Another Step to Benchmark Fallbacks

ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues in derivatiViews, reflecting ISDA's long-held commitment to making the market safer and more efficient.

Efforts to prepare for the use of risk-free rates (RFRs) as an alternative to LIBOR and other interbank offered rates (IBORs) continue to gather momentum. Awareness of the issue is much greater than it was a year ago, and trading volumes in over-the-counter derivatives linked to RFRs are slowly rising. We continue to believe the best possible strategy is to take action early before a cessation of LIBOR, or before any potential decline in LIBOR liquidity.

But we also recognize the need for a safety net that will allow derivatives contracts that still reference LIBOR and other IBORs to survive a discontinuation of the underlying benchmark with the minimum possible disruption.

The implementation of that safety net came a step closer this month with the publication of two new consultations on derivatives fallbacks.

One of those consultations sets out options for adjustments that will apply to the relevant RFRs if fallbacks are triggered for derivatives referencing US dollar LIBOR, Hong Kong’s HIBOR and Canada’s CDOR. As US dollar LIBOR is an input for Singapore’s SOR, the consultation also asks questions about fallbacks for SOR if US dollar LIBOR is discontinued. The consultation follows an earlier one last year that focused on six other IBORs.

The adjustments are necessary because IBORs are available in multiple tenors, but the RFRs are overnight. The IBORs also incorporate a bank credit risk premium and a variety of other factors, while RFRs do not. The adjustments are intended to ensure the contracts function as closely as possible to what the counterparties originally intended after a fallback kicks in. That doesn’t mean the adjusted RFR will exactly match the relevant IBOR – it won’t, so there will be winners and losers. That’s another reason to act early and reduce or eliminate exposure to LIBOR.

The other consultation explores pre-cessation issues, and is in response to a request by the Financial Stability Board’s Official Sector Steering Group for ISDA to ask for comment on the how derivatives market participants would address a determination that LIBOR and certain other IBORs are no longer capable of representing an underlying market.

Both consultations close on July 12, and we strongly encourage you all to make your voice heard. You can listen to a webinar that describes the consultations here.

So, what’s next?

We’re working to flesh out the parameters and mechanics of the term and spread adjustments for fallbacks. Internal work is already under way to analyze the feedback received so far and to perform sensitivity analyses. The findings will be released for comment sometime after the outstanding consultations close, likely August 2019.

We recognize how important it is for the term and spread adjustment to be independently calculated and widely available across the market. As a result, we issued a request for proposal in February for an independent service provider to calculate and publish the adjustments. We expect to announce the successful vendor later this quarter.

Finally, we aim to amend the ISDA definitions in the fourth quarter to implement fallbacks for new contracts referencing those IBORs subject to consultation so far. We’ll also publish a protocol to allow firms to modify their legacy trades to include the fallbacks. We expect the effective date for the amendments to be early 2020.

Once the alternative risk-free rate for euro – €STR – is published in October, we’ll conduct a separate consultation on the term and spread adjustments for euro LIBOR and EURIBOR fallbacks.

A lot of progress has been made in the course of a year, but – for fallbacks at least – the end is in sight. One year from now, we should have robust fallbacks in place for derivatives contracts. This will go a long way to easing the systemic implications of a sudden discontinuation of LIBOR and other IBORs.


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