1. Why is ISDA working on developing fallbacks for LIBOR and other key IBORs?
The Official Sector Steering Group (OSSG) approached ISDA in 2016 and requested that ISDA embark on an initiative designed to improve the contractual robustness of contracts referencing IBOR rates.
2. What are the objectives of the ISDA working groups?
Selection of a fallback rate, or if determined necessary, fallback rates and/or other fallback mechanisms, that would apply in the event that the applicable IBOR is permanently discontinued.
Amendments to the 2006 ISDA Definitions to add selected fallbacks that would apply upon any such permanent discontinuation.
Development of a proposed plan to amend legacy contracts referencing the applicable IBORs to include the amended definitions, including potential development of a protocol mechanism to facilitate multilateral amendments.
3. What would LIBOR or theother key IBORs fall back to if such rates were permanently discontinued today (or at any time before fallbacks are implemented)?
In the 2006 ISDA Definitions, LIBOR and most other key IBORs currently fallback to a poll of four major banks in the relevant interbank market i.e. London for any LIBOR, the Euro-zone for EURIBOR, Hong Kong for HIBOR etc.. If this initial dealer poll procures fewer than two quotations, the calculation agent will poll major banks in the relevant city i.e. Sydney for AUD-LIBOR, Toronto for CAD-LIBOR etc..
There are some exceptions, for example AUD-BBR-BBSW falls back to a poll of five major banks in Sydney in the first instance, however upon procuring less than the required two quotations it will be the responsibility of the calculation agent to determine the rate having regard to comparable available indices.
4. What problems arise as a result of these current fallbacks?
One of the main problems is the potential for divergence in the application of fallbacks. This would create basis risk for institutions and a significant degree of market fragmentation, which may have negative consequences for financial stability.
For example, an individual institution may have a portfolio of trades that are cleared through a number of different clearing houses. Certain clearing houses may incorporate the 2006 ISDA Definitions into their rulebooks, whilst others may not. Most clearing houses will also have their own fallback methodologies. This could create basis risk in an institution’s cleared trading book, which could be exacerbated by additional differences between the fallbacks applicable to cleared and uncleared trades. Finally, futures exchanges and other electronic trading platforms may utilize their own fallback methodology, creating even further inconsistency across a trading portfolio.
As well as basis risk within a derivatives portfolio, the triggering of LIBOR/IBOR fallbacks may also create basis risk between the derivative and the financial exposure it is being used to hedge against. For example, a loan referencing LIBOR would look to the bank’s cost of funding in the event of LIBOR discontinuation. A bond, on the other hand, would reference a previous LIBOR fixing post-discontinuation. Upon LIBOR discontinuation, there would be basis risk between both of these products and the corresponding LIBOR swap, which would fall back to dealer poll in London followed by dealer poll in the relevant country pursuant to the currency of the swap.
We note that a number of these bases risks may exist under the current fallbacks architecture. ISDA is liaising with market participants, infrastructure providers and various trade associations in order to align the approach and work towards a cross-product solution.
Another issue relates to the process of polling reference banks. In their 2014 report, Reforming Major Interest Rate Benchmarks the OSSG noted that in the post-global financial crisis environment, this methodology was unlikely to be sustainable, especially since it needed to be repeated in respect of every payment date.
5. What is “contractual robustness”?
Derivatives and other financial instruments with a fallback or fallbacks that unambiguously set out the steps that would follow in the event that the reference rate is permanently discontinued.
6. Why is contractual robustness important?
Contractual certainty and robustness are essential in fostering market confidence, upholding market stability and mitigating against the potentially damaging impact of market fragmentation.
7. How would derivatives counterparties know that a fallback has been triggered?
All of the proposed triggers require a public statement:
A public statement by the supervisor of the relevant IBOR administrator of the insolvency of such IBOR administrator (and there is no successor administrator that will continue publication of the relevant IBOR);
a public statement by the relevant IBOR administrator that it will cease publishing the relevant IBOR permanently or indefinitely (and there is no successor administrator that will continue publication of the relevant IBOR);
a public statement by the supervisor for the relevant IBOR administrator that the relevant IBOR has been permanently or indefinitely discontinued; or
a public statement by the supervisor for the relevant IBOR administrator that the relevant IBOR may no longer be used.
8. What does “may no longer be used” mean in the last trigger above?
It means an actual public prohibition on the use of the relevant IBOR by the IBOR’s supervisor.
It would not include a statement that the supervisor “no longer supports” the benchmark, or certain aspects of the benchmark.
9. Instead of agreeing to contractual fallbacks that would apply upon the permanent discontinuation of LIBOR or another IBOR, could the administrators for the IBORs switch to a methodology that does not require panel bank submissions?
