ISDA IBOR Fallbacks Supplement and Protocol: What You Need to Know

I.  Introduction
In 2017, the UK’s Financial Conduct Authority (“FCA”) announced that it will not require the calculation and publication of interbank offered rates (“IBORS”) beyond 2021.  The absence of a guaranteed IBOR after 2021 has triggered one of the largest and intricate challenges that financial markets have confronted to date.  Trillions of dollars of derivatives contracts and many other financial transactions lack provisions to deal with the end of IBORs or include provisions that could cause significant and unintended economic consequences.

2. IBORs versus Alternative Risk-Free Rates
Risk Free Rates (“RFRs”) are alternative reference rates developed by regulators and industry working groups to replace reliance on IBORs. Key differences are:

IBOR is a forward-looking term rate whereas RFRs are backward-looking overnight rates;
IBORS may vary the length of the interest period whereas RFRs are overnight rates;
IBOR is derived from quotes provided by panel banks’ submissions which are meant to be estimates of where they could borrow funds whereas RFRs are benchmarks based on actual transactions;
IBOR is an unsecured borrowing rate and includes the implied credit risk of the international panel banks and a liquidity premium related to the length of the interest period whereas RFRs do not include a credit risk element nor a liquidity premium.

3. Next Steps
To mitigate the risk of economic disruption, on October 23, 2020, the International Swaps and Derivatives Association, Inc. (“ISDA”) published a supplement to the 2006 ISDA Definitions that adds new IBOR Fallbacks (the “Supplement”) and the ISDA 2020 IBOR Fallbacks Protocol (the “Protocol”). The Supplement and the Protocol will become effective on January 25, 2021, well ahead of the deadline to transition away from IBOR.

The Supplement amends the definitions applicable to various IBORs under the 2006 ISDA Definitions so that new transactions that incorporate those definitions will “fallback” to alternative reference rates upon the occurrence of specified events including, the disappearance of IBOR.  The Protocol is a multilateral contractual amendment that amends existing contracts referencing IBORs to provide for corresponding fallbacks.

The Alternative Reference Rates Committee (“ARRC”) has published best practices that recommend all market participants modify their existing contracts as soon as possible by adhering to the Protocol before the effective date.  Regulators worldwide have also urged market participants to adhere to the Protocol.

4. The Supplement
The Supplement amends the 2006 ISDA Definitions.  These amendments provide that, upon certain specified events, references to IBORs will “fallback” to alternative reference rates.

Items to Note:

The amendments will affect agreements and transactions that incorporate the 2006 ISDA Definitions following the effective date; they do not amend existing transactions.
Agreements that do not apply the 2006 ISDA Definitions will need a different approach to incorporating IBOR fallbacks.
The Supplement leaves the relevant IBOR in place until specified events occur to trigger the switch to a fallback benchmark.
The Supplement amends IBOR definitions relevant for the following currencies: GBP, CHF, USD, Euro, JPY, AUD, CAD, HKD, SGD, THB.  Unlike IBOR, RFRs have characteristics specific to the relevant currency. Hence, the pace of market adoption will continue to vary across regions and will impact cross-currency markets.
The Supplement provides for both temporary and permanent cessation of an IBOR.
The Supplement includes a “waterfall” approach with relevant triggers to be used if the specified IBOR fallback rate (i.e., Fallback Rate (SOFR), in the case of USD LIBOR) were to cease to be provided, temporarily or permanently.
Cleared trades at the central counterparty (CCP) clearing houses are governed by terms that are independent of bilateral (CSAs) and fallback alternative reference rates will be incorporated into each CCP’s rule book.

5. Permanent Fallbacks
The IBOR fallbacks generally follow a standard approach of a specified “risk-free rate” compounded in arrears, observed with a two business-day backward shift and a spread adjustment.

Items to Note:

Compounded in Arrears. The version of SOFR (USD) incorporated into the Supplement is compounded in arrears, i.e., by using a compounded rate over the current interest period. Note that, unlike other forms of SOFR, the compounded in arrears rate means that final rates will not be known until the end of an interest period.
Backward Shift. Given the timing issue noted above, a two Business Day shift will be applied so that an interest rate calculation period will start two Business Days before the relevant period and end two Business Days before the end.  Note this change may result in different observation periods for each leg of cross-currency swaps if fallbacks are not concurrently triggered.
Spread Adjustment.  The spread adjustment is intended to capture the credit component of IBOR and will be based on a five-year historical median looking at the relevant IBOR and the relevant compounded risk-free rate.  The spread adjustment will be added to the compounded setting in arrears rate after compounding thus the spread adjustment itself will not be compounded.
Market participants that engage in other types of cash products should consider how the ISDA-standard fallbacks interact with other types of products. Loans and other cash-market transactions, that lack an industry-wide solution similar to that presented by ISDA, may not necessarily use the same fallback rates or conventions, so adjustments may need to be made to hedges.

6. The Protocol
The substantive amendments made by the Protocol apply the Supplement to existing transactions under ISDA documentation, including ISDA master agreements, ISDA credit support documents, and confirmations. The Protocol also amends other standard form contracts, including securities lending (MSLA, GMSLA), repurchase agreements (MRA, GMRA), and other commonly used standardized contracts. Agreements and transactions that reference “LIBOR” or another IBOR generically, without reference to ISDA-published definitions, require more substantive amendments under the Protocol but with similar effect.

Items to Note:

The Protocol will amend contracts that are not typically amended by ISDA protocols and IBOR references in transactions not documented on ISDA-published forms may require further attention.
Parties will need to separately agree to not apply the terms of the Protocol if they wish to preserve the negotiated fallbacks for any specific Agreement or Transaction.
The amendments made by the Protocol are standardized and adherence means acceptance without negotiation (unless done on a separate, bilateral basis).
Market participants with non-standard interest rate terms should closely review their contracts to determine whether the amendments made by the Protocol will fully preserve the economic intent of the original transaction.
ISDA is publishing a series of bilateral templates that parties could use to apply the terms of the Protocol on a one-off basis. These forms are expected to be used primarily by non-adhering parties but could also be used by adhering parties to modify specific terms of the Protocol (e.g., to exclude certain transactions from the scope of the Protocol).

7. Buy Side Considerations
The cessation of LIBOR may impact the hedging structure of a portfolio and could result in a mismatch between the rate referenced in one instrument (e.g., bonds or loans) and that referenced in another instrument (e.g., derivatives or other hedges).   There are distinct differences between the ARRC’s recommended fallback language for syndicated and bilateral loans and ISDA’s Protocol fallback language.  To minimize this basis risk, parties may want to remove the hedging agreement from the scope of the ISDA IBOR Fallbacks Protocol and instead incorporate the LIBOR fallback language provided for the cash market instrument.  Or vice versa.

Market participants looking to negotiate amendments to the Supplement or Protocol should initiate discussions with their counterparties before adhering to the Protocol or risk having less leverage to put bilateral amendments in place.  However, this option may be limited due to timing and manpower limitations.   Recognizing these constraints, potential adherents should approach their counterparties to address the need for amendments, e.g., to exclude certain transactions as noted above, even if any amendments are not put in place before both parties have adhered to the Protocol.

8.

Summary of alternative RFRs in selected currency areas:

The Protocol delivers a consistent, industry-wide methodology to facilitate the calculation of fallbacks across a range of derivative and financial products.  However, the Protocol is not a full-service solution for all as the effect of adherence may not be ideal for certain buy-side market participants (e.g., with underlying floating rate exposures who have hedged with interest rate derivatives).  Market participants should consider the effects of adherence on any underlying or offsetting exposures and discuss IBOR transition strategies with their counterparties.