The International Swaps and Derivatives Association, Inc. ("ISDA") has finally published its long-awaited "Amendments to the 2006 ISDA Definitions to include new IBOR fallbacks" under the unassuming name "Supplement number 70 to the 2006 ISDA Definitions" ("IBOR Supplement"),1 accompanying "protocol" ("Protocol"), 2 and a series of accompanying bilateral template agreements and language ("Bilateral Templates"). 3 The Protocol will be open for adherence on October 23, 2020, and the IBOR Supplement is "effective" January 15, 2021, which means that all derivatives transacted on or after that date incorporating the 2006 ISDA Definitions will automatically incorporate the IBOR Supplement.
Briefly stated, the IBOR Supplement updates the 2006 ISDA Definitions to amend existing "Floating Rate Option" definitions that reference certain "inter-bank offered rates" ("IBORs") to include workable "fallback" provisions to facilitate a transition to "(nearly) risk-free rates" ("RFRs") 4 in the event one or more IBORs, as a result of regulatory pressure or otherwise, cease to exist. Most pertinently, the London Interbank Offered Rate(s) ("LIBOR") is widely expected to cease to exist in whole or in part in early 2022. 5 The 2006 ISDA Definitions in their current form are ill-equipped to handle such a cessation.
Publication of the Protocol represents an immediate "go/no-go" decision point for the over-the-counter derivatives market. The Protocol provides market participants a "one-stop" opportunity to amend all (but not less than all, absent bilaterally agreed exclusions) of their existing derivatives with other "Adhering Parties" in accordance with the "IBOR fallbacks" as described in the IBOR Supplement.
he IBOR Supplement and Protocol accordingly provide critically important tools in the transition from IBORs to RFRs for interest rate and other over-the-counter derivatives across a range of major currencies. Over-the-counter derivatives, by some estimates, represent approximately 75% of IBOR exposure globally. 6 Jones Day has been monitoring, advising clients, and writing about the IBOR transition in the derivatives and other markets since the outset. 7
RFR TRANSITION—GENERAL BACKGROUND
IBORs, in very broad strokes, represent (or are meant to represent) the cost of funding in the inter-bank market over a variety of currencies and tenors. LIBOR is perhaps the most prominent IBOR and is actually a series of rates that encompasses five currencies (the United States dollar ("USD"), British pound sterling ("GBP"), euro ("EUR"), Japanese yen ("JPY"), and Swiss franc ("CHF")) and seven maturities ranging from overnight to 12 months.8 IBORs are compiled from individual bank submissions that, because of a decline in actual reportable inter-bank deposit activity, are increasingly based on "expert judgment."9 IBORs accordingly: (i) have a term structure; (ii) implicitly embed bank credit risk; and (iii) are not necessarily based on "actual transactions."
RFRs, on the other hand, exhibit the polar opposite features. Although the details for specific RFRs differ, they universally reflect actual market activity and are calculated and reported on a next-day basis. They are also strictly overnight transactions that have no term structure and, because they are overnight (and because some of them, like the Secured Financing Overnight Rate ("SOFR")10 for USD, are collateralized), they are "(nearly) risk-free."
These fundamental differences make IBOR cessation and the transition to RFRs extremely challenging (economically, legally, and operationally) for both future transactions and "legacy" transactions. "Synthetic term" structures must be developed to replicate the term structures in IBORs,11 and the bank credit risk inherent in IBORs must be calculated and added to RFRs to minimize the "value transfer" that would otherwise occur if even "synthetic term" RFRs were simply "substituted" for IBORs on a one-to-one basis. This is, of course, because "(nearly) risk-free" rates would be expected, in any given market environment, to be lower than their IBOR counterparts. On a more technical level, the operational challenges are still emerging.
The IBOR Supplement and Protocol mirror and address the IBOR transition challenges for future and "legacy" transactions. The IBOR Supplement introduces "hardwired" fallbacks to RFRs in the event various "Relevant IBORs" permanently cease to exist12 (or, in the case of LIBOR, are declared by the FCA no longer to be "representative of the underlying market and economic reality that [LIBOR] is intended to represent"). The Relevant IBORs include LIBOR for all five currencies; the Euro Interbank Offered Rate ("Euribor");13 the Tokyo Interbank Offered Rate ("TIBOR," which comes in on-shore (Japanese yen) and off-shore (euroyen) varieties); the Australian Dollar Bank Bill Swap Rate ("BBSW"); the Canadian Dollar Offered Rate ("CDOR"); the Hong Kong Interbank Offered Rate ("HIBOR"), the Singapore Dollar Swap Offer Rate ("SOR"), and the Thai Baht Interest Rate Fixing ("THB-SOR"). Meanwhile, the Protocol offers a means for willing market participants to amend their "legacy" derivatives transactions and governing agreements with all other Adhering Parties simultaneously so as to align them with the IBOR fallbacks in the IBOR Supplement.
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2 ISDA, ISDA 2020 IBOR Fallbacks Protocol (2020).
4 The transition from IBORs to RFRs for the derivatives market can ultimately be traced to a 2014 report and recommendation from the Financial Stability Board ("FSB"), an international group of regulatory authorities, in which the FSB recommended the development of "at least two rates" for each currency: an RFR for derivatives and one that includes bank credit risk for "cash" products such as loans and corporate bonds. Fin. Stability Bd., Reforming Major Interest Rate Benchmarks at 10, 58-59 (July 22, 2014) ("2014 FSB Report").
5 The United Kingdom's Financial Conduct Authority ("FCA") jolted the markets in July 2017 when it announced without warning that market participants (including "cash" market participants) would be unable to rely upon LIBOR's continued existence beyond year-end 2021. Andrew Bailey, The Future of LIBOR (July 27, 2017). Mr. Bailey was at the time the chief executive of the FCA, which had gained regulatory authority over LIBOR in the wake of the "LIBOR rigging" scandals that began to emerge during the 2008 financial crisis. Mr. Bailey was careful to acknowledge that the FCA did "not suspect further wrongdoing." However, the pervasive and continuing absence of actual transactions in the unsecured wholesale term loan market for banks had rendered LIBOR, in the view of the FCA, incapable of ever being "genuinely representative of market conditions." Id.
6 See, e.g., Alternative Reference Rates Committee ("ARRC"), Second Report at 2 (March 2018) (reporting estimated volumes for United States dollar LIBOR as of year-end 2016). The ARRC is the USD rate reform private sector "working group" that was established under the auspices of the Board of Governors of the Federal Reserve and the Federal Reserve Bank of New York pursuant to the 2014 FSB Report to determine an RFR for the USD and was reconvened in early 2018 in response to Mr. Bailey's 2017 announcement.
7 Articles and biographies for Jones Day's IBOR Initiative Working Group can be accessed on Jones Day's dedicated "LIBOR Insights" webpage.
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