27 January 2021

ISDA: A Big Milestone for Benchmark Reform

ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues in derivatiViews, reflecting ISDA's long-held commitment to making the market safer and more efficient.

This week marked a major milestone for benchmark reform. On Monday, ISDA’s new fallbacks came into effect, with more than 12,000 entities across nearly 80 jurisdictions adhering to an ISDA protocol that allows firms to incorporate the fallbacks into existing derivatives contracts linked to LIBOR and other key interbank offered rates (IBORs).

The ISDA Fallbacks Protocol remains open, so the total is continuing to climb – it is close to breaching 13,000 today. This is a major achievement and will significantly reduce the systemic impact of an IBOR permanently ceasing or, in the case of LIBOR, being deemed non-representative. According to analysis by the UK Financial Conduct Authority (FCA), over 85% of non-cleared interest rate derivatives in the UK referenced to sterling LIBOR now have effective fallbacks in place because both counterparties have adhered to the protocol. Once cleared derivatives and futures are added, the FCA reckons approximately 97% of sterling LIBOR interest rate derivatives are covered by fallbacks.

Actual coverage could even be higher than that. As well as adhering to the protocol, firms have the option of bilaterally agreeing with their counterparties to include the new fallbacks into their legacy non-cleared derivatives trades (and ISDA has published templates to help firms achieve that). The launch of the ISDA Fallbacks Supplement means fallbacks will also be included in all new covered IBOR derivatives trades that reference ISDA’s standard interest rate definitions from January 25, mitigating risk on an ongoing basis.

Assuming protocol coverage in the UK is replicated in other LIBOR currencies and jurisdictions, and adjusting for contracts that mature, the risk associated with a large portion of the estimated $260 trillion in outstanding LIBOR-linked contracts has now been significantly reduced.

That’s not to say the job is done. Fallbacks are a vital one-size-fits-all safety net to ensure a workable back-up rate based on a clear, consistent and transparent methodology automatically applies at the point an IBOR ceases to exist or (for LIBOR) becomes non-representative, avoiding the risk of market disruption. However, once robust fallbacks are in place, regulators have emphasized that market participants may be able to better tailor the economic terms of their contracts by actively transitioning their portfolios to alternative rates before any cessation event. There’s also the matter of developing a solution for outstanding tough legacy exposures – those predominantly cash contracts where it’s not possible to make contractual amendments – and ensuring that solution is as consistent as possible across linked products and jurisdictions.

There should soon be greater certainty on the timetable for completing this transition. Also on Monday, ICE Benchmark Administration (IBA), the administrator of LIBOR, closed a consultation on its intention to cease publication of all sterling, euro, Swiss franc and yen LIBOR settings and one-week and two-month US dollar LIBOR immediately after publication on December 31, 2021, and to stop the remaining US dollar LIBOR settings following publication on June 30, 2023.

Any subsequent announcement by IBA and/or the FCA confirming the dates of cessation or non-representativeness of those LIBOR settings would provide clarity to market participants as they progress with transition. It would also trigger a fixing of the spread adjustment under the fallback methodology for those LIBOR currencies covered by the announcement.

There’s still much to do, but the implementation of robust, viable fallbacks is a gigantic step on the path to benchmark reform. This was only possible because of global coordination and cooperation among ISDA, regulators and industry participants. By working together, we’ve successfully mitigated the risk of an IBOR cessation event for trillions of dollars worth of derivatives notional exposure.

ISDA

© ISDA - International Swaps and Derivatives Association