Background and analysis
On 1 October 2020, ISDA received a positive business review letter from the US Department of Justice in relation to the proposals. ISDA has also discussed the proposals with other competition authorities, including the EU’s Directorate-General for Competition. Satisfied that no adverse action is anticipated in relation to the proposals, on 9 October 2020 ISDA announced the launch of the IBOR Fallbacks Supplement and the IBOR Fallbacks Protocol. The Working Group on Sterling Risk-Free Reference Rates has welcomed ISDA’s announcement and has encouraged early adherence to the Protocol.
The previously announced two-week escrow adherence period is now open. This allows key market participants to adhere “in escrow” before 23 October. ISDA hopes that this will allow a significant degree of market support to be demonstrated at the time of formal launch.
The formal launch of the Protocol and Supplement is a welcome development in the IBOR transition journey. They form part of a helpful roadmap towards uniformity in the market. However, the effectiveness of the solution set out in the Protocol and Supplement is largely dependent on the level of adherence to the Protocol. Parties seeking to adhere will also need to model the impact of the changes set out in the Protocol on their portfolio of transactions to ensure that it is fully appropriate for them, taking into account hedging across transactions.
The market reaction to the Protocol and Supplement may lead the FCA to set out its plans in relation to the anticipated amendments to the Benchmarks Regulation (as implemented by the UK) and proposals for a synthetic LIBOR in relation to “tough legacy” contracts. Please click here for our article on this development.
What do the IBOR Fallbacks Supplement and Protocol do?
The IBOR Fallbacks Protocol helps market participants with IBOR references in legacy transactions, including floating rate options in the 2006 ISDA Definitions, by incorporating the new fallbacks into the existing documentation among adhering parties.
Separately from the Protocol, these changes will also apply automatically to derivatives documentation incorporating the 2006 ISDA Definitions on or after 25 January 2021. This is because, from that date, the 2006 ISDA Definitions will be updated by the IBOR Fallbacks Supplement.
The Protocol will also cover certain other industry agreements, including stock-lending and repo documentation such as the GMRA and GMSLA.
The Protocol will remain open for adherence after the January 2021 effective date.
Can I use fallbacks to transition from the IBORs?
The Supplement and the Protocol have been developed by an ISDA working group to help market participants transition from interbank offered rates (IBORs) to the risk-free rates (RFRs) in the derivatives market. The reason for this is the expectation that IBOR rates will be discontinued or that they will become unrepresentative at the end of 2021. In order to prevent potentially serious market disruption in such an event, the Supplement and Protocol provide for IBOR exposures to be replaced with RFRs. In this way, the Supplement and the Protocol provide a tool to transition from the IBORs to RFRs for legacy transactions, though new transactions will be expected to.
What is the fallback rate?
The fallback rates that will apply are the relevant RFRs compounded over the relevant period, plus a spread (determined by reference to the historical difference between the RFR and the IBOR) as calculated and published by Bloomberg. For instance, in the case of LIBOR, the relevant successor rate is compounded SONIA.
It is worth noting that the default fallback rate may not be appropriate, or desirable, in all circumstances. Issues may also arise if market participants have different fallback rate calculation mechanisms across different documents on a related transaction. This can lead to mismatches and liability issues that arise, for example, where multiple exposures exist on one transaction.
Governing law and disputes relating to adherence to the Protocol
The Protocol and each Adherence Letter are stated to be governed by English law. However, the amendments under the Protocol to each “Protocol Covered Document” (being the ISDAs and other documents covered by the Protocol) are to be governed by the law specified to govern that Protocol Covered Document.
The form of Adherence Letter annexed to the Protocol provides for disputes in relation to adherence to be referred to arbitration under the Rules of Arbitration of the International Chamber of Commerce (the Rules) by three arbitrators.
Next steps and issues
- Consider whether the Protocol is appropriate for your portfolio of transactions. In particular, parties should consider whether there are transactions or agreements that they wish to exclude bilaterally from the Protocol. Parties cannot, through the Protocol mechanism itself, elect to include only some, but not all, transactions or agreements. Adherence is on an “all or nothing” basis and any exclusions must be agreed bilaterally.
- Consider adhering to the Protocol now in escrow (if eligible) or once it opens for general adherence from 23 October 2020.
- The Implementation Date with respect to any two Adhering Parties will be the date of acceptance by ISDA, as agent, of an Adherence Letter (in accordance with paragraph 1(b) of the Protocol) from the later of such two Adhering Parties. As such, the timing of any calculations and payments under the Protocol Covered Documents should be carefully monitored to avoid errors and defaults. The Implementation Date varies where an Agent (for example, an asset manager with the relevant authority) is involved in providing adherence to the Protocol.
- The underlying governing law of the Protocol Covered Documents should be considered to ensure it does not contain restrictions on a party’s ability to adhere to the Protocol and implement changes to the Protocol Covered Documents.
- Parties should consider the “universe” of contacts to which the Protocol applies. The Protocol applies to a much wider range of documents than the parties might expect and is typically the case for ISDA Protocols. Parties should consider the impact of the Protocol on other agreements that they have entered into that should not be covered by the Protocol. For example, there may be restrictions on amending derivates contracts entered into in support of a wider transaction, there may be transactions where third party consents are required and separate amendments may need to be made to ensure that IBOR transition takes place consistently across transactions and portfolios.
- The changes to be implemented to Protocol Covered Documents by virtue of the Protocol may also affect transactions that have specific hedging strategies in place and any agreements entered into in relation to the hedges put in place in support of the transaction. These should be considered and any related changes put in place if a party is considering adhering to the Protocol. This is to avoid breaches, defaults and unexpected liabilities.
- The Protocol includes representations and warranties akin to the “Basic Representations” in clause 3 of the ISDA 2002 Master Agreement. This includes a representation that the execution, delivery and performance under the Protocol do not violate or conflict with any contractual restriction binding on or affecting an Adhering Party or any of its assets. This should be considered carefully prior to adhering to the Protocol, in particular considering any third party consents or other restrictions referred to above.
- Agents and Trustees seeking to adhere to the Protocol should consider carefully on whose behalf they are providing Adherence Letters and whether they can do so by virtue of their powers to implement substantive changes to the transaction documents. In this regard, considerations may also need to be given to their duties and the terms of any communications they are sending to parties.
- Financial institutions that have been advising on hedging strategies and provided services to hedge exposures on deals should carefully consider the impact of the Protocol and Supplement to, for example, ensure they are continuing to comply with their duties and obligations.
On the ISDA Benchmarks website you can find the links to the finalised IBOR Fallbacks Supplement, the IBOR Fallback Protocol, the Protocol FAQs and the bilateral template documents. Please click here for the ISDA Benchmarks website.