What happens to contracts with a notional value of trillions of dollars if they refer to a benchmark that no longer exists? This has always been one of the big challenges associated with the transition from the London Interbank Offered Rate (LIBOR) to an alternative reference rate (ARR), once LIBOR is phased out at the end of 2021. Now, the answer is getting clearer.
After several years of preparation, the International Swaps and Derivatives Association (ISDA) has published its official Fallback Protocol, optionally replacing legacy trades where both parties adhere, and a supplement, updating definitions that have been in effect since 2006. The protocol applies to derivative trades that reference LIBOR or certain other Interbank Borrowing Rates (IBOR) benchmarks. According to the protocol, if such a benchmark is no longer published — what ISDA calls a “permanent cessation” — certain references to that benchmark rate will change. More specifically, benchmark rates will “fall back” to a new benchmark in contracts that are governed by Master ISDA agreements and existed before the effective date, provided that the counterparties have both agreed to adhere to the protocol. For new ISDA trades, executed on or after the protocol supplement’s effective date, the new definitions will automatically apply.
The fallback rules are expected to promote fairness and transparency by providing market participants a clear calculation of what the replacement rate would be when LIBOR is no longer available. But incorporating a fallback may not make transition issues go away. In fact, even relying on the protocol as intended could be complicated, particularly for financial institutions that trade billions of dollars of swaps each day. We believe that for most market participants, adhering to the protocol is the right approach, but you’ll want to complete a proper due diligence review. Here is a rundown of what lies ahead.
The ISDA fallback protocol (and its supplement) is only intended to be a backup plan. Some describe the protocol as a seatbelt: it can prevent serious injuries in case of a crash, but it’s much wiser to avoid the crash in the first place. ISDA itself encourages companies to sign the protocol — and then, close out positions that could be affected and voluntarily convert to instruments that reference ARRs where possible, before LIBOR becomes unavailable. This will give you the greatest chance of completing the transition with economic hedges and investments that are appropriate for your goals.
The ISDA protocol is intended to be comprehensive. It covers the majority of derivative exposure, by notional value, across a range of currencies. Under the protocol, US dollar LIBOR transactions would fall back to the Secured Overnight Financing Rate (SOFR). Similarly, UK Sterling LIBOR would revert to the Sterling Overnight Index Average (SONIA). There are also ARR benchmarks defined for the potential cessation of other key LIBORs and IBORs, covering six other currencies: Australian, Canadian and Hong Kong Dollars; Swiss Franc; Euro; and Japanese Yen.
That said, the protocol specifically applies to ISDA contracts and, under certain conditions, certain other contracts. It doesn’t apply to cash instruments or cleared derivatives (though there will likely be alignment, as discussed below), non-ISDA derivatives repos, securities lending. Some of these products may be scoped in, but it should be clear that “is intended to be comprehensive” is not the same as “covers everything.”
The protocol directly applies to non-cleared derivatives — though cleared derivatives will effectively be converted too. The rules cover derivatives that are governed by a Master ISDA agreement and not cleared through a central counterparty (CCP). Contracts cleared through CME and LCH are guided by the rules of those CCPs. ISDA notes that its rules should be consistent, as the clearing houses will use the powers in their rulebooks to implement the ISDA fallbacks in their legacy cleared derivatives transactions as well, once the new definitions take effect. Still, some differences may be expected: for example, CCP rules are unlikely to be voluntary for legacy trades, and this may create breaks with non-cleared contracts, as well as other potential breaks depending on final rulebooks. We also note that other CCPs may handle the transition differently.
The protocol generally aligns with cash instruments, though there are differences. This is not designed to cover cash products such as floating rate notes, syndicated loans and securitizations, or bilateral business loans. Unlike derivatives, which are all governed by ISDA, these cash instruments have less consistency across their contracts. They will be guided by recommendations from the national ARR working groups, such as the Alternative Reference Rates Committee (ARRC) in the US. The ARRC is a group of private market participants convened by the Federal Reserve Board and the Federal Reserve Bank of New York. It has largely aligned its own fallback recommendations for cash products with the ISDA approach. To sync with ISDA’s “triggers” for derivatives, ARRC has tried to align both the permanent cessation and the “pre-cessation” triggers that would start the benchmark replacement for loans. Still, we note that ARRC’s guidance is just that — and in any event, meaningful differences remain. For example, many loan contracts are likely to revert to Daily Simple SOFR; meanwhile, ISDA relies on an overnight rate, pulling from daily fixing throughout an instrument’s tenor and then compounded in arrears. A more detailed discussion of these differences is beyond the scope of this article. Similarly, these comments apply to USD and GBP, but they may not apply equally to other LIBOR and IBOR fallbacks.
