ISDA IBOR Fallbacks Tool Goes Live on 25 January 2021

Why is 25 January important?

Given that most¹ LIBOR values will cease to be computed and announced on 31 December 2021, ISDA’s 23 October 2020 launch of its IBOR Fallbacks Supplement (see here) (the “Supplement”) and IBOR Fallbacks Protocol (see here) (the “Protocol”), after lengthy consultation, was hotly anticipated. 

The Supplement will introduce into derivatives contracts entered into from 25 January 2021, that incorporate the 2006 ISDA Definitions and reference in scope IBORs, certain fallbacks in the event of the permanent discontinuance (or, in the case of in scope LIBOR settings, non-representativeness) of that IBOR.

The Protocol, which is already open for adherence, enables any pair of adhering parties to incorporate the same fallbacks into their legacy non-cleared derivatives contracts, and certain other in scope contractual arrangements, with effect from 25 January 2021 (or, if later, the effective date of adherence to the Protocol by the later of the two parties to adhere).

Given:

• the current levels of exposure to IBORs in the derivatives markets; and

• the fact that pre-Supplement/Protocol IBOR fallback arrangements for derivatives contracts are not designed to deal with a situation where an IBOR is permanently discontinued,

the possibility that an IBOR discontinuance would occur while such exposure continues is a significant systemic risk.  The adoption of robust fallbacks in derivatives contracts referencing IBORs is an essential mitigant of that risk.

The Supplement at a glance

• It only affects derivatives contracts entered into on or after 25 January 2021 referencing certain IBORs and incorporating the 2006 ISDA Definitions.

• The IBORs encompassed are all five currency LIBORs (GBP, CHF, USD, EUR and JPY), EURIBOR, on-shore Japanese yen and offshore (euroyen) TIBOR, the Australian Dollar Bank Bill Swap Rate (BBSW), the Canadian Dollar Offered Rate (CDOR), the Hong Kong Interbank Offered Rate (HIBOR), the Singapore Dollar Swap Offer Rate (SOR) and the Thai Baht Interest Rate Fixing (THB-FIX).

• It provides that an in scope IBOR will continue in use until:
  • the permanent or indefinite cessation; or
  • solely in the case of a LIBOR setting, the date with effect from which that rate is no longer representative of the underlying market and economic reality that it is intended to measure, as determined by the regulatory supervisor (the UK Financial Conduct Authority) of the LIBOR administrator (ICE) in the knowledge that such determination would trigger contractual fallbacks,

• of the relevant tenor. Once such an event occurs the IBOR will, subject to the following, be replaced by an adjusted version of an alternative risk-free rate (RFR) in respect of the relevant currency.  If such an event occurs with respect to the relevant tenor but there are at least two other tenors of the same IBOR, one of which is longer and one of which is shorter than the relevant tenor and each of which is unaffected by the event, the rate for the relevant tenor will be determined by interpolating between the next shorter and next longer of such other tenors.

• The RFRs are required to be adjusted because they are structurally different to IBORs; RFRs are overnight rates without any credit component, whereas IBORs have a credit-sensitive term structure. The date with effect from which the required adjustment to the relevant RFR is calculated may be earlier than the date with effect from which the IBOR is replaced by the adjusted RFR, depending on whether certain advance publications or statements regarding the permanent/indefinite cessation or non-representativeness, as applicable, are made. 

• Bloomberg Index Services Limited (BISL) has been appointed by ISDA to calculate and publish the adjusted RFRs (compounded in arrears), the related spread adjustments and the “all in” IBOR fallback rate. The calculations are based on publicly available methodologies developed by ISDA after market consultation.  BISL has published indicative versions of that information since 21 July 2020 and will continue to publish on an indicative basis until, in respect of any IBOR, a permanent/indefinite cessation, non-representativeness or related advance publication or statement referred to above occurs. Once that occurs the spread adjustment can be fixed and actual information will be published.

• Derivatives contracts incorporating the 2006 ISDA Definitions that are entered into on or after 25 January 2021 will incorporate the trigger events and fallbacks referred to above.  This may result in a mismatch between the trigger events and fallbacks applicable to any such contract that is a hedge for a related instrument, such as a loan or a security, and those applicable to that related instrument.  If it is required to match the derivative contract fallbacks to those of the related instrument, the parties would need to amend the Supplement provisions as they apply to the derivative contract.

