On June 4, 2021, drafts of the new 2021 ISDA Interest Rate Derivatives Definitions and related documentation are scheduled to become public.1 The 2021 ISDA Definitions are scheduled to go into effect on October 4, 2021. What effect will this have on current US dollar rates disclosures in medium-term note program prospectus supplements?
Up to now, draftspersons have turned to the descriptions of the various interest rates in the 2006 ISDA Definitions and generally closely conformed rates disclosures to those descriptions. Those days are over – we are now living in the "Matrix." To be specific, when drafting rates disclosure, one must first turn to the "2021 ISDA Interest Rate Derivatives Floating Rate Matrix" to determine which provisions, particularly related to fallbacks, to include in the description of the relevant rate.
The US dollar portion of the Matrix lists the following rates, together with cross-references to the main 2021 ISDA Definitions for various characteristics of each rate, including fallbacks: Ameribor (overnight, 30- and 90-day averages, and a forward-looking term rate), USD BSBY, CMT, the 11th District Cost of Funds Rate,2 Commercial Paper, Federal Funds (effective and OIS compounded), LIBOR, LIBOR ICE Swap Rate, Municipal Swap Index, Overnight Bank Funding Rate, Prime Rate, S&P Index High Grade, SOFR (OIS Compound and overnight) and US Treasury Bills (secondary market). The Constant Maturity Swap rate ("CMS") is not included in the Matrix. The 2021 ISDA Definitions allow for the use of rates not included in the Matrix.
How does one use the Matrix? Let's take the red pill and proceed.
WHAT TYPE OF RATE IS THIS?
It's helpful to compare the differences in two common rates to understand how the Matrix works. In this case, we'll look at the Commercial Paper rate ("CP") and the Federal Funds rate ("FFE").
The first three columns in the Matrix are "Category/Style," "Underlying Benchmark" and "Designated Maturity." For CP, the category is "Calculated Rate," the "Style" is "Specified Formula" and the specified formula is Money Market Yield. The Underlying Benchmark is "US Dollar Commercial paper-Nonfinancial" and the Designated Maturity is applicable.
In contrast, the category for FFE is "Screen Rate" and the style is "Overnight Rate." The Underlying Benchmark is "the US Dollar effective federal funds rate ('EFFR')" and the Designated Maturity is "Not Applicable." What does this mean?
CP has always been calculated as the "money market yield," with part of that formula being the rate published in H.15(519) for the relevant maturity (the Designated Maturity), and the other part of that formula being the actual number of days in the interest period.3 The Matrix simply breaks out the elements, noting that this rate is calculated, listing the money market yield formula (which is included in the 2021 ISDA Definitions), and one must know the Designated Maturity (1-, 2- or 3-months) to perform the calculation.4
The FFE is a Screen Rate, overnight, with no Designated Maturity. This makes sense, as the FFE is published on H.15(519) and is also available from commercial vendors, like Bloomberg or Refinitiv. No calculations are required to determine the FFE.
The next several columns in the Matrix cover some mechanical aspects of these rates: the "Fixing Time," which is the time of day to take the rate, the "Fixing Day," which tells you what day to take the rate in relation to the reset date, the rate's administrator (Board of Governors of the Federal Reserve System for CP, Federal Reserve Bank of New York for FFE) and the day count fraction.5
THE NEW FALLBACKS
The familiar polling fallback provisions, known generically as "Reference Banks," are nowhere in the Matrix. The shortcomings and potential problems inherent in using the Reference Banks provisions are well known, and have been replaced with a new fallback regime, which will be familiar to those conversant with the ARRC's recommended USD LIBOR fallbacks or the SOFR fallbacks.
The "Applicable Fallback Rate" column is "not applicable" for each of CP and FFE. For USD LIBOR, the fallback is SOFR; for SOFR, the fallback is the "Fed Recommended Rate, or any subsequent fallback contemplated with the Permanent Cessation Fallbacks for SOFR."
Because there is no Applicable Fallback Rate for either CP or FFE, we need to sort through the Temporary Non-Publication Trigger/Temporary Non-Publication Fallback, the Permanent Cessation Trigger/Permanent Cessation Fallback, and then the Administrator/Benchmark Event/Administrator Benchmark Fallback. As these column headings imply, the new fallbacks cover temporary and permanent cessations of the rate. A third option, essentially impracticability, is also covered.