To keep the transition as economically neutral as possible for both parties, going forward, there is a clearly defined methodology. LIBOR includes a forward-looking credit component, known in advance. In contrast, SOFR is considered a “risk-free rate” (RFR): it is based on an average of overnight, secured lending. To account for LIBOR’s term risk premium, ISDA consulted with a broad group of market participants, examining various ways to calculate an appropriate spread adjustment that could be applied to the risk-free rate (RFR). It settled on a five-year lookback at the median of the historical spread between a particular currency-tenor of LIBOR and its corresponding, term-adjusted alternative reference rate. So, when replacing a three month USD LIBOR transaction, one could calculate SOFR’s overnight value, compounded in arrears over the same tenor (i.e. three months). Payments could be settled quarterly, at the end of the period (once SOFR’s value for the period is known), building in the predefined spread adjustment.
Fallback calculations are now available. Bloomberg Index Services Ltd., the vendor that ISDA selected to calculate the fallback rates for derivatives covered by its Master Agreements, has started to calculate and publish these rates. In fact, these figures are now available as individual components — the fallback rate, the adjusted RFR (compounded in arrears) and the credit spread adjustment — for 11 indices across eight currencies, with multiple tenor bases for each. That means financial institutions can already start assessing the fallback ramifications, such as the potential impact of transition on their ISDA derivative portfolios.
Despite ISDA’s helping hand, financial institutions face market risk. Credit spreads are inherently dynamic. If your LIBOR-pegged derivative switches to SOFR, but your corresponding cash instrument does not, or does not migrate in exactly the same way, then you potentially have a mismatched hedge — particularly since the recommendations and implementation for cash instruments is still a work-in-progress in some cases. This transition introduces basis risk, particularly as it is not a given that all types of products will transition at the same time, and you should determine its materiality based on your circumstances.
Similarly, we note that the credit spread adjustment between SOFR and LIBOR floats today, but it will eventually be fixed, and LIBOR’s replacement will simply be SOFR plus that spread (for ISDA derivatives). This fixing could happen upon LIBOR’s cessation, when banks stop reporting interbank lending rates to LIBOR’s administrator, Intercontinental Exchange Benchmark Administration (ICE BA). It could also happen if ICE BA or its regulator, the UK Financial Conduct Authority (FCA), were to make a “pre-cessation announcement” that LIBOR will have become (or already has become) non-representative of the underlying market the rates seek to measure. Either ICE BA or FCA could issue a statement to clarify the timeline about the future ‘non-representativeness’ of LIBOR, before the end of 2020. Such a “death notice” would likely include the date of cessation, or, if applicable, the date from which the relevant LIBOR settings are not going to be representative. So, firms could be making assumptions about future rates for 2022 based on SOFR plus a spread adjustment that is locked in this fall.
The transition will be operationally complex. Even if 100% of market participants sign on to the protocol and apply it uniformly, companies would still need to carry out some level of system development and operational planning. Hedges may become economically decoupled from underlying cash instrument positions if they apply different conventions for the same reference rates or, perhaps, different benchmarks; this could make asset and liability management (ALM) more complicated. Implementing the protocol itself could be more challenging with certain non-linear derivative products. Finally, currency-tenor pairs may not all follow the same transition timeline: some may be declared non-representative or stop being published earlier than others. For firms that hold financial instruments with exposure to different currencies and tenors, this could add a lot of operational complexity when implementing the protocol.
The ISDA protocol has broad regulatory and industry support. While the adoption of the ISDA protocol is voluntary, it provides a widely recognized measure of protection against the potential for contractual chaos. Regulators around the world have recommended adopting it, and some have put it in stark terms. Edwin Schooling Latter, Director of Markets and Wholesale Policy at the FCA, recently said it seemed “a huge risk” for a firm to not sign the protocol. He added, “any UK regulated firm with major uncleared derivative exposures that chooses not to sign will need to be ready for some serious questions from our supervisors on how they will mitigate these risks.”
