ISDA's IBOR Fallbacks Protocol FAQ

Interest rate markets continue to transition from IBOR (USD LIBOR, GBP LIBOR, etc.) to alternative risk-free rates (RFRs — SOFR, SONIA, etc.). The International Swaps and Derivatives Association (ISDA) released final forms of documentation designed to facilitate a smooth transition to RFRs in hedging markets. To help you understand ISDA’s release, Chatham has provided an explanation of how these documents will affect your existing and future interest rate hedges. We welcome you to contact us with questions on how these changes will affect your organization.

What documents has ISDA published to transition caps and swaps from LIBOR to SOFR?

On October 23, 2020, ISDA is expected to publish the following documents designed to facilitate a smooth transition. These documents will take effect on January 25, 2021:

• ISDA 2020 IBOR Fallbacks Protocol: ISDA designed their protocol to facilitate bulk (multilateral) amendments to hedge documentation to include their updated fallback methodology in existing IBOR-based derivatives, including caps, swaps, and other floating-rate interest hedging transactions
• IBOR Fallbacks Supplement: this updates ISDA’s fallback methodology, as codified in the 2006 ISDA Definitions, to accommodate a permanent transition from IBORs to risk-free rates (SOFR, SONIA, etc.)

What are the 2006 ISDA Definitions?

ISDA periodically publishes basic definitions of key economic terms for the documentation and implementation of derivative transactions. The 2006 ISDA Definitions serve as an update of the 2000 ISDA Definitions and are intended for use in confirmations and individual transactions governed by ISDA Master Agreements. ISDA has updated their definitions over time through the publication of a series of Supplements that apply to a given transaction or set of transactions.

What are the ISDA 2020 IBOR Fallbacks Protocol and IBOR Fallbacks Supplement?

ISDA 2020 IBOR Fallbacks Protocol

The ISDA 2020 IBOR Fallbacks Protocol provides market participants with a mechanism to amend their existing derivatives contracts that reference interbank offered rates (IBORs). If both parties adhere to the Protocol, any “Protocol Covered Documents” between them will be amended in accordance with the terms of the Protocol. Specifically, the Protocol will amend derivatives contracts that have incorporated the following Definitions Booklets published by ISDA:

• the 2006 ISDA Definitions
• the 2000 ISDA Definitions
• the 1998 ISDA Euro Definitions
• the 1998 Supplement to the 1991 ISDA Definitions
• the 1991 ISDA Definitions

The list of Protocol Covered Documents, which will be published as an Annex to the Protocol, is broad and includes:

• ISDA Master Agreements (including Schedules)
• ISDA-published credit support documentation (e.g., Credit Support Annexes and Deeds)
• ISDA trade confirmations
• select non-ISDA derivatives agreements and credit support documentation

It is important to note, however, that the IBOR Fallbacks Protocol doesn’t apply to documentation governing cleared transactions. Parties instead should refer to the rules of their central counterparty for cleared trades, as these rules may contain similar amendments or terms in the event of cessation of an IBOR.

IBOR Fallbacks Supplement

ISDA’s IBOR Fallbacks Supplement amends the 2006 ISDA Definitions by creating new floating rate option definitions that include robust fallback provisions applicable in the event of cessation of an applicable IBOR or fallback index. The Protocol amends each Protocol Covered Document to apply a consistent approach to address the risk of IBORs being discontinued or becoming no longer representative of the market. The Protocol incorporates all new floating rate option definitions and more robust fallback provisions contained within the IBOR Fallbacks Supplement. This includes technical adjustments when necessary for agreements using another Definitions Booklet or referencing the IBOR into these covered legacy contracts.

What trigger, fallback rate, and spread adjustment do the Protocol and Supplement contemplate?

The main issues in transitioning a given loan or derivative from an IBOR to an RFR are:

• Fallback trigger: what will give rise to a transition from an IBOR?
• Fallback rate: what rate will replace an IBOR?
• Spread adjustment: how will the loan spread and derivative economics be adjusted to reflect any difference between an IBOR and its replacement rate?

Trigger

The Protocol and Supplement contemplate both temporary and permanent cessation triggers in the event an IBOR is unavailable:

• Temporary cessation trigger: the benchmark administrator or distributor has not provided or published the relevant IBOR. Under a temporary cessation trigger, the relevant IBOR is expected to be published again in the future, but some event or situation caused a short-term cessation of the publication of the relevant IBOR.
• Permanent cessation trigger: the benchmark administrator or its supervisor makes a public statement or publication, noting that an IBOR has ceased or will cease to provide the applicable IBOR. Two of the triggers included in fallback language for all IBORs addressed in the Supplement will be “permanent cessation” triggers.
• Pre-cessation trigger: when the relevant IBOR has been officially declared as no longer representative of the underlying market and the announcement is made in awareness that it will trigger contractual fallbacks. This “pre-cessation” trigger is only applicable to specific LIBOR indices, including USD LIBOR and EUR LIBOR.

In the event of a temporary cessation trigger, the amended 2006 ISDA Definitions allow for the use of a substitute rate agreed by the parties, recommended by the administrator of the IBOR (or its supervisor), or if neither are available, as determined by the Calculation Agent named under the derivatives contract. In the event of either of the permanent or pre-cessation triggers listed above, the contract will use the named Fallback Rate in respect of the relevant IBOR starting from the date on which the IBOR is permanently discontinued (or, in the case of the LIBOR rates to which a pre-cessation trigger applies, the date such rate is no longer representative).

