On May 16, the International Swaps and Derivatives Association, Inc. (“ISDA”) published two consultations in connection with the potential discontinuation of certain interbank offered rates (“IBORs”), seeking input on (i) the replacement of USD LIBOR, CDOR and HIBOR (the “Second Benchmark Consultation”)[1] and (ii) the preferred approach for addressing pre-cessation issues in derivatives that reference certain IBORs (the “Pre-Cessation Consultation”). [2] These Consultations follow an earlier consultation published by ISDA in July 2018 (the “First Benchmark Consultation”[3] and, together with the Second Benchmark Consultation and the Pre-Cessation Consultation, the “Consultations”) relating to the potential discontinuation of numerous IBOR benchmark rates.
Since the 2017 announcement by the UK Financial Conduct Authority (the “FCA”) that it would no longer compel panel banks to submit quotations on which certain IBOR benchmark rates are based to the administrator of those rates,[4] the derivatives market has been active in considering adjustments to alternative rates and an effective manner in which to deal with legacy transactions.
As discussed in a previous client alert, the 2006 ISDA Definitions (the “Definitions”), which are incorporated into most existing interest rate derivatives, typically provide that the relevant IBOR rate applicable to a swap for a particular calculation period is determined by looking to a specific published rate.[5] If that rate does not appear on the specified page for a reset date, then, absent the parties having agreed otherwise in their transaction documentation, the rate for that reset date is generally determined based on quotations from reference dealers.[6] This process may be a workable alternative in the case of a limited group of trades, or for a short period of time. However, the permanent discontinuation of a benchmark rate without any pre-designated replacement rate for the vast majority of legacy transactions would overwhelm the market, as banks (acting in their capacities as “calculation agents”) would need to conduct thousands of dealer polls daily, and would inevitably arrive at different rates, resulting in market confusion and potential disconnects between, for example, rates under hedges and rates under corresponding underlying loans.[7]
As result, the derivatives market has responded with a more proactive action plan. The contemplated procedure for facilitating the transition to alternative rates for derivatives includes (i) amending the Definitions with a “Supplement” to provide for (x) trigger events for the permanent discontinuation of benchmark rates and (y) fallbacks to the applicable successor rates; and (ii) publishing an ISDA Protocol which derivatives counterparties to legacy transactions may voluntarily agree to the terms of the amended Definitions. New transactions incorporating the Definitions automatically would be governed by those provisions upon the effectiveness of the amended Definitions, which is expected to be three months after they are finalized and to coincide with the Protocol effective date.[8] In connection with these efforts, ISDA has sought market input through the Consultations.[9]
The First Benchmark Consultation primarily focused on arriving at a market view on an approach for calculating adjusted “risk-free rates” (“RFRs”)[10] and making spread adjustments to those rates. More specifically, it requested market feedback on how to adjust the relevant RFRs to take into account adjustments for differences with the relevant benchmark rates with respect to term (RFRs are overnight rates, whereas IBORs are for designated maturities) and credit (RFRs are fully-collateralized, whereas IBORs inherently include spreads for credit and other factors).
ISDA received numerous responses to this Consultation from different types of market participants across jurisdictions.[11] An overwhelming majority of respondents – almost 90% of them – expressed a preference for an adjusted RFR that is “compounded setting in arrears,” meaning that the rate for a particular calculation period would be the average RFR over that period, compounded daily. This approach is simple and understandable for market participants; however, the applicable rate would not be known at the start of the relevant period. In addition, a significant majority of respondents – some 67% of them – expressed a preference for a spread adjustment to the RFR using a “historical mean / median” approach, which is the mean (or median) of the spread between the relevant benchmark rate and the term-adjusted RFR over a significant lookback period prior to the fallback trigger. This approach is also simple, and is resistant to distortion and manipulation; however, the market continues to consider, inter alia, whether the mean or median be used and what period is appropriate for the lookback period.[12]
Similar to the First Benchmark Consultation, the Second Benchmark Consultation requests input on the adjustment of RFRs if the fallbacks for certain IBORs not covered by the First Benchmark Consultation are triggered. This Consultation is a streamlined version of the First Benchmark Consultation and, among other things, asks whether “the compounded setting in arrears rate approach and the historical mean/median approach [is] also appropriate for fallbacks”[13] for the additional rates covered by the Second Benchmark Consultation.
The Pre-Cessation Consultation differs from the other two Consultations in that it seeks input on the preferred approach for addressing pre-cessation issues in derivatives referencing LIBOR and certain other IBORs, as opposed to input on adjustments to RFRs. As discussed above, ISDA plans to amend certain floating rate options in the Definitions to include fallbacks that would apply upon a discontinuation of the applicable benchmark rate. These fallbacks would effectively trigger upon the permanent cessation of the relevant rate: generally, a public statement by the IBOR’s administrator or a public sector (or similar) official with authority over the IBOR’s administrator or the central bank for the relevant currency.[14] In other words, the benchmark fallbacks would not apply until the actual discontinuation of the IBOR (although the date of a public statement will be relevant for purposes of the calculation of the spread adjustment).
