ISDA LIBOR Fallbacks Protocol alert for financial institutions
The ISDA IBOR Fallbacks Protocol (the Protocol) will be made available this Friday, October 23, 2020, with adherence being free until January 25, 2021. Chatham will be sending a bulletin this coming Friday to all clients, however; the below message is meant to provide specific details on the impact of the Protocol to our financial institution clients.
The London Interbank Offered Rate (LIBOR) has been used extensively as a reference rate in a range of financial products and instruments for more than 40 years. The Financial Conduct Authority (FCA) previously announced that after December 2021, they will no longer compel banks to submit rates for the calculation of LIBOR, which may lead to a permanent cessation of this benchmark.
As a result, the International Swaps and Derivatives Association (ISDA) is updating its ISDA Definitions (the Definitions) to reflect what happens if and when LIBOR and other IBORs cease to function as a benchmark rate, as well as to provide fallback rates. The current Definitions contain fallback language that describe a mathematical average of rates offered by “reference banks”. The amended Definitions will remove the current fallback, define the parameters of an index cessation event, and address fallbacks upon the occurrence of a temporary or permanent unavailability of a relevant rate. The effective date of amended Definitions will occur on January 25, 2021. Therefore, any transaction executed after the effective date of the amended Definitions will automatically include the updated fallbacks for LIBOR to the extent such Definitions are included in the ISDA Schedule or Confirmation.
What will LIBOR be replaced with?
The Secured Overnight Financing Rate (SOFR) has been selected to be the replacement rate/index for USD LIBOR by the Alternative Reference Rates Committee and ISDA has designated a fallback SOFR index as the replacement rate for derivative transactions currently tied to USD LIBOR.
Understanding the Protocol
In conjunction with the release of the amended Definitions, ISDA has also published the IBOR Fallbacks Protocol. The Protocol is a mechanism that allows for the amended Definitions to be incorporated into existing trades. ISDA has also made language available that accomplishes the fallback changes so that counterparties may amend contracts outside of adhering to the Protocol. The release of the ISDA IBOR Fallbacks Protocol is this Friday, October 23, 2020.
The Protocol facilitates the inclusion of the amended Definitions into existing derivatives contracts. The fallbacks, as it pertains to USD-LIBOR, in the Definitions will be triggered upon:
- A public statement or publication of information by the LIBOR administrator announcing that it has ceased or will cease to provide LIBOR permanently or indefinitely; or
- A public statement or publication of information by the regulatory supervisor for the administrator of LIBOR, the UK central bank, an insolvency official with jurisdiction over the LIBOR administrator, or a court with authority over the LIBOR administrator, which states that the LIBOR administrator has ceased or will cease to provide LIBOR permanently or indefinitely.
Please note that the fallbacks do not go into effect until the actual discontinuation of LIBOR — not upon adherence to the Protocol or when the amended Definitions are effective.
Adherence to the Protocol
Broad adherence to the Protocol is universal and will amend any ISDA between two adhering parties. The Protocol does not apply to documentation governing cleared transactions, although similar amendments will likely be applied through the rulebooks of each central counterparty. Further, the Protocol is also not meant to apply to agreements for cash products. Adjustments to account for the spread differential between LIBOR and SOFR will be incorporated via the Protocol as well.
The Protocol is free to the buy-side (e.g., non-primary ISDA members) during the adherence period, or until January 25, 2021. After that time, the Protocol will cost $500 per adherence.
Both parties must adhere for the Protocol to apply to the relevant trade documentation. Some parties may prefer to incorporate the fallback definitions via a “bilateral” approach utilizing the language that ISDA has provided. While there isn’t a one-size-fits-all approach for all institutions, we believe that the ISDA IBOR Fallbacks Protocol is likely the preferred solution for most institutions and customers if you have a customer-facing hedging program.
Ensure that your institution has reviewed and understands the relevant timeline:
- October 23, 2020, ISDA IBOR Fallbacks Protocol open for adherence
- January 25, 2021, ISDA Definitions updated with fallback definitions and Protocol begins to cost $500 (also date when both CME and LCH intend to update rulebooks with fallback definitions)
- TBD, LIBOR announced to be non-representative and date set for LIBOR ceasing to exist, referred to as the index cessation event
- TBD, LIBOR ceases to exist, fallback definitions kick in, but only for transactions that have been amended or updated via the Protocol (LIBOR falls back to Fallback SOFR), referred to as the index cessation effective date
Beginning October 23, parties may adhere to the Protocol. As such, financial institutions should familiarize themselves with the Protocol and work with their LIBOR transition teams on the considerations with respect to the institution’s hedging programs. Institutions should plan on how and when to adhere to the Protocol for derivatives transactions and should also incorporate necessary fallback definitions into any cash product that might require specification.
It is of critical importance that financial institutions are aware that action must be taken on existing derivative contracts prior to the cessation of LIBOR. There is no default or mechanism by which unamended ISDAs will automatically convert to SOFR.
The LIBOR transition will pose complex challenges for many organizations, and we recommend you share this alert with your LIBOR transition teams. In the next week, your Chatham client relationship manager will contact you with more specific information regarding adherence to the Protocol, how the Protocol may impact your hedging program, and more. In the meantime, we encourage you to reach out to discuss your intended approach to adherence and transition, along with any questions. For more LIBOR transition information please visit Chatham’s LIBOR transition insights page.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.20-0407
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