A new milestone on the IBOR reform road

ISDA Fallbacks Supplement and Protocol

A new milestone on the IBOR reform road

On 23 October 2020, the International Swaps and Derivatives Association (ISDA) launched the IBOR Fallbacks Supplement to the 2006 ISDA Definitions and the ISDA 2020 IBOR Fallbacks Protocol. The supplement and the amendments resulting from the protocol will take effect on 25 January 2021.

What are they?

Both the supplement and the protocol have been developed by ISDA and are meant to help market participants in the events of:

  • the discontinuation of LIBOR per 1 January 2022.
  • the possibility that in the current period LIBOR could cease to be representative of the underlying market which it is intended to measure.

The supplement amends the definitions of the floating rate options, included in the 2006 Definitions, by incorporating risk-free rates (RFRs) as fallback rates. Fallbacks will apply when certain events are triggered, such as the permanent cessation of IBOR or temporary non-publication of the rate. It covers IBOR rates for the following currencies: GBP, CHF, USD, EUR (not EURIBOR), JPY, AUD, CAD, HKD, SGD, and THB.

Fallback rate

The IBOR rate (term rate) and the RFR (overnight rate) are different by nature and cannot be simply substituted without changing the underlying contract. Therefore, the replacement RFR needs to be adjusted.

The first adjustment is that the RFR rate needs to be compounded over the payment period. The payments become in-arrears (the rate to be paid is known at the end of the period) compared to the IBOR rate, which is a payment in advance (the rate to be paid is known at the beginning of the period).

The second adjustment is the addition of a spread to consider that the IBOR is not a risk-free rate (liquidity spread, credit spread). This spread is calculated using the five years historical difference between the compounded RFR and the IBOR. The replacement rate (adjusted RFR plus spread) is calculated and published by Bloomberg. It should be noted that, at the cessation event, the spread will be fixed and static.

The third adjustment is triggered by the backward looking of the adjusted RFR (in-arrears) to give operational time, the calculation period is shifted back by two business days.

Which contracts?

Per 25 January 2021, all new derivatives contracts that incorporate the 2006 ISDA Definitions and reference one of the covered IBORs will contain the new fallbacks.

For legacy contracts, the new fallbacks will be incorporated in the contracts if both counterparties have adhered to the protocol or otherwise bilaterally agreed to include the new fallbacks in their contracts.

And now?

It is strongly recommended for firms to remove their LIBOR dependencies. The launch of these fallbacks is a good step in removing a piece of uncertainty in the long IBOR reform road. However, firms need to consider all their instruments before agreeing with the fallbacks, as they only cover the derivatives. If the derivatives are used to hedge other instruments, such as loan facilities not covered by the fallbacks), for example, it is recommended to look at the hedge relation in its whole in order to avoid mismatches.