One of the main drivers behind the development of interest rate derivatives was the need to hedge bonds and loans that reference a floating rate of interest, typically an IBOR. In relation to a bond or a loan that references an IBOR that is hedged by a derivative, any change to the IBOR will need to be replicated exactly in the derivative in order to avoid any basis risk. Accordingly, the way that the derivatives market manages the transition from IBORs to RFRs ought to be informed by the bond and loan markets. However, that is not the approach that the derivatives market has taken, as is explained below.
Confirmations for interest rate derivatives typically incorporate the 2006 ISDA Definitions. Other definitions booklets for other derivative products that reference IBORs (e.g. equity, FX and commodity) also exist. All address, to a greater or lesser extent, the consequences of the unavailability of an IBOR but, with some exceptions, they generally only work effectively where the unavailability is temporary. They are not therefore always suitable where the IBOR has been permanently discontinued or, for that matter, where any required regulatory approval for administration, contribution or use of the IBOR does not or ceases to exist or is suspended.
In order to avoid situations whereby the performance of a derivative would be compromised, ISDA has developed a Benchmarks Supplement, (including various product-specific Annexes)which includes various fall-backs to deal with permanent IBOR discontinuance or benchmark regulatory non-compliance (where these events are not already addressed in the relevant Definitions booklet). Work is ongoing in relation to supplement the ISDA 2006 definition which, when the relevant supplement is published, will apply priority fall-backs in relation to certain designated IBORs on the occurrence of an “index cessation event”. This is designed to ensure that, where a specific IBOR is intended to transition in an orderly manner to a specified RFR, the transition occurs as intended.
The aim of these documents is to assist users of benchmarks to comply with their obligations under the EU Benchmarks Regulation and to provide for the consequences of a permanent cessation of (or of regulatory non-compliance with respect to) a benchmark, such as an IBOR, in the context of transactions that incorporate one or more of the 2006 ISDA Definitions, the 2002 ISDA Equity Derivatives Definitions, the 1998 FX and Currency Option Definitions and the 2005 ISDA Commodity Definitions. The Benchmarks Supplement was published in final form on 19 September 2018. While it is ostensibly motivated by a desire to help benchmark users to achieve compliance with the Benchmarks Regulation, it is also designed to be used more generally to ensure contractual robustness in relation to any ISDA-documented derivative contract that references a benchmark. Legacy and/or new trades that incorporate (either by way of (i) the ISDA 2018 Benchmarks Supplement Protocol published on 10 December 2018 or (ii) bilateral negotiation) the Benchmarks Supplement will automatically benefit from its fall-back provisions.
The Benchmarks Supplement provides for a waterfall of fall-backs that could apply on a permanent cessation of (or regulatory non-compliance with respect to) an IBOR, which may include:
- The parties pre-agreeing that a certain replacement benchmark will apply
- The parties agreeing that a post-event nominated replacement will apply
- Negotiation between the parties of an alternative benchmark, or
- The selection by the Calculation Agent (subject to various controls, checks and balances) of an alternative benchmark.
The fall-backs operate in parallel, rather than sequentially, and, in the event that none of them provides a solution, the ultimate remedy is no fault (i.e. mid-market) termination.
Since IBORs and RFRs are fundamentally different economic metrics, the straight substitution of an IBOR with an RFR by itself will drastically change the risk profile and economic reality of the relevant transaction. To cater for this, the Benchmarks Supplement provides that either an adjustment payment (i.e. a one-off payment between the parties) is to be paid or an adjustment spread (i.e. a spread added to the floating rate leg) is to be added to the transaction. Note that, in the absence of an adjustment spread/payment, the mark to market for the fixed rate payer (typically an end-user/borrower) under an IRS is likely to decrease (because RFRs are historically lower than the IBORs they are intended to replace, so the fixed rate payer will receive less under the contract going forward). This could have significant P&L, accounting and cash-flow consequences for such entities. Note that an adjustment spread may be preferable to a one-off payment for liquidity reasons.