On March 12, representatives of the FCA and FRBNY sent a letter to ISDA encouraging it to ask for market opinion on an additional pre-cessation trigger.[15] The FCA and FRBNY noted that “[t]riggers that would only take effect on the date on which LIBOR permanently or indefinitely stopped publication could leave those with LIBOR-referencing contracts still exposed to numerous risks.”[16] Specifically, the FCA and FRB expressed concern over the situation where the FCA, as required by the EU Benchmark Regulation, makes a determination that LIBOR is no longer “representative,” potentially leaving derivatives market participants forced to continue using LIBOR as their benchmark rate in legacy contracts in a “severely disrupted market.”[17] The addition of a pre-cessation (of IBOR publication) trigger would put derivatives contracts more in line with the triggers currently contemplated for cash products.[18]
In response, the Pre-Cessation Consultation seeks further input on the preferred approach for addressing pre-cessation issues in derivatives referencing certain IBORs (such as LIBOR), including in the context of a regulator statement that the relevant IBOR is no longer “representative.”[19] However, ISDA noted certain fundamental differences between derivatives and cash market products (including that the latter “cannot be amended by way of a protocol in the same way that derivatives contracts can”)[20] and cautioned that the inclusion of pre-cessation fallback triggers as part of its contemplated amendments “would avoid mismatches if cash products have equivalent triggers and fallbacks but result in mismatches if they do not.”[21]
Several benchmark transition challenges remain for derivatives, including: (i) considering the treatment of the change in present value of a swap before and after transition; (ii) potential disconnects between the fallback rates under in assets / liabilities (such as loans) and related hedges; (iii) various accounting issues;[22] and (iv) clarification of the status of clearing and margin exemptions following transition.
The deadline for responses to the Second Benchmark Consultation and Pre-Cessation Consultation is July 12.
[1] ISDA, Supplemental Consultation on Spread and Term Adjustments for Fallbacks in Derivatives Referencing USD LIBOR, CDOR and HIBOR and Certain Aspects of Fallbacks for Derivatives Referencing SOR (May 16, 2019), https://www.isda.org/a/n6tME/Supplemental-Consultation-on-USD-LIBOR-CDOR-HIBOR-and-SOR.pdf.
[2] ISDA, Consultation on Pre-Cessation Issues for LIBOR and Certain Other Interbank Offered Rates (IBORs) (May 16, 2019), https://www.isda.org/a/md6ME/FINAL-Pre-cessation-issues-Consultation.pdf.
[3] ISDA, Consultation on Certain Aspects of Fallbacks for Derivatives Referencing GBP LIBOR,1 CHF LIBOR, JPY LIBOR, TIBOR, Euroyen TIBOR and BBSW (July 2018), http://assets.isda.org/media/f253b540-193/42c13663-pdf/.
[4] For additional details on this announcement, click here.
[5] For example, USD-LIBOR-BBA (sometime referred to as USD-LIBOR-ICE) is generally determined with respect to each reset date as the “rate for deposits in U.S. Dollars for a period of the Designated Maturity [e.g., 1 month, 3 months, 6 months] which appears on the Reuters Screen LIBOR01 Page as of 11:00 a.m., London time, on the day that is two London Banking Days preceding that Reset Date.” (Note that certain legacy transactions may instead incorporate the earlier 2000 ISDA Definitions.)
[6] For example, in the case of USD-LIBOR-BBA, the fallback rate under the Definitions in the event that the published rate is not available is “USD-LIBOR-Reference Banks,” which is, generally, determined on the basis of the rates at which deposits in U.S. Dollars are offered by the “Reference Banks” (i.e., four major banks in the London interbank market).
[7] Note that, pursuant to ICE Benchmark Administration’s (“IBA”) Reduced Submissions Policy, IBA may continue to publish, at least for some time, the previous day’s rate if it receives insufficient submissions. See ICE Benchmark Administration, Reduced Submissions Policy 2 (Aug. 2018), https://www.theice.com/publicdocs/ICE_LIBOR_Reduced_Submissions_Policy.pdf (“IBA’s policy for insufficient submissions currently applies when four or fewer complete submissions per currency are received. In such an event, IBA would be likely to re-publish the previous day’s published rate for all tenors in that particular currency.”).
[8] ISDA currently expects to finalize the Supplement and launch the Protocol by the end of 2019, with the amendments taking effect during the first quarter of 2020. See Letter from ISDA to FCA and Federal Reserve Bank of New York (“FRBNY”) (Apr. 10, 2019), at 3 (the “ISDA April 2019 Letter”). It is currently expected that certain major central clearing parties for cleared interest rate derivatives will implement fallbacks for those transactions consistent with the Supplement by using the discretion available to them under their rulebooks. See, e.g., LCH’s Position in Respect of ISDA’s Recommended Benchmark Fallback Approaches (Circular No. 3999) (Dec. 20, 2018), https://www.lch.com/membership/ltd-membership/ltd-member-updates/lchs-position-respect-isdas-recommended-benchmark (announcing its intention to “introduce rulebook amendments to give effect to [expected amendments to the Definitions by ISDA], where necessary, through [its] regular Rulebook change consultation process”).