Fallback rate

The Fallback Rate for each IBOR will be a term-adjusted risk-free rate (RFR); for USD LIBOR, the risk-free rate to be used as the fallback is SOFR, with GBP LIBOR falling back to SONIA. SOFR will be compounded daily in arrears and, with a spread adjustment (further discussed below) added to the compounded RFR, will serve as the applicable “all-in” rate which will be used as the new index going forward under the derivative contract.

The amended 2006 ISDA Definitions also include fallback provisions that apply should the applicable Fallback Rate, index, or tenor in turn become unavailable. The triggers will be similar in nature to the temporary and permanent cessation triggers noted above (excluding the pre-cessation trigger, which is only relevant initially to a cessation of specific IBORs), and upon a permanent cessation of a Fallback Rate, the new index would be one recommended by the relevant governmental authority. Some rates have a waterfall of additional indices named beyond this “recommended rate,” which could apply in the event of further cessations of the applicable index.

Spread adjustment

The spread adjustment methodology uses the median over a five-year period of historical differences between the IBOR and the RFR compounded over each corresponding period. The spread adjustment will be calculated looking back from the date of the public announcement causing the trigger event to take place, not from the date of discontinuance or the date the rate is no longer representative; therefore, the timing for the spread adjustment calculation will vary from the timing implementing the new rate under the derivatives contract.

How do I adopt the ISDA 2020 IBOR Fallbacks Protocol?

“Protocol adherence” is the method by which a party recognizes and announces that they agree to be bound by a relevant ISDA Protocol, which amends their legacy agreement(s). Any party interested in adhering to the ISDA 2020 IBOR Fallbacks Protocol should visit the Protocols section of the ISDA website and select the relevant protocol. Adherents must provide certain information, including contact details, legal entity identifier (LEI) or other identification number, and adherence authority, after which the adherent will receive a form adherence letter for download. The adherent then has 90 days to sign (by hand or electronically) and upload the adherence letter to the ISDA protocol system for approval.

A party’s adherence to the ISDA 2020 IBOR Fallbacks Protocol is publicly searchable. To encourage widespread adoption, adherence is free for non-primary ISDA members during the three-month period between the Protocol Publication Date, October 23, 2020, and the Protocol Effective Date, January 25, 2021. Primary members and parties who adhere after the Protocol Effective Date must submit a onetime fee of USD 500 before or in conjunction with the Adherence Letter.

ISDA also has published a series of bilateral templates that parties may use in addition to Protocol adherence to (a) exclude certain agreements/transactions from the application of the Protocol; (b) add fallback language to agreements that would not otherwise be modified; or (c) disapply pre-cessation triggers.

Besides the ISDA Protocol, are there other ways to update my derivatives documents on account of IBOR transition?

In addition to the Protocol and bilateral templates that modify it, derivatives counterparties also may use bilateral (i.e., one-off), non-Protocol amendments to provide more flexibility around IBOR fallbacks, whether they want to incorporate Protocol-like terms or otherwise (and to eliminate the need to pay ISDA’s USD 500 Protocol-adherence fee). While adherence to the Protocol provides a standardized approach and automatically applies to all Protocol Covered Documents where your counterparty has also adhered, bilateral agreements are customizable and thereby permit and require individual negotiation. Some may prefer to use these bilateral templates to better match their loan and interest rate hedge fallback methodologies.

ISDA has published two bilateral IBOR fallback templates that parties may use in lieu of negotiating their own custom document. ISDA’s intention is to publish both a Short Form and Long Form version of their Bilateral Amendment Agreement, which will be made available at the same time the Protocol is released. The Short Form Bilateral incorporates the terms of the Protocol by reference, while the Long Form Bilateral is a restatement of the Protocol with the additional flexibility to modify those terms.

How might the Protocol fallback methodology differ from the fallback in my debt agreements?

Because loan fallback language in most cases was negotiated bilaterally between a borrower and lender, the extent to which the Protocol fallback provisions and your company’s specific debt fallback language are aligned will vary on a case-by-case basis. For example, the fallback methodology in the Protocol and the methodology in the ARRC recommended fallback language for syndicated loans will differ in certain ways. With your advisor, review any relevant fallback language in your debt documentation to determine the potential impacts it may have in the event you adhere to the Protocol.

What LIBOR transition-related resources are available?

Chatham Financial has prepared the following resources:

• LIBOR transition insights
• USD LIBOR to SOFR transition
  • SOFR: An end user's guide
  • USD LIBOR transition to SOFR FAQ
  • USD LIBOR transition quarterly market brief
  • USD LIBOR transaction activity update
• GBP LIBOR to SONIA transition
  • SONIA: An end user's guide
  • GBP LIBOR transition to SONIA FAQ
  • GBP LIBOR transition quarterly market brief
  • GBP LIBOR transaction activity update

The New York Fed publishes the following SOFR rates each business day at 8 a.m. EST:

• Daily spot SOFR
• SOFR averages - compounded averages of the SOFR over rolling 30-, 90-, and 180-calendar day periods
• SOFR index - reflects the cumulative impact of compounding the SOFR on a unit of investment over time, allowing for calculation of compounded SOFR averages over custom time periods

Some key players in LIBOR transition have published:

• ARRC: Recommended Best Practices for Completing the Transition from LIBOR (May 2020)
• Fannie Mae and Freddie Mac: LIBOR Transition Playbook (June 2020)
• ISDA: Benchmark Reform and Transition from LIBOR (first published May 2020)
• FASB: Reference Rate Reform