally, the spread adjustment would be calculated based on observed market prices for the forward spread between the relevant IBOR and the adjusted RFR in the relevant tenor at the time the fallback is triggered;[6]
(ii) the Historical Mean/Median Approach, under which, generally, the spread adjustment would be based on the mean or median spot spread between the relevant IBOR and the adjusted RFR calculated over a significant, static lookback period (e.g., 5 years or 10 years) prior to the relevant announcement or publication triggering the fallback;[7] and
(iii) the Spot-Spread Approach, under which, generally, the spread adjustment would be based on the spot spread between IBOR and adjusted RFR on the day preceding the relevant announcement or publication triggering the fallback provisions.[8]
Responses to the Consultation must be submitted by October 12, 2018.
Footnotes
[1] ISDA Publishes Consultation on Benchmark Fallbacks (July 12, 2018) (available here).
[2] The Consultation addresses fallbacks for derivatives referencing GBP LIBOR, CHF LIBOR, JPY LIBOR, TIBOR, Euroyen TIBOR and BBSW. Although it does not directly address fallbacks for derivatives referencing USD LIBOR, EUR LIBOR, or EURIBOR, it may offer insight into what ISDA will propose with respect to those IBORs in subsequent consultations. Note that USD LIBOR and EURIBOR together represent approximately 80% of the total IBOR market exposure. See IBOR Global Benchmark Survey, 2018 Transition Roadmap, located here, at 8. For additional information on USD LIBOR discontinuance, click here.
[3] For example, in the case of U.S. dollar LIBOR (although outside the scope of the Consultation), if USD-LIBOR-BBA (or USD-LIBOR-ICE) does not appear on the specified page, then, absent the parties having agreed otherwise in their transaction documentation, the rate for that reset date is to be determined as if the parties had specified a different rate, USD-LIBOR-Reference Banks. This fallback rate is, generally, determined by the party specified as the calculation agent on the basis of quotations from major banks in the London interbank market. If fewer than two quotations are provided, then there is a further embedded fallback whereby the rate is to be determined as the arithmetic mean of quotations from major banks in New York City, selected by the calculation agent.
[4] Consultation, at 5.
[5] In connection with the determination of IBORs, panel banks are generally asked to provide the lowest perceived rate upon which they could obtain unsecured funding in the relevant interbank money market in the specified currency for the relevant period, which inherently includes costs associated with their credit risk.
[6] Note that this approach requires a forward IBOR curve and a forward adjusted RFR discount curve, both of which ideally would extend out to 30-60 years. Consultation, at 12. Also, this approach is not compatible with the Spot Overnight Rate and Convexity-Adjusted Overnight Rate adjustment options for tenor. Id.
[7] Note that this approach contemplates a one-year transition period after the fallback takes effect, during which the spread adjustment would be calculated through linear interpolation between (x) the spot IBOR / adjusted RFR spread at the time the fallback takes effect and (y) the spread that would apply after the one-year transition period.
[8] A variation of this approach would be to use the average of the daily spot spread between IBOR and the adjusted RFR over a specified number of days. Consultation, at 14. Also, note that this approach is not compatible with the Compounded Setting in Arrears Rate adjustment option for tenor. Id.
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