[9] Over the past year, many dealers have begun including language in their trade confirmations addressing benchmark rate discontinuation. Dealer provisions take various forms, but often reflect that, upon a benchmark discontinuation, the dealer will designate an alternative source or methodology for the floating rate, giving consideration to the methodology proposed by ISDA.
[10] Overnight RFR fallback rates (e.g., SOFR for USD LIBOR, SONIA for GBP LIBOR, TONA for TIBOR) have been identified for certain IBORs by relevant public-private working groups. The Alternative Reference Rates Committee (the “ARRC”) identified SOFR (Secured Overnight Financing Rate) as a replacement index for USD LIBOR in June 2017. See The ARRC Selects a Broad Repo Rate as its Preferred Alternative Reference Rate (June 22, 2017), https://www.newyorkfed.org/medialibrary/microsites/arrc/files/2017/ARRC-press-release-Jun-22-2017.pdf. SOFR is based on a liquid market of $800 billion in average daily volume of trades in the Treasury “repo” market. See Federal Reserve Bank of New York, SOFR: A Year in Review (Apr. 2019), https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2019/SOFR_Anniversary.pdf.
[11] ISDA received a total of 164 responses to this Consultation, of which 147 were useful for purposes of considering RFR adjustments. See ISDA, Anonymized Narrative Summary of Responses to the ISDA Consultation on Term Fixings and Spread Adjustment Methodologies 3 (Dec. 20, 2018), http://assets.isda.org/media/04d213b6/db0b0fd7-pdf/.
[12] There does not yet appear to be market consensus on the length of the lookback period, and it is possible that it could differ depending on the IBOR. With respect to USD LIBOR, note that SOFR has only been published by the FRBNY since April 2018; however, sufficient indicative historical information (“indicative SOFR,” published by the FRBNY from August 2014) and proxy information (the volume-weighted mean rate of the primary dealers’ overnight Treasury general collateral repo borrowing activity collected through a FRBNY survey (also known as the “survey rate”) from February 1998) may be available to facilitate a longer lookback period.
[13] Second Benchmark Consultation, at 15. In parallel, ISDA also issued a “request for proposal” on February 4 for the selection of an independent third-party vendor to finalize and prepare to publish the relevant adjustments. See Press Release, ISDA Issues Request for Proposal for Fallback Spread Vendor Role (Feb. 4, 2019), https://www.isda.org/a/F9gME/IBOR-Fallback-Admin-RFP-Press-Release.pdf. Specifically, this vendor would operate as a “golden source” to calculate and publish the term-adjusted RFR and spread adjustment for each applicable IBOR, which is expected to mitigate counterparty disputes and increase transparency. ISDA currently expects this vendor to be selected in the coming months and begin publishing the relevant information by the end of 2019. See ISDA April 2019 Letter, at 2.
[14] More specifically, the applicable events (also known as “index cessation events”) encompass the following: (i) a public statement 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 the time of the statement or publication, there is no successor administrator that will continue to provide that 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 with jurisdiction over the administrator of the relevant IBOR, a resolution authority with jurisdiction over the administrator for 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 of the relevant IBOR has ceased or will cease to provide the relevant IBOR permanently or indefinitely, provided, that, at the time of the statement or publication, there is no successor administrator that will continue to provide the relevant IBOR.
[15] Letter from FCA and FRBNY to ISDA (Mar. 12, 2019), https://www.fsb.org/2019/03/fsb-letter-to-isda-about-derivative-contract-robustness-to-risks-of-interest-rate-benchmark-discontinuation/. The letter was sent by the FCA and FRBNY representatives in their capacity as Co-chairs of the Official Sector Steering Group of the Financial Stability Board.
[16] Id. at 1.
[17] Id. at 2.
[18] The pre-cessation trigger recommended by the ARRC is as follows: “a public statement or publication of information by the regulatory supervisor for the administrator of the Benchmark announcing that the Benchmark is no longer representative.” ARRC Recommendations Regarding More Robust Fallback Language for New Issuances of LIBOR Floating Rate Notes (Apr. 25, 2019).
[19] The likely cause of the reference rate being no longer “representative” is a significant decrease in the number of panel banks providing quotations.
[20] Pre-Cessation Consultation, at 12.
[21] Id. at 13.
[22] See, e.g., ISDA Response to International Accounting Standards Board (17 June 2019), https://www.isda.org/a/fk0ME/Interest-Rate-Benchmark-Reform-June-17-2019.pdf.