 From a speech by Edwin Schooling Latter to an ISDA event on July 14, 2020 on “The Latest in LIBOR Transition, The Path Forward,” retrieved Oct. 6, 2020.
We expect widespread adoption of the protocol; indeed, many large market participants signed up “in escrow,” ahead of the protocol’s launch. We generally see the benefits of signing on as greater than the challenges from doing so. After all, if you and your business partners agree to automatically incorporate the new provisions in your contracts, you still have the opportunity to voluntarily close out or restructure your LIBOR derivative positions. By adhering to the protocol, you are effectively creating a backstop for all of your non-cleared derivatives at once — and in any case, once the new definitions take effect, any new instruments will automatically include these revised terms. To be fair, some firms may feel that their bargaining power to renegotiate positions could be reduced once they sign up. We also note that even firms that sign onto the protocol could still face both operational and market risks.
Operational risk. As we note in point #1 above, this fallback protocol is a long-awaited, crucial step in the LIBOR transition, but it should be seen as a start rather than an end. Once it is in place, firms should expect an ongoing period of negotiation as LIBOR-denominated transactions are unwound or novated — but we believe many firms are still unprepared for the reviews that lie ahead. After all, even after signing the protocol, counterparties can still agree to different terms bilaterally for select trades even after signing the protocol.
But if you are approached with an offer to change terms in this way, will you know what constitutes a good deal? Many firms may not be prepared to manage this process, given that they’ll need to do this at scale, under time pressure, while also coping with a pandemic. We have also seen little indication that firms are prepared to track the status of trade-level overrides which may be necessary for derivatives hedging cash instruments such as loans and bonds.
Market risk: One of ISDA’s key considerations has been to eliminate or minimize value transfer at the time the fallback is applied. Still, market participants will inevitably face risk, given that an IBOR is being replaced. As we’ve seen, SOFR and LIBOR are structurally different, and so hedges that had been effective might soon be somewhat mismatched. Additionally, ARRs have different levels of market liquidity and volatility, relative to LIBOR and each other. You should analyze how your portfolio's value could be affected across a number of different LIBOR transition and interest rate scenarios.
To be clear, you could face some degree of this basis risk on virtually every trade, whether or not you sign on to the protocol. The majority of the market is expected to adhere to the new ISDA terms, as LCH and CME have indicated they will do, and market participants that choose not to adhere could introduce more risk. Still, you’ll want to understand what basis risk you might be introducing by applying (or nor applying) the protocol. This will depend on the composition of your book of business, as well as the ultimate relationship between LIBOR and SOFR at the time of transition. You may be able to model scenarios over these outcomes, especially as indicative fallback spread adjustments are now being calculated and published. Of course, even after you’ve signed up for the Protocol, you may still conduct bilateral negotiations to transition contracts to SOFR or other rates in an effort to reduce your LIBOR exposure.
After several years of planning, the industry is now moving quickly toward winding down one of the pillars of modern finance. The ISDA fallback protocol is a key step; it provides a safety valve to prevent the massive derivatives market from seizing up. In the coming months, we expect most firms to rally around the agreement — but as we’ve noted, you’ll still have work to do if you sign on, to confirm that your interests and, for issuers, your clients’ interests are protected.
If you haven’t made LIBOR transition planning a key priority yet, it’s time to move. The decisions are starting to come quickly, and the stakes are too high to “wing it.” Whether or not derivatives are a key part of your business, you’ll want to approach this with a firm plan in mind. In fact, the entire LIBOR transition is highly interconnected, drawing on systems and other resources from across geographies and business units. While you can look at each step independently — the ISDA fallback process, valuation, accounting implications, back-office integration, etc. — you’re far more likely to get the outcomes you want by managing them consistently and transparently, with a view to the bigger picture.
Global Financial Services Leader, PwC US
Partner, PwC US
Financial Services, Principal, PwC US
Financial Services, Partner, PwC US
Capital Markets Strategy Partner, PwC US
Asset & Wealth Management, Partner, PwC US