The ‘trouble’ with the Benchmarks Supplement is that it is a stand-alone solution adopted for the derivatives markets. If – in relation to, say, a loan that is hedged by an interest rate swap – the parties incorporate into the former an LMA-driven IBOR-replacement solution and incorporate into the latter the Benchmarks Supplement, it is almost inevitable that IBOR discontinuance will give rise to economic mismatch i.e. basis risk. To the extent that basis risk of this sort existed in the transaction before IBOR discontinuance, this may not be an issue. But in more cash-flow critical structures, the problem will need to be addressed. In addition, the Benchmarks Supplement does not address the mechanical issues to which IBOR discontinuance or replacement gives rise. This will take place through a rewrite of the relevant Definitions booklets.
A further issue for the OTC derivatives market is whether the replacement of IBOR in legacy OTC derivative contracts will constitute a material change to such contracts i.e. a life-cycle event for the purposes of EMIR, which in turn may require such contracts to be margined and/or centrally cleared. The indications from the FCA are that it will not – although there has been nothing from e.g. ESMA on the issue (indeed ESMA Q&A suggest exactly the opposite) and there are contra-indications in the U.S. in relation to those institutions/relationships/OTC derivatives that are within scope of U.S. regulations (Dodd-Frank Act, etc.). That said, a recent ARRC letter has recommended that US regulations should not apply to legacy transactions. In the context of this confusion, the question of whether parties adhering to or incorporating the Benchmarks Supplement should do so with respect to legacy transactions remains a moot point.
A separate consideration is the extent to which IBOR replacement will necessitate accounting, regulatory capital and other adjustments in relation to affected transactions, especially where IBOR discontinuance gives rise to basis of the sort discussed above.
At the request of the Financial Stability Board’s Official Sector Steering Group, ISDA has led initiatives to establish appropriate fall-backs (such as RFRs) for certain IBORs to address the permanent discontinuation of such benchmarks. Specifically, ISDA’s working groups aim to:
- Identify fall-back triggers
- Identify alternative rates and other fall-back mechanisms
- Identify strategies for fall-back implementation
- Amend the 2006 ISDA Definitions and other definitions booklets, allowing fall-backs to be incorporated into new trades, and
- Create a protocol to incorporate fall-backs into legacy trades.
Much of this work has been completed.
In addition, ISDA, as part of a group of financial market associations, conducted a worldwide review in order to gauge readiness for the transition.
In June 2018, ISDA published a transition report, highlighting the issues raised by market participants, the most significant of which were:
- The lack of standardised documentation making the transition challenging for cash market products
- Possible basis risk arising from the lack of a standardised fall-back mechanism between financial products. Specifically, alternate fall-back rates or timings for fall-back may result in unintended exposure; and
- The risk that synthetic LIBOR continues to be submitted by dealers.
On 12 July 2018, ISDA launched a consultation on technical issues related to benchmark fall-backs for derivative contracts to address some of the items highlighted in the transition report. The ISDA consultation sought input from all (and not just derivatives) market participants regarding various approaches to term and spread adjustments that will need to be made to fall-back RFRs after the transition becomes effective to more fully align the new RFRs to the defunct IBORs. Those issues needed to be addressed because the fall-back RFRs are overnight and risk-free (or nearly risk-free), whereas the relevant IBORs have term structures and incorporate a bank credit risk premium and a variety of other factors (e.g. liquidity, fluctuations in supply and demand).
These issues and the solutions proposed by ISDA to market participants in the ISDA Consultation were:
SOFR and other RFRs are overnight rates whereas IBORs have different rates for specific tenors. Term rates are generally preferred by corporates because it enables them to quantify payments in advance. In order to address this issue, the ISDA Consultation described and requested feedback on four possible approaches to term adjustments listed below:
- Spot Overnight Rate – The fall-back rate would be the RFR 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 – The fall-back rate would be the spot overnight rate but it would be modified to account for the difference between flat overnight interest at the spot overnight rate versus the realised 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 tenor
- Compounded Setting in Arrears Rate – The fall-back would be the RFR observed by looking backwards over the relevant IBOR tenor and compounded daily during that period. One issue identified in connection with this adjustment is that the rate would not be known until the end of the relevant period. This would not enable market participants to know the rate, and therefore the amount of accrued interest, in advance
- Compounded Setting in Advance Rate – This approach would be similar to the compounded setting in arrears rate 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.
