Many of you will be aware that there is a new ISDA Protocol that becomes effective in January 2021 and seeks to address the problem of ineffective fallbacks in the event of the cessation of IBOR publication.
There has been some discussion about whether or not it is appropriate (for borrowers in particular) to sign up to the ISDA Protocol.
In the interests of full disclosure, we can’t answer that question directly as every organisation will have different considerations, but in this note, we’ve identified a few things to consider and identified some useful resources. What we can say is that signing the ISDA Protocol is not the end of the story…
Fallbacks…
As a starting point, there is a very helpful ISDA factsheet titled: Understanding IBOR Benchmark Fallbacks that sets out the background on why replacement fallbacks are required and how fallbacks would be implemented in practice.
The short version is:
The one-page factsheet provided by ISDA is well worth a read (and sharing with your treasury team).
However, it’s worth noting that there are a number of concerns that have been flagged about signing up to the ISDA Protocol.
Hebert Smith Freehills have produced a very helpful note on the ISDA 2020 IBOR Fallbacks Protocol and IBOR Supplement that can be found at: HSF ISDA protocol briefing note. This sets out a number of considerations: both the impact on economics (for example where a derivative caught by the protocol may hedge a loan which is not) as well as the practicalities in choosing whether or not to adopt.
…or Active Transition?
So, does the introduction/adoption of the ISDA fallback language ‘solve’ IBOR transition?
Well, no:
‘Fallbacks are not intended to be a primary means of moving from IBORs to RFRs. Once the fallbacks are in place, it is recommended that market participants focus on voluntary transition before the cessation of any key IBOR. Moving away from key IBORs voluntarily by amending or closing out contracts that reference those rates allows counterparties to tailor their strategies to their specific portfolios, and could allow firms to negotiate terms that avoid the adjustment mechanisms for fallbacks’ (ISDA)
This message is entirely consistent with comments from the regulators around the world: To ensure certainty, and that you are not economically disadvantaged as a result of the cessation of IBORs, you need to Actively Transition contracts that currently reference IBOR and not allow them to fallback to alternate benchmark rates on IBOR cessation.
This is particularly relevant for corporates who will potentially have loans with related derivatives that have been put in place as economic hedges. In the event of IBOR cessation the two instruments may move to different conventions if fallbacks are triggered.
The recent Slaughter and May guide on LIBOR transition can be found at: ACT Practical Guide to LIBOR transition and provides extensive guidance, by product, of considerations when actively transitioning financial contracts. It is recommended as a ‘must read’ ahead of starting a IBOR transition project.
...and back to ISDA (and unintended consequences)
One further thing to note is that at the same time that ISDA published the Protocol (to which one chooses to sign up to as it applies to existing transactions), they also published a Supplement which automatically updates the ISDA 2006 Definitions with effect from 25th January 2021.
The Supplement will ensure that any new IBOR trades on or after 25th January will automatically incorporate ISDA’s new IBOR fallback language where, upon cessation, IBOR will be replaced by a compounded risk-free rate (calculated 2 business days prior to the end of the relevant period) plus a historic IBOR/ risk free rate spread adjustment.
So, even with new transactions, it will be necessary to work through the details carefully to ensure economic effectiveness of any hedging structure put in place (e.g., day count conventions may differ between loan and derivative fallbacks, etc.).
Deciding whether or not it’s appropriate for your organisation to sign up to the ISDA Protocol, depends on your particular circumstances but, in any event, 2021 needs to be the year to Actively Transition as many legacy transactions as possible – to avoid the problems that may arise if fallbacks are triggered.
But not only will you need to Actively Transition legacy transactions, there is also the conundrum of how to manage any economic ineffectiveness arising as a result of fallbacks introduced by the ISDA Supplement going forward.
Nobody said this was easy...