By now, you have probably heard that the London Interbank Offered Rate (“LIBOR”), the most widely used benchmark interest rate in the world, will become a piece of history at the end of 2021. As such, regulators around the world have instructed markets to stop relying on LIBOR.
How are market participants ceasing to rely on LIBOR?
Each of the Alternative Reference Rates (ARRs) to LIBOR for the five major currencies (USD, EUR, GBP, CHF, JPY) is at a different stage of development and liquidity. The focus in South Africa is on USD LIBOR, due to its predominance as the currency for foreign exchange transactions across Africa. For South Africans with exposure to EUR, note that EURIBOR (the Interbank Offered Rate, or IBOR, for Euro) is expected to remain active in the medium term; the focus at present is therefore on other currencies.
LIBOR is widely applied as the floating interest rate benchmark referenced for payment in derivative transactions, bond coupons and loan interest rate determinations. With markets anticipating LIBOR’s cessation, however, an active LIBOR transition is occurring as market participants switch out of LIBOR referenced contracts and into ARR referenced contracts where market liquidity allows, rather than simply waiting until LIBOR ceases to exist. This necessary activity will see ARR forecasting risk gradually replace LIBOR forecasting risk.
Once transitioned into an ARR referenced contract, the parties will rely on the contractual terms to determine the post-cessation applicable interest rate (such contractual terms are commonly called fallback language). One problem becoming apparent with fallback language is that the terms vary across products and markets, and may vary even within products and markets. For example, older bond documentation did not foresee LIBOR cessation, and so a common fallback is to use the last published rate (which would mean that these securities would essentially become fixed rate instruments). In loans, a common ultimate fallback is to the lender’s cost of funds. In the derivatives market, the alternative to LIBOR may be determined by the calculation agent.
In the last few years, the various relevant industry groups have developed fallback language for impacted financial products addressing the permanent cessation of LIBOR. For example, the Loan Market Association has published exposure draft (not yet recommended form) documentation for loans.
The most advanced of these is the International Swaps and Derivatives Association (“ISDA”), which published the 2020 ISDA IBOR Fallbacks Supplement to the 2006 ISDA Definitions on 23 October 2020, which became effective on 25 January 2021. In relation to derivatives, any transactions executed after this date referencing the 2006 ISDA Definitions will automatically contain the new fallback language. The new definitions include pre-defined ARR-based fallbacks for LIBOR (and other IBORS), with the fallbacks triggered by pre-cessation or cessation announcements.
Let’s unpack what happens with ISDA transactions
We must first look at what happens to legacy ISDA transactions which remain unamended and for which both parties do not adhere to the 2020 ISDA IBOR Fallbacks Protocol. The vast majority of the world’s outstanding derivative transactions have been documented under standard master agreements and definitions published by ISDA, including the 2006 ISDA Definitions. The existing definitions for USD LIBOR (identified as USD-LIBOR-BBA and USD-LIBOR-BBA-Bloomberg) did not anticipate the permanent cessation of LIBOR, but addressed short-term disruptions in the publication of USD LIBOR.
In the first instance, if USD LIBOR is not published, the 2006 Definitions call for the calculation agent (usually one of the parties to the transaction) to determine the fallback rate by polling banks in the London market and, failing that, polling banks in the New York market, for interbank lending rates. There is, of course, the risk that banks simply refuse to provide requested rates. Beyond that, the sheer volume and scope of transactions referencing USD LIBOR would make the polling approach impractical at best with results inconsistent from transaction to transaction. At worst, polling will be impossible to carry out, leaving trillions of dollars’ notional of derivative transactions with no methodology to calculate the floating rate or to determine market value.
To avert such a scenario, and to ease bilateral negotiation of amendments to legacy transactions, ISDA’s Protocol allows parties to amend such transactions by adhering to the Protocol. The Protocol incorporates ISDA’s fallback language, which provides for a clear transition from USD LIBOR to the Secured Overnight Financial Rate (“SOFR”) upon the occurrence of certain objective, easily observable events, and avoiding the existing, inadequate fallback mechanics. SOFR is the recommended ARR for USD transactions. The Protocol’s fallback language is intended to match the fallback terms that are incorporated into the Amendments to the 2006 Definitions, creating uniform fallback language across new and existing transactions, synchronised in both timing and rate.
But what happens after adherence to the Protocol? The Protocol incorporates fallback language by amending “Protocol Covered Documents” between that adhering party and all other adhering parties. By default, the term Protocol Covered Documents includes:
- Protocol Covered Master Agreements;
- Protocol Covered Credit Support Documents; and
- Protocol Covered Confirmations (including Master Agreements, Credit Support Documents and Confirmations that incorporate the 2006 Definitions or other covered ISDA Definitions, or otherwise reference a covered IBOR, including USD LIBOR).
Parties may additionally elect to include certain non-ISDA documents as Protocol Covered Documents. The agreement between two adhering parties to incorporate the Protocol amendments becomes effective on the date of adherence by the latter of the two parties (the Implementation Date), unless one or both parties have adhered through an agent, which is subject to other terms.
Although it is easier to adhere to the Protocol, it is also possible for parties to use the ISDA Amendment Fallbacks without adhering to the Protocol. ISDA has provided various forms of bilateral agreements for parties to use. These forms allow two counterparties to agree to incorporate the terms of the Protocol, either verbatim or subject to modifications agreed to between the parties. These bilateral agreements will only impact the transactions between the two parties – they will not impact any agreements or transactions with third parties.
Although the ISDA Protocol covers some non-derivative agreement types, bonds and loans sit outside of the Protocol’s scope. This creates obvious challenges and complexities across linked products where fallback language and methodology may differ between the products. For example, a LIBOR interest rate hedging a loan or a bond might be amended pursuant to the Protocol and remain in effect following LIBOR cessation, but a different fallback methodology is used in the loan to refer to a different rate replacing LIBOR.
In relation to all bonds and loans, parties will need to review any linked or hedged transactions to evaluate, and if necessary, conform, each of the contractual fallbacks in place for LIBOR.