The Protocol at a glance

• The Protocol is a multilateral agreement that, as between any pair of adhering parties, operates as a mutually agreed modification – on the terms specified by the Protocol - of any outstanding bilateral contractual arrangements between them that are in scope for the Protocol.

• The Protocol enables a pair of adhering parties to an in scope legacy contractual arrangement referencing an IBOR to amend it to include the relevant Supplement fallbacks and related Supplement terms and definitions.

• The Protocol encompasses the same IBORs, and incorporates the same fallbacks and trigger events, as the Supplement.

• Whereas the Supplement is forward-looking, addressing only derivatives contracts transacted from 25 January 2021, the Protocol is designed to address the significant body of derivatives contracts referencing in scope IBORs that will be outstanding on 25 January 2021.

• The Protocol applies only to prescribed “Protocol Covered Documents”, largely comprising in scope ISDA and certain other master agreements, credit support documents and confirmations.  The list of non-ISDA documentation to which it applies is set out in the Additional Documents Annex.

• The Protocol does not apply to documentation governing cleared derivatives contracts² or any agreement in which the parties expressly state that the terms of the Protocol do not apply. 

• The Protocol applies to the use in Protocol Covered Documents of specified sets of ISDA Definitions relating to IBORs, IBOR references defined by reference to such ISDA Definitions and other IBOR references howsoever defined.  The ISDA Definitions encompassed are the 2006 ISDA Definitions, the 2000 ISDA Definitions, the 1998 ISDA Euro Definitions, the 1998 Supplement to the 1991 ISDA Definitions and the 1991 ISDA Definitions.

• Adherence to the Protocol is on an “all-or-nothing” basis. If some, but not all, of the in scope contractual arrangements of a party are suitable for amendment pursuant to the Protocol, that party should agree any required exclusions bilaterally, ideally before it adheres.  

• As Protocol adherence results in the amendment of in scope derivatives contracts with other adhering parties, careful consideration should be given by any party considering adherence to applicable operational, systems, regulatory, tax, accounting (including hedge accounting), hedging and other implications for it.

• Protocol adherence is open to ISDA members and non-members.  The fee (US$500) applicable to ISDA Primary Members is waived for non-ISDA Primary Members if they adhere prior to 25 January 2021, being the effective date of the Protocol.

Bilateral Alternatives/Add-ons to the Protocol

ISDA has published template wording that a pair of adhering parties to the Protocol can use to agree bilaterally to:

• exclude one or more in scope contractual arrangements from the scope of the Protocol and provide for the application to them of alternative fallbacks;

• disapply the Protocol fallbacks in respect of legacy derivative contracts used to hedge other products (e.g. loans and securities) and instead provide that the fallbacks applicable to the hedged products shall apply;

• extend the Protocol’s application to documents that are not, on its terms, in scope; and/or

• provide that the fallbacks shall not apply following a non-representativeness determination for one or more LIBOR settings.

Any such agreement will only affect the legacy derivatives contracts between the two parties to the relevant bilateral agreement and expressed by its terms to be subject to it and not, for the avoidance of doubt, any agreement arising under the Protocol between one of those parties and any third party adherent to the Protocol.

ISDA has also published template wording to enable a pair of parties, one or both of which has not adhered to the Protocol, to apply the Protocol terms to their contractual arrangements.  Two versions of this wording has been produced; a short-form version which confirms that the terms of the Protocol will apply between the two parties and a long-form version which sets out the substantive terms of the Protocol in full and permits the parties to amend those terms if required.

Is this the solution to IBOR transition?

Perhaps the most important point regarding the fallbacks the subject of the Supplement and Protocol was made by ISDA CEO, Scott O’Malia in his 14 January 2021 blog³:

Parties need to bear in mind that the one-size-fits-all safety net afforded by the Supplement/Protocol fallbacks may not be appropriate for bespoke products and also that their application may result in discrepancies between the fallbacks applicable to derivatives contracts used for hedging and those applicable to the hedged liability. They need to assess their existing derivatives portfolios to determine whether adherence to the Protocol or bilateral amendment is more appropriate in light of the issues identified above. In due course they should also consider whether to transition new trades, and restructure existing trades, to reference RFRs rather than IBORs which, in the case of hedges, will be affected by the approach taken to the hedged liability. It would also be a good time to consider whether any existing trades can be compressed. They then need to implement their preferred approach.

So whereas 25 January 2021 is a very important date in derivatives market participants’ calendars, it is just a pit-stop on the way to IBOR transition’s podium finish.