ISDA Publishes Consultation on USD Libor Fallbacks for Derivatives

The International Swaps and Derivatives Association Inc. (ISDA) has taken a major step toward the modification of global derivatives documentation to address the anticipated discontinuation of Libor (the London Interbank Offered Rate) at the end of 2021. On May 16, 2019, ISDA published its "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" (2019 Consultation), soliciting market feedback on a variety of possible methodologies and terms to standardize the transition from certain benchmark rates to their identified successor "risk-free rates," including the transition from U.S. Dollar-denominated Libor (USD Libor) to its successor rate, the Secured Overnight Financing Rate (SOFR). The 2019 Consultation follows the publication of a similar consultation, in 2018, regarding the replacement of Libor denominated in a number of currencies other than U.S. dollars. The results of the 2019 Consultation will ultimately be used by ISDA to produce standardized terms for the fallback from USD Libor to SOFR, impacting derivatives transactions with trillions of dollars in notional amount.

Background

Libor, one of the most widely used interest rate benchmarks in the world, underlies an estimated $350 trillion of outstanding contracts in maturities ranging from overnight to more than 30 years, according to its administrator, Intercontinental Exchange (ICE) Benchmark Administration. Each London business day, Libor is produced for five currencies with seven maturities, based on an average of rates provided by a panel of participating banks, with each bank indicating the rate at which it could obtain unsecured funding for a given period in a given currency.

In 2013, against a backdrop of scandals regarding manipulation of Libor and decreased liquidity in interbank lending, the Financial Stability Board (FSB), a global body that monitors the world's financial systems, established the Official Sector Steering Group (OSSG), consisting of senior officials from central banks and regulatory authorities, to coordinate the review and reform of global interest rate benchmarks. In 2016, the OSSG launched a new initiative, focusing on the improvement of contract robustness to address concerns regarding discontinuation of certain key interest rate benchmarks. The OSSG invited ISDA to lead the initiative with respect to discontinuation and fallbacks in the derivatives market.

In 2014, in response to recommendations of the FSB, the Federal Reserve System and the Federal Reserve Bank of New York jointly created the Alternative Reference Rates Committee (ARRC), consisting of a wide variety of market participants, trade organizations and ex officio regulators. One of the ARRC's initial objectives was to identify a "risk-free alternative" rate for USD Libor and to develop a plan to implement the voluntary adoption of the alternative rate. In 2017, the ARRC identified SOFR as the replacement for USD Libor. SOFR, published daily and administered by the Federal Reserve Bank of New York, is based on more than $700 billion in overnight repurchase transactions secured by U.S. treasuries. ISDA subsequently agreed that SOFR would be the "risk-free" alternative to USD Libor for derivatives purpose as well.

Efforts regarding discontinuation of key benchmarks took on an increased urgency in 2017, as the United Kingdom's Financial Conduct Authority (FCA), the regulator of Libor, announced that it would no longer compel participating banks to provide submissions beyond 2021, giving the global financial system only a few years to prepare for the possible end of Libor.

Existing Derivatives Documentation

The vast majority of the world's derivatives transactions are documented under standardized master agreements and definitions published by ISDA, including the 2006 ISDA Definitions (2006 Definitions). The existing definitions for USD Libor (identified in the 2006 Definitions as USD-LIBOR-BBA, USD-LIBOR-BBA-Bloomberg and USD-LIBOR-LIBO) did not anticipate permanent discontinuation of the rate. Although the 2006 Definitions include certain fallback provisions, they were intended primarily to address short-term disruptions in the publication of USD Libor. In the first instance, if USD Libor is not published, the 2006 Definitions call for the calculation agent (usually one of the parties to the transaction) to determine the fallback rate by polling banks in the London market and then, failing that, polling banks in the New York market, for interbank lending rates. In addition to the risk that banks simply refuse to provide requested rates, the sheer volume and scope of transactions referencing USD Libor would make this approach impractical at best, inconsistent from transaction to transaction and potentially impossible to carry out, leaving trillions of dollars of derivative transactions with no way to calculate the floating rate or to determine the market value. As bilateral contracts, any methodology for replacement of the USD Libor floating rate would have to be agreed upon by both parties, which raises concerns regarding transfer of value as well as potential tax, accounting and other implications for participants in all sectors of the market.

2018 ISDA Consultation

In July 2018, pursuant to its mandate from the OSSG, ISDA published a market-wide consultation (2018 Consultation) seeking input on technical issues related to new benchmark fallbacks for derivatives contracts referencing a range of interbank offered rates in various currencies (each, an IBOR), excluding USD Libor. At the time, ISDA indicated that USD Libor fallback would be covered by a future consultation. The 2018 Consultation provided several approaches for calculating the replacement "risk-free" rate for each covered IBOR and solicited market feedback for each approach. ISDA indicated that, consistent with its separate but related efforts in fallback implementation, the identified replacement rates would become effective only upon the occurrence of certain objectively defined events related to actual cessation of the underlying IBOR rates.