However, the application for a temporary publication cessation is quite simple. The Matrix tells us that the Temporary Non-Publication Trigger is the Standard Temporary Non-Publication Trigger. The Standard Temporary Non-Publication Trigger for a floating rate note using the Matrix means "the Applicable Benchmark (here, CP or FFE) is not published by the Administrator or an authorized distributor and is not otherwise provided by the Administrator by either (a) the later of (I) the Reset Date and (II) the Fixing Day or (b) such other date on which the Applicable Benchmark is required ...."
If a Standard Temporary Non-Publication Trigger occurs, the Matrix guides us to the answer: use the Temporary Non-Publication Fallback in the Matrix. For both CP and FFE, that is the previous day's rate (the "last provided or published level of that Applicable Benchmark").6 Even the Oracle couldn't beat that for simplicity. This is also a massive improvement on going to polling for a temporary disruption in a rate's publication.
However, if the parties agree, polling could be chosen for a Temporary Non-Publication Fallback, as "Reference Banks" is still an option in the 2021 ISDA Definitions.7
What if publication of either CP or FFE permanently ceases, or as discussed below, use of the rate become impracticable? Again, instead of polling, the solution is similar to the ARRC's USD LIBOR recommended fallbacks, or the current fallbacks for Compounded SOFR. To determine whether a Permanent Cessation Trigger has occurred, one must check the choice in the Matrix which, unless the parties specify otherwise, is "Index Cessation Event."
An Index Cessation Event includes two events, with an option for a third. The first two events are:
- a public statement or publication of information by or on behalf of the Administrator of the Applicable Benchmark announcing that it has ceased or will cease to provide the Applicable Benchmark permanently or indefinitely, provided that, at the time of the statement or publication, there is no successor administrator or provider, as applicable, that will continue to provide the Applicable Benchmark;
- a public statement or publication of information by the regulatory supervisor for the Administrator of the Applicable Benchmark, the central bank for the currency of the Applicable Benchmark, an insolvency official with jurisdiction over the Administrator for the Applicable Benchmark, a resolution authority with jurisdiction over the Administrator for the Applicable Benchmark or a court or an entity with similar insolvency or resolution authority over the Administrator for the Applicable Benchmark, which states that the Administrator of the Applicable Benchmark has ceased or will cease to provide the Applicable Benchmark permanently or indefinitely, provided that, at the time of the statement or publication, there is no successor administrator or provider that will continue to provide the Applicable Benchmark ....
These two subparagraphs are identical to the definition of "Benchmark Transition Event" for both USD LIBOR and SOFR. If "Non-Representative" is indicated in the Matrix, such as for USD LIBOR (but not for CP and FFE), a third paragraph of the definition of Index Cessation Event is included:
- a public statement or publication of information by the regulatory supervisor for the Administrator of the Applicable Benchmark announcing that (I) the regulatory supervisor has determined that such Applicable Benchmark is no longer, or as of a specified future date will no longer be, representative of the underlying market and economic reality that such Applicable Benchmark is intended to measure and that representativeness will not be restored and (II) it is being made in the awareness that the statement or publication will engage certain contractual triggers for fallbacks activated by pre-cessation announcements by such supervisor (howsoever described) in contracts ....8
If an Index Cessation Event has occurred, we would move on to the designated Permanent Cessation Fallback, which, for both CP and FFE, is "Generic Fallback Provisions." However, there is another way that we might end up at the Generic Fallback Provisions.
Instead of an Index Cessation Event, there could be what is defined as an "Administrator/Benchmark Event." The Matrix designates this as applicable for all USD rates. An Administrator/Benchmark Event is defined as "the delivery of a notice by one party to the other specifying, and citing Publicly Available Information that reasonably confirms events or circumstances which have the effect that either or both of the parties or the Calculation Agent is not, or will not be, permitted under any applicable law or regulation to use the Applicable Benchmark to perform its or their obligations under the Transaction ...." Upon the occurrence of an Administrator/Benchmark Event, the parties would, for CP and FFE, proceed under the Generic Fallback Provisions.