This is a question for the relevant administrator and, most likely, the supervisor for the relevant administrator. Among other things, the administrator would have to ensure that the governing documents for the applicable IBOR allow for such a change. Another relevant consideration would be whether this type of change in methodology would result in “contract frustration” on the grounds that the rate is no longer the rate that counterparties intended to reference when they entered into the relevant contract.
Specific Fallback Rates
10. How will the fallback rates be selected?
The ISDA working groups are likely to determine that the most suitable fallback rates are the alternative rates selected by the relevant risk-free rate working groups. Among other things, these risk-free rate working groups are implementing transition plans to increase liquidity in the rates and encourage trading in them as alternatives to the relevant IBORs.
For other IBORs, local regulators provided guidance on their preferred fallback rate through the FSB OSSG.
Risk-Free Rate Working Groups
11. How is work to develop fallbacks different than the work of the risk-free rate working groups?
Although arising out of different regulatory initiatives, there are a number of common issues between fallbacks and the transition towards near risk-free rates, which can lead to confusion.
It is important, however, to bifurcate the two work streams as their differing dynamics might mean that their common issues call for different solutions.
The transition to near risk-free rates, for example, will likely occur under fairly stable market conditions. The process will involve a commercial negotiation whilst LIBOR or the relevant IBOR is still in existence. The objective should be to produce a mutually beneficial result.
Conversely, LIBOR/IBOR fallbacks will almost inevitably only be relevant during times of market stress arising as a result of the discontinuation of a key reference rate underpinning a huge number of financial contracts. The outcome may not be the perfect solution, but the objective should be to minimise market disruption and maintain contractual continuity.
Amendments to Definitions and Protocol
12. How will the 2006 ISDA Definitions be amended?
Currently we do not know the precise form of amendment mechanic. We will update this FAQ when further discussions and consultation have been undertaken.
13. How would a protocol to amend legacy transactions work?
We expect that the protocol would be straightforward and provide that any contracts referencing one of the relevant IBORs would be deemed to reference the relevant IBOR with the fallback.
As with other ISDA protocols, the amendments would apply to contracts between adhering parties. This multilateral amendment process would avoid counterparties having to enter into many thousands of bilateral amendments.
Note that the protocol would not amend contracts that adhering parties entered into with counterparties that do not also adhere to the protocol.
We are working with regulators to scope and implement fallback solutions as soon as possible. The precise timing for implementation will be confirmed in due course.
14. Would a protocol apply to cleared transactions? If not, how would legacy cleared transactions be amended?
CCPs do not typically adhere to ISDA protocols, please consult with your contacts at the relevant clearing houses for further information on their plans to amend legacy trades to incorporate the fallbacks.
15. Will ISDA amend the 2000 ISDA Definitions?
ISDA does not intend to amend the 2000 ISDA Definitions but will consider whether a protocol to amend legacy contracts needs to cover contracts based on the definition of a relevant IBOR in the 2000 ISDA Definitions.
Coordination between Derivatives and Other Financial Instruments
16. What will happen under documents for other financial products that reference an IBOR if the IBOR is permanently discontinued?
ISDA is currently liaising with trade associations for loans, bonds and other financial instruments that reference IBORs, with a focus on those that are hedged by derivatives. The terms of relevant documentation for those instruments must be analyzed separately but ISDA is committed to coordinating with these trade associations and implementing fallbacks that would support hedges.
17. What would happen if financial instruments and the derivatives that hedge them have different fallbacks?
This will create basis risk between the two exposures and may lead to imperfect hedging, although we note that this likely already exists under the current fallbacks system. For further details, see question 4 above.
Spreads and Term Fixings
18. Why is a spread necessary for fallbacks?
Unlike IBORs, the alternative risk-free rates selected or under consideration by the risk-free rate working groups are overnight risk-free rates that do not account for interbank credit risk. If the fallback is triggered, it would be necessary to apply a spread to it to account for this difference in order to avoid or minimize the transfer of economic value from one party to the other.
19. How will spreads be calculated?
The methodology is still under development and ISDA will consult market participants before finalizing anything.
The intention is to provide a methodology that can be universally adopted so that market fragmentation is avoided.
20. How will term IBORs fallback to overnight risk-free rates?
This question is still under consideration. The OSSG has expressed the view that the ISDA working groups should not wait for forward-looking term rates to be developed by the risk-free rates working groups but should identify an interim solution. ISDA will keep market participants apprised as this work progresses.
The ISDA working groups understand that term fixings are very important, particularly for end users.
21. When will the ISDA working groups finalize the fallbacks?
We are working with regulators to scope and implement fallback solutions as soon as possible. The precise timing for implementation will be confirmed in due course.Fallbacks may be implemented at different times for different IBORs.