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.
January 14, 2021
More than 5,900 entities across roughly 70 jurisdictions have so far adhered to an ISDA protocol that will allow firms to incorporate new, more robust fallbacks into existing derivatives contracts linked to LIBOR and other key interbank offered rates (IBORs). That’s a big number, and drums home just how important viable fallbacks are. But with less than two weeks to go until the new fallbacks take effect, now’s the time for those who haven’t considered this to take action. The alternative is not having a clear back-up rate in place in the event an IBOR disappears – a situation that would create massive uncertainty for firms and their counterparties.
The new fallbacks were never intended to be a primary means of transition – they are instead a one-size-fits-all safety net intended to mitigate the systemic impact of an IBOR cessation in the worst-case scenario. Various regulators have recommended that firms implement robust, well-defined fallbacks in their derivatives contracts as a first step, and then use the remainder of 2021 to proactively negotiate a shift from LIBOR to alternative reference rates in order to achieve more tailored outcomes. Firms would then be safe in the knowledge that if they don’t finish their transition efforts in time, a workable back-up will automatically kick in.
The January 25 effective date follows the October 23 launch of the IBOR Fallbacks Supplement (which incorporates the fallbacks into new IBOR derivatives referencing the 2006 ISDA Definitions entered into from the effective date) and the IBOR Fallbacks Protocol (which inserts the fallbacks into legacy non-cleared derivatives with other counterparties that choose to adhere to the protocol). Publication of these documents was necessary because existing fallbacks simply won’t work in the event an IBOR is permanently unavailable – a scenario set to occur for most LIBOR settings at the end of 2021.
Under current fallback arrangements, the calculation agent would be required to call dealers for estimates of where LIBOR would have been had it been published – something dealers almost certainly won’t do if an IBOR permanently ceases to exist. This would result in a potentially chaotic situation where any potential replacement rate is uncertain, cannot be predicted in advance and may differ trade to trade.
In contrast, the new fallbacks will provide a viable back-up based on a clear, consistent and transparent methodology if an IBOR ceases to exist or, in the case of LIBOR, the UK Financial Conduct Authority determines that the rate is no longer representative of the underlying market.
To be clear, fallbacks and voluntary transition are very much meant to work in tandem – it’s not an either/or choice. The new fallbacks can be incorporated into legacy trades by the protocol or via bilateral negotiation (and ISDA has published templates to help with this). But, as the ISDA board of directors has stated, the protocol “is the most efficient way for participants in the vast majority of non-cleared derivatives markets to mitigate against the risks associated with the discontinuation of a key IBOR”.
The protocol will remain open after the January 25 effective date. But time is short until the end of 2021, when all sterling, euro, Swiss franc and yen LIBOR settings and one-week and two-month US dollar LIBOR are expected to cease publication. A lot remains to be done in that time, including tackling tough legacy exposures for which there is no easy contractual solution. More than 5,900 firms from Barbados to Bahrain have taken the decision to adhere to the protocol now and, at a stroke, remove the risk across much of their portfolio of an IBOR ceasing to exist while they still have derivatives exposure linked to that rate. It’s not too late to join them.