The Generic Fallback Provisions are a set of wide-ranging options that apply when a Permanent Cessation Trigger occurs or a transaction potentially may fail due to an Administrator/Benchmark Event. Some of the Generic Fallback Provisions may not be workable for floating rate notes, and the parties to the transaction may elect to deviate from the requirements. The general thrust of the Generic Fallback Provisions is that the parties to the transaction (the issuer and the trustee, on behalf of the holders, in the case of floating rate notes) must work in good faith to go through each of the "Alternative Continuation Fallbacks" to get to a "Continuation Amendment."9 A Continuation Amendment means "an amendment to the terms of the Transaction to allow the Transaction to continue in accordance with its terms as amended in accordance with the relevant Alternative Continuation Fallback."10
There are five Alternative Continuation Fallbacks:
- Agreement between the parties;
- Application of Alternative Pre-nominated Index;
- Application of Alternative Post-nominated Index;
- Application of Calculation Agent Nominated Replacement Index; and
- No fault termination.
For floating rate notes, the second option is likely the most workable. In this case, and in the context of floating rate notes, the issuer would specify in the offering document for the notes and in the notes the Alternative Pre-nominated Index, which is defined as "the first of the indices, benchmarks or other price sources specified by the parties as an 'Alternative Pre-nominated Index' that is not subject to a Fallback Trigger."11 As the definition implies, the issuer could specify more than one replacement rate.
If this Alternative Continuation Fallback were to be used, then:
the terms of the Transaction shall be adjusted so that (a) references to the Impacted Index are replaced by references to the Alternative Pre-nominated Index, (b) if the parties agree to an Adjustment Payment, the Adjustment Payment shall be made in accordance with that agreement or, if the parties do not agree to an Adjustment Payment, the Calculation Agent shall apply the Adjustment Spread to the Alternative Pre-nominated Index and (c) the Calculation Agent shall, after taking into account any Adjustment Payment or Adjustment Spread, make any other adjustments to the Transaction that are necessary to account for the effect on the Transaction of referencing the Alternative Pre-nominated Index.12
Life Outside of the Matrix
As mentioned above, the CMS Rate is not included in the Matrix. Issuers have generally settled on provisions for temporary non-publication and permanent cessation of the CMS Rate, and are unlikely to change them in response to the 2021 ISDA Definitions.
Between now and October 4, issuers will need to revisit their MTN program disclosures of US dollar rates and update them in response to the 2021 ISDA Definitions. It remains to be seen how the market will respond, and whether a uniform approach will develop. Redrafting in a way that is understandable to the investor will be a challenge.
1. This article is based on a review of finalized pre-publication drafts.
2. The COFI Rate will cease publication on December 31, 2021.
3. "Money Market Yield" is defined at Section 6.8.2 of the 2021 ISDA Definitions.
4. H.15(519) can be accessed at: The Fed - Selected Interest Rates (Daily) - H.15 - May 14, 2021 (federalreserve.gov). The terms "Screen Rate," "Calculated Rate," "Screen Rate Style," "Calculated Rate Style" and "Specified Formula" are defined in Sections 6.5.1(i) and (ii), 6.5.2, 6.5.3 and 6.5.3(iii), respectively, of the 2021 ISDA Definitions. USD T-Bill Secondary Market Bond Equivalent Yield is also a Calculated Rate, with the Specified Formula being the Bond Equivalent Yield.
5. "Fixing Day" and "Fixing Time" are defined in Sections 6.6.5 and 6.6.6, respectively, of the 2021 ISDA Definitions.
6. "Temporary Non-Publication Trigger," "Standard Temporary Non-Publication Trigger" and "Temporary Non-Publication Fallback" are, for floating rate notes, defined in Sections 8.1.1(i), 8.1.2(i) and 8.1.3(i), respectively, of the 2021 ISDA Definitions.
7. See Section 8.1.6 of the 2021 ISDA Definitions.
8. "Permanent Cessation Trigger," "Permanent Cessation Fallback," "Index Cessation Event" and "Non-Representative" are, for floating rate notes, defined in Sections 8.2.1(i), 8.2.2(i), 8.2.3 and 8.2.5, respectively, of the 2021 ISDA Definitions.
9. See Sections 8.6.1(i) and 8.6.2 of the 2021 ISDA Definitions.
10. Section 8.7.2 of the 2021 ISDA Definitions.
11. "Alternative Pre-nominated Index" is defined in Section 8.7.3 of the 2021 ISDA Definitions.
12. See Section 8.6.3(ii) of the 2021 ISDA Definitions.
Originally published in REVERSEinquiries: Volume 4, Issue
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