Results of ISDA consultation on benchmark fallbacks now available

On 12 July 2018, the International Swaps and Derivatives Association (ISDA) published a consultation paper on technical issues related to new fallback provisions for derivatives contracts that reference certain interbank offered rates (IBORs) [1].  

For a brief clarification of the transition from IBORs to new risk-free rates (RFRs) and the necessity of new fallback provisions in derivatives contracts, reference is made to our previous publication [2]. That publication addresses the preparation by the International Swaps and Derivatives Association (ISDA) of certain amendments to its standard documentation to implement fallback provision for certain key IBORs. It also clarifies that these RFR fallback provisions would apply upon the permanent discontinuation of those key IBORs and that the amendments will be incorporated by means of a supplement to the 2006 ISDA definitions, which include standard provisions regarding interest rate swaps and other interest rate derivative contracts, including an existing fallback option with respect to an event whereby an applicable IBOR becomes temporarily unavailable. 

Among other things, the consultation paper identifies nine combinations of alternative options for calculating adjusted RFRs and spread adjustments to address certain differences between certain IBORs [3] and RFRs and asks market participants to rank these combinations in order of preference and specify whether their preferences apply universally across the covered benchmarks. ISDA has received 142 responses from a broad range of market participants, including banks, asset managers, pension funds, corporate entities, exchanges and clearing houses, global financial services firms, industry and trade associations and government entities. These responses are summarised in a report that was prepared for ISDA by the Brattle Group and published on 20 December 2018 [4].

The report states that there was an overwhelming support for two of the nine combinations of options, while none of the other combinations received credible support. These combinations are (i) the compounded setting in arrears rate with the historical mean/median approach to the spread adjustment, which was favoured by 86 of the 142 respondents, and (ii) the compounded setting in arrears rate with the forwarded approach to the spread adjustment, which was favoured by 41 respondents. 

Following the outcome of the consultation, ISDA has announced that it will proceed with developing fallbacks for inclusion in its 2006 definitions based on the compounded setting in arrears rate and the historical mean/median approach to the spread adjustment for all of the benchmarks covered by the consultation [5].

Under the compounded setting in arrears rate approach the relevant RFR is observed over the relevant IBOR tenor and compounded daily during that period [6]. This result in an "average" rate for the relevant tenor. The historical mean/median approach is based on the mean or median spot spread between the IBOR and the adjusted RFR calculated over a significant, static lookback period (e.g., 5 years, 10 years) prior to the relevant announcement or publication triggering the fallback provisions. This spread adjustment is then used from the end of a one-year transitional period after the fallback takes effect. During the transitional period, the spread to be used is calculated using linear interpolation between the spot IBOR/adjusted RFR spread at the time the fallback takes effect (i.e., the spot IBOR-adjusted RFR spread on the last date that the relevant IBOR is published) and the spread that would apply after the end of the transitional period [7].

More information, including details on the appropriate parameters for the historical mean/median approach to the spread adjustment and implementation issues, as well as an independent sensitivity analysis is expected to be made available in the first half of 2019 before the actual implementation of fallback provisions in the 2006 definitions.

------------------------------------------

1. Interbank Offered Rate (IBOR) Fallbacks for 2006 ISDA Definitions - Consultation on Certain Aspects of Fallbacks for Derivatives Referencing GBP LIBOR, CHF LIBOR, JPY LIBOR, TIBOR, Euroyen TIBOR and BBSW (the ISDA Consultation Paper): http://assets.isda.org/media/f253b540-193/42c13663-pdf/.
2. /publications-and-insights/isda-publishes-consultation-on-benchmark-fallbacks.
3. The ISDA Consultation Paper focuses on the following IBORs: GBP LIBOR,  CHF LIBOR, JPY LIBOR, TIBOR, Euroyen TIBOR and BBSW. In addition, it solicits preliminary feedback from market participants with respect to fallbacks for derivatives contracts referencing USD LIBOR, EUR LIBOR and EURIBOR.
4.  Anonymized Narrative Summary of Responses to the ISDA Consultation on Term Fixings and Spread Adjustment Methodologies prepared for International Swaps and Derivatives Association (“ISDA”) prepared by The Brattle Group, December 20, 2018 (the Brattle report): http://assets.isda.org/media/04d213b6/db0b0fd7-pdf/.
5. Brattle Report, page 6.
6. ISDA Consultation Paper, page 10.
7. ISDA Consultation Paper, page 13.