On January 25, 2021, ISDA’s 2020 IBOR Fallbacks Protocol (the Protocol) came into effect, enabling parties to certain documents to amend their terms using provisions set out in Supplement 70 to the 2006 ISDA Definitions (the Supplement). This is a major landmark for the derivatives industry as it prepares for the replacement of IBORs with risk free reference rates (RFRs).
While the Protocol was never intended to resolve all the industry’s issues arising from transition, there are some commonly traded derivatives products which, it was hoped, would be successfully addressed by it, but which are not. This article highlights some of these.
The Supplement amends the 2006 ISDA Definitions by including new IBOR fallbacks in the definitions of certain GBP, USD, EUR, CHF and JPY IBORs. As interest rates based on IBORs are phased out and new RFRs introduced in their stead, it is important that the definition of an IBOR referenced in an ISDA document includes appropriate fallback language providing for an RFR to replace the IBOR following the latter’s cessation. This is what the Supplement intends to achieve.
As of January 25, 2021, the new definitions provided by the Supplement apply to all subsequently traded derivatives using the relevant IBORs. In contrast, those derivatives entered into before January 25, 2021 will only be amended to include the fallback RFRs if the parties have adhered to the Protocol. To date, over 12,000 companies, organizations and, in some instances, individuals from around the world have adhered to the Protocol.
Common interest rate derivative payment flows for which the Protocol may not solve
The Protocol resolves issues relating to payment flows based on IBORs. Most derivatives involve two payment flows, and some derivatives involve more. When considering whether the Protocol resolves the issues arising from IBOR transition in relation to a derivatives portfolio, each payment flow must be analyzed individually.
Constant maturity swaps
If the derivative involves swapping an IBOR payment flow for a fixed rate, the fixed rate leg will generate no issues. However, if the IBOR payment flow is exchanged for a swap rate, as is often the case in constant maturity swaps, the Protocol will only remediate the IBOR payment flow; it will not amend the definitions of swap rates. While it may well be that the benchmark administrators for all such swap rates will provide solutions in time, there is currently a risk that, when LIBOR ceases, it may not be possible to publish those swap rates settings that use a LIBOR as the floating leg for the relevant interest rate swap. Constant maturity swaps may require separate remediation in these circumstances.
The confirmation of the derivative may contain its own fallback language, and such language may be inconsistent with the Protocol. In the event of any inconsistency between a confirmation and the relevant ISDA Definitions, the confirmation will usually provide for the terms of the confirmation to govern. As such, confirmations that contain fallback language of their own may be unaffected by the “remediating” fallback language in the relevant ISDA Definitions.