Credit Risk Spread Adjustments
IBORs take into account bank credit risk while RFRs do not. In order to avoid significant value transfer to occur because of this difference on the day the fall-back to the relevant RFR is activated, the ISDA Consultation proposed the following three possible approaches to incorporate a spread adjustment to RFRs:
- Forward Approach – The spread adjustment would be based on observed market prices for the forward spread between the relevant IBOR (to the extent such forward curves exist at the relevant time) and the adjusted RFR in the relevant tenor at the time the fall-back is triggered. This would entail comparing the two curves (relevant IBOR and fall-back RFR) and the spread between those two curves would apply. The spread would be static and would therefore not change at all. That being said, the spread in reality is not a constant number but will vary based on the differences between the two curves going out for the remaining tenor of the relevant contract.
- Historical Mean/Median Approach – The spread adjustment would be based on the mean or median spot spread between the IBOR and the adjusted RFR calculated over a significant, static look-back period (e.g. 5 years, 10 years) prior to the relevant announcement or publication triggering the fall-back provisions. This approach also provides for a one year transitional period (subject to linear interpolation) and would become finally fixed at the end of the transitional period.
- Spot-Spread Approach – 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 fall-back provisions. This is the same as the second (historical mean/median) approach but applied over a shorter period of time.
ISDA consulted on the following IBORs: GBP LIBOR, CHF LIBOR, JPY LIBOR, TIBOR, European TIBOR and BBSW. In addition it sought preliminary feedback in relation to USD LIBOR, EUR LIBOR and EURIBOR. The final report, published on 20 December 2019, PTO highlighted that the overwhelming majority of respondents preferred the ‘compounded setting in arrears rate’ for the adjusted RFR and a significant majority across different types of market participants preferred the ‘historical mean/median approach’ for the spread adjustment. It also notes that the majority of respondents preferred and use the same adjusted RFR and spread adjustment across all benchmarks covered on the consultation and potentially other benchmarks (including those on which only preliminary feedback was sought). ISDA expects to launch a supplemental consultation in early 2019 to gather further feedback in relation to these other benchmarks. It remains to be seen whether the preferred methodologies will be entirely consistent across all currencies and across the derivatives and cash markets. ISDA’s plan is to incorporate the preferred methodologies into it’s re-write of the 2006 Definition in due course.
Frequently Asked Questions
Q. Can’t I just substitute an RFR for IBOR in my swap documentation?
A. No – the metrics are different and without an adjustment (e.g. to the spread) to compensate for this, the transaction economics will be fundamentally altered. In addition, floating amounts will accrue differently, payment mechanics will alter and systems will need to be modified accordingly.
Q. Is a Protocol or similar solution to the problem contemplated?
A. Yes (and it has now been published). This enables parties (through ISDA Amend or via the ISDA web-site) to incorporate the Benchmarks Supplement into designated transactions. Parties are of course free to repaper on a transaction by transaction basis. Relevant definitions booklets will also be amended in due course to cater for mechanical issues.
Q. How does the Benchmarks Supplement work?
A. Click on the link: ISDA Benchmarks Supplement – FAQs
Q. How does the protocol work?
Check list of things to consider
- What is my intended RFR?
- When do I want the change to take effect?
- Is there to be a spread adjustment or one-off payment?
- How do I intend to amend my documentation? If through the ISDA Benchmarks Supplement, then how? By Protocol or bilaterally? Do I adhere or repaper with respect to new transactions only or new and legacy? If the latter, does that constitute a life-cycle event?
- Are there regulatory capital and/or compliance implications?
- Are there implications for payment mechanics, mark to market etc.?
- Is the transaction a hedge for another instrument? If so: (a) how is IBOR disappearance being dealt with in that instrument; (b) do I need to follow suit in the derivative transaction; (c) do I need to carve the transaction out of the Benchmarks Supplement?
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