While the industry already started planning for transition away from the decaying interbank offered rates (IBORs) into the more robust alternative reference rates (ARRs), the amount of contracts referencing IBORs remains significant. Author: Silvia Devulder
According to the results of the latest survey[1] from the International Swaps and Derivatives Association (ISDA), in 2018, the interest rate derivatives (IRD) referencing IBORs still represented 63% of total IRD traded notional while those referencing ARRs, including SOFR, SONIA, SARON and TONA, represented only 3.4% of total IRD traded notional.
For contracts maturing after 2021, the date beyond which there is a high risk that LIBOR will cease to be published, the volume and complexity of contractual amendments coupled with the client outreach efforts are anticipated to be among the main legal challenges. Further, the transition of legacy cash instruments to ARRs may turn out to be impracticable because of limited standardization and lack of industry protocols in cash market contracts.
Although some contracts may contain fallback clauses defining steps in case the referenced benchmark is not published, these are generally not suitable and robust enough to withstand the event of its permanent discontinuation. Finally, with contracts not being typically digitized in an easily searchable format, the assessment of legal risk will prove to be a lengthy and complex exercise.
Institutions need a well-coordinated plan across all asset classes. It is essential to start reducing the population of contracts at risk by introducing efficient fallback provisions immediately.
Derivatives documentation
In the derivatives markets, ISDA released in December 2018 the results of the industry consultation on the fallbacks for derivatives that reference GBP LIBOR, CHF LIBOR, JPY LIBOR, TIBOR, Euroyen TIBOR, and BBSW. The industry feedback was, in particular, sought for the adjustment to reflect the lack of term structure and methodology to define the credit spread. In accordance with the results (i.e., in favor of the compounded setting in arrears for the term rate and the historical mean/median approach for the spread adjustment), ISDA is currently developing fallback language to be included into the 2006 ISDA Definitions (and potentially other product Definitions, e.g., future planned 2019 ISDA Interest Rate Definitions) for all of the benchmarks covered by the consultation. The supplemental consultation for USD LIBOR, HIBOR and CDOR is planned for release in the first half of this year while the EUR LIBOR and EURIBOR consultation will await the publication of ESTER.
The originally proposed ISDA fallbacks would be triggered upon a public statement by the administrator or supervisor of the administrator announcing permanent discontinuation of the relevant IBOR; however, ISDA will further consult on pre-cessation issues and related documentation solutions. Further discussions are unfolding as other industry bodies and working groups develop their product fallback language with some deviations from the ISDA proposal. As this may cause, for example, a decoupling of bonds from their hedges, the industry concerns were raised. In his January 2019 speech, Edwin Schooling Latter, Director of Markets and Wholesale Policy at the FCA, further suggested to use the announcement of the benchmark non-representativeness as a common trigger between products and markets.
When published, the revised ISDA Definitions will apply to all new trades referencing the amended ISDA Definitions. An ISDA protocol shall be made available for adherence to amend the legacy transactions’ documentation “en masse” between the adhering parties accordingly. The final language will not be known before the planned publication in the last quarter of this year.
In the meantime, the ISDA Benchmarks Supplement[2] complements the IBOR fallback work, as it enables firms to agree on interim fallback arrangements should an IBOR cease to exist before the IBOR fallbacks are implemented. The Benchmark Supplement aims at addressing the requirements of art. 28(2) of the European Benchmark Regulation (BMR) that “supervised users” have to plan for the cessation or material change of any benchmark (large or small, across large variety of asset classes), reflect this in contracts and nominate alternative rates where feasible and appropriate.
The IBOR fallbacks will take precedence for specified IBORs once implemented, but the ISDA Benchmarks Supplement will continue to provide an additional layer of protection with respect to index cessation in the event an IBOR fallback fails.
The ISDA Benchmark Supplement also enables parties to specify primary fallbacks if a benchmark (including an IBOR) is prohibited from use in a derivatives transaction. For example, EONIA has already been announced as not being BMR compliant. Therefore, it cannot be used as a reference in financial instruments[3] after the end of the transition period – originally set at 1 January 2020, but in the process of being extended until 31 December 2021. Indeed, the Council of the European Union and the European Parliament have recently reached an agreement to extend the BMR transition period for use of critical benchmarks – EURIBOR, EONIA, LIBOR and STIBOR – and third country benchmarks for two years. The agreed extension of BMR transitional provisions, however, does not cover EU-domiciled non-critical benchmarks that are required to comply with the regulation from 2020.
