ISDA: Get Ready for 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.
— ISDA (@ISDA) December 16, 2021
It’s now just a matter of weeks until 30 LIBOR settings either cease to exist or become non-representative. At that point, fallbacks will automatically kick in for a large proportion of derivatives that continue to reference those LIBOR tenors, creating a safety net for those transactions that hadn’t switched to alternative reference rates before the end-December deadline. But that doesn’t mean those firms relying on fallbacks don’t need to prepare – there are several implications from fallbacks taking effect that participants need to consider.
Fallbacks were never designed to be a primary means of transition, but feedback from market participants suggests more firms than anticipated will switch via this method. It’s therefore vital that people fully understand what the fallbacks are and how they differ from market standard conventions.
The fallbacks are based on risk-free rates (RFRs) but with an adjustment to reflect a portion of the structural differences between interbank offered rates (IBORs) and RFRs, intended to ensure trades previously negotiated to reference an IBOR continue to meet the original objectives of the counterparties as far as possible. Following multiple industry consultations, it was determined that the fallback for each IBOR setting will be based on the relevant RFR compounded in arrears with a shift, plus a spread adjustment calculated using a historical median approach over a five-year lookback period.
Importantly, the compounded in arrears methodology incorporates a backward shift to the calculation period, meant to ensure payment amounts are known at least two days before they are due. However, this differs from standard RFR overnight index swaps, which typically have a payment delay – a convention also being adopted by clearing houses when converting legacy cleared LIBOR derivatives trades to RFRs (albeit with a spread adjustment on the RFR leg or a cash adjustment to compensate for any changes in valuation).
The fallback rates are also published by Bloomberg, whereas a calculation agent usually computes the value of overnight index swaps at the end of each period. Firms should make sure they review both Bloomberg’s IBOR Fallback Rate Adjustments Rule Book and the contractual language to ensure they fully understand how publication and the backward shift will function.
The differences in conventions mean there will inevitably be variations between cleared trades and non-cleared trades that have relied on fallbacks – as well as between cash instruments that may have applied different methodologies. Modifications to systems and processes may be required as a result to account for these differences, although market participants may choose to bilaterally negotiate changes to their reference rates over time to reduce discrepancies.
Another important point to understand is when the fallbacks will take effect. For non-cleared derivatives referencing euro LIBOR, sterling LIBOR, Swiss franc LIBOR and yen LIBOR that incorporate the fallbacks, the replacement rates will apply on January 4, the first London banking day after cessation/non-representativeness – although they will only have an impact on payment calculations on the subsequent reset date for each trade, which will occur at different times and may be many months later.
One-week and two-month US dollar LIBOR will also cease after December 31, but the RFR-based fallbacks will not immediately take effect for these settings. Instead, the rate for the one-week and two-month US dollar LIBOR settings will be computed by each calculation agent using linear interpolation between the next shorter and next longer tenors that continue to be published. The fallbacks for all US dollar LIBOR settings will then apply after the end of June 2023, when the remaining US dollar LIBOR tenors cease or become non-representative.
As US dollar LIBOR is a component in the calculation of the Singapore dollar Swap Offer Rate and the Thai Baht Interest Rate Fixing, fallbacks for these rates will also apply after June 30, 2023.
Both public and private sectors have worked together closely over the past four-and-a-half years to tackle one of the biggest challenges ever to face financial markets and to ensure transition is as smooth as possible. The development of robust fallbacks for derivatives has been a critical part of that effort, and significantly reduces the potential for systemic risk. The fact that nearly 15,000 entities across 90 jurisdictions have now adhered to the ISDA 2020 IBOR Fallbacks Protocol shows the global support this solution has gained. But firms relying on those fallbacks should spend the next few weeks tying up any last loose ends to make sure they’re ready for LIBOR’s demise.
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