ISDA also outlined its anticipated approach to address the bilateral nature of derivatives documentation, to be implemented once the methodology for calculating the replacement rate for each IBOR is finalized (to be based on the feedback received from the consultation and further market input). For new transactions, ISDA expects to publish an amendment to the 2006 Definitions, which would automatically amend the terms for any new transactions entered into after the date of such amendment. For existing transactions, ISDA expects to administer a standard protocol through which market participants could agree to make their existing transactions subject to the new fallbacks as long as both parties adhere to the protocol. Adherence, of course, is purely voluntary, which may undermine the efforts to harmonize the fallbacks among all market participants and may result in certain parties requiring alternate solutions.

ISDA, through an independent third party, published the results of the 2018 Consultation in December 2018, providing valuable insight into market preferences for the specified IBORs.

2019 ISDA Consultation for USD Libor

The 2019 Consultation generally follows the form and content of the 2018 Consultation as it applied to non-USD Libor. As with the 2018 Consultation, the 2019 Consultation indicates that the amendments to the USD Libor fallbacks will be implemented through an amendment to the 2006 Definitions for new transactions, and a bilateral protocol for existing transactions. Also consistent with the 2018 Consultation, the 2019 Consultation anticipates that the fallbacks would be triggered only upon actual cessation of the underlying benchmarks. The ARRC, which is separately and independently working on fallback methodologies for replacement of USD Libor in the cash markets, has proposed certain trigger events that would result in the fall back to SOFR prior to actual cessation of USD Libor, generally upon a public statement to the effect that the benchmark "is no longer representative." (See Holland & Knight alert, "Summary of ARRC's Libor Fallback Proposal for Floating Rate Notes," May 23, 2019.) As a result of this discrepancy in approach, and following a request by the ARRC to consider harmonization, ISDA has published, simultaneously with the 2019 Consultation, a separate consultation seeking market feedback on the potential use of pre-cessation triggers in the derivatives market. Differences between timing of fallback in the derivatives market and the cash market may result in additional basis risk for hedged loans in particular.

The 2019 Consultation mirrors the 2018 Consultation in soliciting input on methodologies for calculations comprising two aspects of the replacement risk-free rate (RFR) for each covered IBOR maturity. In each case, the replacement rate is the sum of an "Adjusted RFR" and a spread adjustment.

Adjusted RFR Calculations

The 2019 Consultation identifies four separate potential methods for calculating the Adjusted RFR for each Libor maturity, which match the methods identified in the 2018 Consultation. These methods are intended to account for the move, in each case, from a "term" rate to an overnight rate and are as follows:¹

• Spot Overnight Rate Approach: This would be the risk-free rate (SOFR) that sets "on the date that is one or two business days (depending on the relevant IBOR) prior to the beginning of the relevant IBOR tenor."
• Convexity-Adjusted Overnight Rate Approach: This would be similar to the Spot Overnight Rate Approach, except with a first-order modification to adjust for convexity. The 2019 Consultation states that "[t]he modification attempts to account for the difference between flat overnight interest 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. This is achieved by using an approximation in which "today's" overnight RFR is assumed to hold constant at "today's" value on each day during the relevant IBOR's tenor."
• Compounded Setting in Arrears Rate Approach: This would be based on the relevant RFR observed over the relevant IBOR tenor and compounded daily during the period. Application of this approach means that the rate for a particular period would not be known until the end of the period, which is in contrast to the calculation of USD Libor and may result in timing issues, particularly where swap payments are linked to related debt or where parties are required to budget for swap payments in advance. Based on the results of the 2018 Consultation, the overwhelming majority of respondents preferred this method for calculating the Adjusted RFR for the covered IBORs and indicative responses with respect to USD Libor were similar.
• Compounded Setting in Advance Rate Approach: As described in the 2019 Consultation, "[t]his approach is mathematically the same as the compounded setting in arrears rate approach but, while the observation period would be equal in length to the IBOR tenor, it would end immediately prior to the start of the relevant IBOR tenor so that the rate would be available at the beginning of that period." This rate would be set in advance, similar to USD Libor, but would be based on observed rates for the prior period and not based on forward-looking market expectations.