On the non-cleared derivatives side, both LCH and CME have supported ISDA’s fallback work and will require the cleared trades to adopt the new fallback language.
Lastly, the Basel Committee on Banking Supervision (BCBS) and International Organization of Securities Commissions (IOSCO) have released a statement this week announcing that amendments to legacy derivative contracts pursued solely for the purpose of addressing interest rate benchmark reforms do not require the application of the margin requirements for the purposes of the BCBS/IOSCO framework, although the position may be different under relevant implementing laws.
Cash markets
While the issues of fallbacks in derivative contracts have been tackled by ISDA, the cash market is more fragmented and has no central body to help coordinate the transition of legal language. Careful consideration should also be given to interdependencies between cash and derivatives markets.
Loan documentation
In the syndicated loan documents recommended by the Loan Market Association (LMA), the existing fallbacks are not designed to be used long-term or where LIBOR has been permanently replaced by a different rate with a different methodology for calculation. The ultimate fallback is to cost of funds; however, administering loans on this basis for any significant period of time is unworkable (as shown when certain LIBOR currencies and tenors were discontinued in 2014).
A longer-term solution was included in the LMA documentation in 2014 in the form of a “Replacement of Screen Rate” clause (42.5). However, it only applies where a Screen Rate is unavailable and to provide for a substitute benchmark (an earlier transition to a new rate and/or changing the margin would need all lender consent). It may not be commercially-accepted on all deals (where all lender consent may be required), and raises practical difficulties with obtaining consent of the requisite lender and borrower groups.
The US working group, ARRC, has consulted on the fallback language for floating rate notes and syndicated loans, followed by a second consultation regarding the securitized products and bilateral business loans. As it currently stands, the fallback triggers may slightly differ from the ISDA proposal, as it includes certain pre-cessation triggers. At the same time, the Structured Finance Industry Group (SFIG) released its “Green Paper” with recommendations for the securitization markets that are slightly at odds with the ARRC proposal. For example, one of the suggested trigger events is the statement by the benchmark administrator or its regulator that the applicable benchmark is “no longer representative or may no longer be used as a benchmark reference rate in new transactions.”
In Switzerland, the National Group on Swiss Franc Reference Rates presented the Swiss approach for the Swiss retail lending market last year. Indeed, LIBOR is highly relevant for the retail mortgage lending market in Switzerland. The proposed replacement clause diverges from its international equivalents – firstly, given the uncertainties, the trigger event is not hardwired; secondly, it provides for a primary fallback to another rate that is economically equivalent, or alternatively to a rate determined by a third party or a bank (e.g., with add-on to the last available CHF-LIBOR rate).
Bond documentation
Current fallback provisions in the majority of bond documentation could cause a market disruption for issuers and investors by converting the floating rate to the fixed one (last available IBOR rate) in case of IBOR discontinuation.
While the trustee does not have the legal authority to change the terms, obtaining consent of all or a majority of bondholders may prove impracticable, especially when the bonds are held in bearer form.
Repapering of legacy contracts, especially with retail clients, bears significant conduct and litigation risk. Indeed, the outcome of the transition may not be favorable for the consumer, even when the terms were negotiated on an arm’s-length basis.
Firms need to understand the extent of their existing exposure to IBORs and need to act now to prevent an increase in exposure. Addressing new contracts now will be easier than solving the problems of the past.
Interested in more?
A Swiss Perspective; or reach out to Silvia Devulder
[1] http://assets.isda.org/media/149a8621/afdf96f9-pdf/
[2] The ISDA Benchmarks Supplement is available on the Books section of the ISDA website. An FAQ is also available.
[3] However, it is to be noted that ESMA has confirmed that EONIA can still be the reference rate for collateral as it would not be “strictly ‘use of a benchmark’ in the sense of the BMR,” according to Jakobus Feldkamp, senior policy officer for market integrity at ESMA.
