On October 23, 2020, the International Swaps and Derivatives Association, Inc. (“ISDA”) launched its much anticipated IBOR Fallbacks Supplement to the 2006 ISDA Definitions (the “Supplement”) and the ISDA 2020 IBOR Fallbacks Protocol (the “Protocol”) to address the expected cessation of LIBOR and several other interbank offered rates (“IBORs”) at the end of 2021. This marks a major milestone in the effort by regulators and industry groups to facilitate the transition of LIBOR-based derivatives to alternative benchmark rates. It is expected that adoption of the Protocol by the market will be widespread. The Supplement and Protocol will become effective on January 25, 2021 (the “Effective Date”), although the Protocol is open for adherence today (and free of charge until the Effective Date). While this bulletin is not a detailed analysis of LIBOR cessation and alternative benchmark rates, it is intended to give you an overview of these helpful developments in order to assist those who may be thinking about—or are already in the midst of—forming a strategy to address their portfolio of derivatives transactions.

The Supplement

The vast majority of the world's derivatives transactions are documented under standardized master agreements and definitions published by ISDA, notably the 2006 ISDA Definitions, as well as certain prior – but less common iterations of the definition booklets published by ISDA that are still in use¹ (together, the “ISDA Definitions”). These ISDA Definitions contain the floating rate option definitions for LIBOR and other IBORs. The rate option definitions do contain fallback provisions, but they were only intended to address short-term disruptions to the publication of LIBOR and other IBORs. With the permanent end of IBORs in sight, these current fallback provisions would appear to be inadequate to ensure a smooth transition to alternative benchmark rates. The Supplement resolves this dilemma by amending those rate option definitions – primarily – by introducing certain objective and observable trigger events for each IBOR and the alternative benchmark rate that such IBOR will “fall back” to. By issuing the Supplement, ISDA has paved the way forward for all new transactions entered into after the Effective Date. In other words, all derivatives transactions entered into on or after the Effective Date of the Supplement will contain the terms and conditions that will guide the transition away from LIBOR and other IBORs when the time comes.

The Protocol

What about existing transactions? This is what the Protocol was designed to address. The Protocol allows parties to derivatives transactions to bilaterally amend their existing transactions to incorporate the terms and conditions that are contained in the Supplement. Adherents to the Protocol will agree that derivative transactions that they have entered into with other adherents prior to the Effective Date of the Supplement will incorporate the terms of the Supplement regardless of when the transactions were entered into. The Protocol will cover the universe of ISDA-based documentation² as well as many non ISDA-based agreements³ that are linked to the ISDA Definitions or otherwise reference an IBOR. In a sense, the Protocol paves the way backwards for all existing transactions entered into prior to the Effective Date.

Seems like a lot to take in? An easy way to think about this is to use the Effective Date as a dividing line. On January 25, 2021, all derivatives trades placed from that point forward will incorporate the terms of the Supplement. Derivatives trades entered into prior to that date – if amended through the Protocol – will also incorporate the terms of the Supplement. These overlapping devices are intended to align, creating a standardized and fully synchronized benchmark replacement mechanism across all (existing and new) derivatives transactions.

Do I need to adhere?

It should be noted that there is no legal or regulatory requirement to adhere to the Protocol. ISDA has provided various forms of bilateral agreements and other slot-in template provisions for parties to use. These forms allow two parties to agree to incorporate the terms of the Protocol, either verbatim or subject to modifications agreed to between the parties. While parties have the option to bilaterally amend their transactions – and there are certainly circumstances where it is practical to do so – the Protocol provides parties with an efficient solution where a party has multiple counterparties. In addition, regulators have strongly encouraged regulated financial institutions and market participants to adhere to the Protocol⁴ . Accordingly, it should be expected that swap dealers will, in turn, prompt their counterparties to adhere. Regulators in the U.S. and the EU have also provided comfort that amendments to existing transactions for purposes of replacing the benchmark fallbacks will not trigger any additional requirements, such as margin requirements, under their respective swap regulatory regimes.

Other considerations

LIBOR is the world’s most widely used benchmark and is pervasive throughout the global financial system. It is the benchmark for over US $350 trillion in financial contracts worldwide, and so a transition strategy should give consideration to all sources of exposure. Many use interest rate derivatives to hedge the floating rate of interest under a credit facility or loan. These market participants should consider if and how the floating interest rate under that instrument will be adjusted and how such adjustment will compare to adjustments to any associated derivative transaction made bilaterally or through the Protocol. It may be appropriate to document matching fallback terms and triggers across both instruments at the same time in order to ensure that such instruments transition in the same way. Moreover, if the loan instrument requires consent from an administrative agent or lenders to amend such interest rate derivative, market participants should ensure that appropriate consents are obtained prior to amending the derivative transaction or adhering to the Protocol.

Where there is a loan-level hedging program or a “back-to-back” structure in place, it may be advisable to take a hybrid approach to address your derivatives portfolio. For example, regional and/or community banks that utilize these programs may want to use bilateral agreements to address any customer-facing derivatives while utilizing the Protocol for their offsetting dealer-side derivatives transactions. The bilateral approach is likely to be particularly helpful in circumstances where a lender may have negotiated a customized fallback rate or rate adjustment mechanism in their agreements. In addition, because the Protocol also amends a wide range of non-ISDA based agreements, bilaterally amending derivatives transactions will enable parties to narrow the scope of the Supplement to exclude these other agreements where it is desirable or appropriate.

While many transition challenges remain, the Supplement and Protocol represent a significant step forward for the derivatives market in terms of LIBOR cessation. 

¹The 1991 ISDA Definitions (as amended by the 1998 Supplement), the 1998 ISDA Euro Definitions, and the 2000 ISDA Definitions.
²See the “Definitions” section of the Protocol starting on page 12.
³See the “Annex” section of the Protocol starting on page 23.
⁴ https://www.fsb.org/2020/10/fsb-encourages-broad-and-timely-adherence-to-the-isda-ibor-fallbacks-protocol/