Reference is made to the 2018 Consultation, which provided, for each methodology, a number of advantages and disadvantages. It should be noted that the various documents produced thus far by the ARRC addressing fallback in the cash markets anticipate, as a first fallback, reference to "forward-looking" term RFRs. These "forward-looking term RFRs do not yet exist and ISDA's proposals do not include any reference to "forward-looking" term rates. As a result, there is likely to be some basis risk between transactions implementing the ARRC's proposals and transactions implementing ISDA's proposals. This is of particular concern with respect to hedged loans.

Spread Adjustments

As with the 2018 Consultation, the 2019 Consultation provides three alternative methodologies for calculating the spread adjustment. The spread adjustments are intended to account for the fact that the RFRs are risk-free, while the IBORs are, in part, a function of bank credit risk and other factors, including liquidity and fluctuations in supply and demand. As contemplated by the 2019 Consultation, the spread adjustment for each maturity of each IBOR will be calculated as of the business day before the fallback is triggered and will be effective when the fallback takes effect (which will, in most cases, occur after the day the fallback is actually triggered). The spread adjustment will not change once it has been set for each maturity of each IBOR.

The three methodologies for calculating the spread adjustments are as follows:²

• Forward Approach: As described in the 2019 Consultation, the spread adjustment could 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. A forward spread curve up to 30-60 years for the adjusted RFR in each relevant tenor could be published on a daily basis up until the date the fallback is triggered. Upon the permanent discontinuation of the relevant IBOR, the fallback would consist of the adjusted RFR (as published each day going forward), plus a spread based on the relevant curve (which would specify the spread to be applied for every future date and would be frozen at the point of trigger). For future dates beyond the length of the curve, the spread would remain static at the spread for the last date on the curve." This proposal also includes an option to look at an average of spreads for a specified period prior to the trigger.
• Historical Mean/Median Approach: As described in the 2019 Consultation, the spread adjustment could be "based on the mean or median spot spread between the IBOR and the Adjusted RFR calculated over a significant, static lookback period (e.g., 5 years, 10 years) prior to the relevant announcement or publication triggering the fallback provisions." The 2019 Consultation also includes some discussion of a potential transition period.
  
  Based on the results of the 2018 Consultation, a significant majority of respondents preferred this method for calculating the spread adjustment for the covered IBORs and indicative responses with respect to USD Libor were similar.
• Spot-Spread Approach: As described in the 2019 Consultation, the spread adjustment could be "based on the spot spread between the IBOR and the adjusted RFR on the day preceding the relevant announcement or publication triggering the fallback provisions. A variation would be to use the average of the daily spot spread between the IBOR and the adjusted RFR over a specified number of days (e.g., 5 trading days, 10 trading days or 1 month). This approach is similar to the historic mean/median approach but for a very short time and without the transitional period."

Conclusion

The 2019 Consultation is open for responses until July 12, 2019. ISDA intends to develop the fallback methodologies based on market response to the 2018 Consultation and the 2019 Consultation and to publish a further consultation soliciting feedback on open issues before implementing final terms. Interested market participants should closely review the various proposed methodologies and timing issues and consider the potential impact that each approach might have on its internal modeling and valuation systems, as well as potential for change in value resulting from the conversion from USD Libor to SOFR.

It is widely agreed that existing financial contracts referencing USD Libor, including loans and corresponding hedges, as well as other derivatives, will have to be modified, preferably in advance, to address the discontinuation of USD Libor. Similarly, consideration should be given to any new derivative transactions and related loans entered into prior to discontinuation. As noted earlier, the ARRC is independently developing its own trigger events and fallback methodologies (including spread adjustments) for the cash markets, including loans, which may be different from the timing and methodologies developed by ISDA for the derivatives markets through the 2019 Consultation. It is anticipated that lenders generally will want to follow ARRC's solutions, perhaps with some variation from bank to bank, while hedging desks will strongly favor ISDA's endorsed methodology and corresponding revised definitions. Differences between these methodologies could result in basis risk to end users and may have other consequences, particularly with respect to new or existing loans that are hedged by derivative transactions. Thus, market participants will want to consider amendments to loan transactions and their corresponding hedges that address USD Libor discontinuation and harmonize, to the extent possible, the trigger events and fallback rates (including spread adjustments) to reduce basis and other risks. The difficulty of that task and the length of time to achieve it should not be underestimated.

Market participants may wish to consult with their legal, tax, financial and accounting advisors with respect to the matters identified in the 2019 Consultation as well as the broader impact of the conversion from USD Libor to SOFR.

¹ Reference is made to the 2018 Consultation and the 2019 Consultation for greater detail, as well as a discussion of the positives and negatives of each approach.

² Reference is made to the 2018 Consultation and the 2019 Consultation for greater detail, as well as a discussion of the positives and negatives of each approach.

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