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.
Hedging instruments
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.
This issue arises most commonly in relation to interest rate swaps intended to hedge a floating rate arising under another transaction (for example, a loan). It is important to identify these swaps and to assess, first, whether the transaction to which the swap links contains fallback language of its own (and, if so, whether the fallback language in the hedged instrument has the same practical effect as the fallback language under the Protocol), and secondly, which of the two rates – (a) the rate defined by the Protocol, or (b) the rate in the hedged instrument – would emerge as the dominant rate in the event of a conflict between the application of the two. It will often be the case that the relevant confirmation will explicitly designate the rate in the hedged instrument as the dominant rate, in which case the Protocol will be of little practical application to the swap. In these cases, it becomes vital that the rate in the hedged instrument contains appropriate fallback language of its own. In other cases, there may be some ambiguity as to which rate is dominant, and unless the two rates have substantially the same fallback result, parties may wish expressly to exclude the Protocol from applying to transactions of this nature.
Trades where the floating rate interest is affected on dates other than reset dates
The Supplement’s definitions of the various IBORs explicitly apply the fallback wording for each of the rates by reference to Reset Dates. An IBOR rate for a non-Reset Date – for example, for an Observation Date in a structured cap or floor – will remain undefined; parties may yet need to amend their confirmations to introduce appropriate fallback language for these rates.
Economic consequences
Even in cases where the legal terms of a trade covered by the Protocol work perfectly well, unintended economic consequences may still result from a switch from a forward-looking IBOR to a backward-looking RFR. Unintended economic consequences may arise, for instance, in standard knockout provisions: while it may still be possible to make sense of the provision following the Protocol, the economic implications of a knockout operating in arrear, rather than on a forward-looking basis, may be significant. In this context, the Working Group on Sterling Risk-Free Reference Rates has published a table detailing its thoughts on the economic equivalence of non-linear derivatives based on compounded-in-arrear SONIA to their LIBOR versions.
Conclusion
The Protocol is certainly of practical use for parties with large portfolios that require transitioning to RFRs; adhering to the Protocol speeds up and facilitates the process and lowers the cost of bilaterally amending multiple trades across multiple counterparties. However, adherence to the Protocol alone is not a cure-all solution; there remains a need to ensure counterparties also adhere to the Protocol, failing which the trade will not be covered by the Protocol.
Further, documents should only be amended en masse via the Protocol if there is a good understanding of the types of trades that comprise the portfolio. Ambiguity or inconsistency in a document can be a side effect and, even where the Protocol works perfectly well from a legal perspective, there can be unintended economic consequences.
ISDA has helpfully produced template language for parties wishing to exclude certain transactions from falling within the scope of the Protocol, and to adopt other solutions to LIBOR transition. Happily, these template provisions can also be used by both parties even after they have adhered to the Protocol to rectify issues they had not considered before they did so.
Client Alert 2021-035
