This alert considers some of the difficult issues that firms will have to consider in deciding whether and when to adhere to the Protocol.
Adhering to the Protocol may not necessarily be the best outcome for every firm but as a minimum they need to understand what they are signing up to.
The Supplement and the amendments to existing contracts made by the Protocol will take effect on 25 January 2021.
From this date, all new contracts that incorporate the 2006 ISDA Definitions and that reference one of the covered IBORs set out in the Supplement will contain the new fallbacks. Covered legacy contracts in existence on the effective date will incorporate the new fallbacks if both counterparties have adhered to the Protocol or otherwise bilaterally agreed to apply the Protocol to their contracts. It is expected that the CCPs will apply the ISDA fallbacks to cleared OTC derivatives from the same date.
Contracts covered by the Protocol are not just uncleared OTC derivatives subject to an ISDA Master Agreement or which incorporate the 2006 Definitions. It also captures ISDA collateral documents as well as derivatives and other transactions under the French FBF and European Master Agreement, amongst others (whether or not they incorporate the 2006 ISDA Definitions). It does not, however, cover the German DRV (even if the trades under it incorporate the 2006 ISDA Definitions).
The Protocol additionally applies to securities financing transactions under a GMRA or a GMSLA. This will not just fix the reference to "LIBOR" in the default interest provisions of earlier vintages of the GMRA and GMSLA but, more importantly, it will also include the ISDA fallbacks in cash-flows in term trades which reference an IBOR as a benchmark.
There is no exclusion for structured transactions. It also applies to non-linear products such as swaptions where the fallbacks will be incorporated into the underlying swap transaction. Transactions that pay out at the start of interest periods such as floating rate agreements will also be captured, even though the fallback methodology will not be suitable for use with those products.
There is no ability to select which of these products the Protocol will apply to so adherence is all or nothing. However, it is open to an adhering party to agree with one or more counterparties bilaterally that certain transactions should be excluded. Ideally this should be done before a party adheres to the Protocol.
ISDA has produced template agreements which allow for parties to bilaterally exclude certain trades or master agreements, to include additional master agreements (such as the DRV mentioned above) or to change the manner in which the fallbacks apply.
The effect of the fallbacks
The new fallbacks mean that on final cessation of the applicable IBOR the relevant replacement rate (such as a compounded Risk Free Rate like SONIA and SOFR) will then apply with its new calculation methodology and a standardised spread adjustment will apply, unless the counterparties have agreed on an adjustment spread bilaterally before the cessation occurs. Bloomberg has been mandated to calculate the spread adjustments and will publish an 'all-in' rate.
The spread adjustment itself is not yet known as the 5 year look-back period over which it is determined has not yet ended – although that period could end at any time if, for example, the FCA were to announce the death knell to that IBOR (so-called pre-cessation).
So it is possible that the adjustment spread could become numerically known before the Protocol takes effect?
The fact that the adjustment spread is calculated on the basis of a median average also makes it possible to determine an upper and lower bound for it in advance of the 5 year window becoming fixed. This is one reason to consider delaying adherence as it fixes one of the variables from what is already quite a complex financial analysis.
The financial impact of adherence
This is perhaps the most difficult aspect for a firm to assess due to the number of variables.
The adjustment spread is the least unknown of the unknowns in that equation. Other factors include the expected difference between the ISDA spread adjustment and the market implied adjustment spread both at the effective date of the Protocol or when the firm adheres, if later. More significant is the anticipated differential at the expected date of discontinuance of the applicable IBOR when the ISDA spread adjustment will actually apply.
The bigger unknown though is what new contracts will be entered into before cessation of the relevant IBOR and what positions might have been bilaterally amended before that date. The composition of firms' portfolios will almost certainly be different: but in what way may be hard to assess at this time.
The analysis is complex as the Protocol applies to various product types and the economic impact will be different depending on the notional, and remaining maturity and linear and non-linear products will be impacted differently.
|A USD 1 billion 6 month LIBOR position (or portfolio) with a 5 year remaining maturity currently shows a basis between the expected ISDA spread adjustment and the spot basis of USD LIBOR to SOFR trading in the market of about 9 basis points.
If this basis persists when USD LIBOR ceases, the potential value shift could be around USD 4.5 million.
Put another way, one party to that position would be USD 4.5 million better off if it traded out of the position bilaterally now, compared to its position if it waited for the ISDA fallback to kick in.
That is just a linear approximation but is perhaps a good enough reason for that party not to adhere to the Protocol if it has other options of monetizing the basis differential.
We are aware that some firms are seeing the Protocol as the only step they need to take to deal with IBOR discontinuance on their derivatives book but this approach runs the risk of losing an economic opportunity.
The position is more complex with non-linear products such as swaptions, where the underlying swap transaction will be adjusted, but there will be no corresponding adjustment to the premium to reflect the basis.
There is an argument for price takers to sign up to the Protocol on the basis that this gives them a free option to let the trades run until cessation of the applicable IBOR or to trade out of the position bilaterally earlier if the price is expected to be more favourable to them. The opposite is true of price makers as they are less able to force a price taker to bilaterally trade out of the position at a price which they deem to be more favourable.
As with all ISDA protocols, adherence is voluntary.
Firms could alternatively choose to make changes to their legacy contracts on a bilateral basis, or opt to keep their outstanding trades unchanged. However, ISDA has expressed its support for broad adherence, noting that it is the most efficient way for most derivatives participants to mitigate against the risks associated with the discontinuation of a key IBOR. No doubt the industry will put pressure on market participants to adhere at some point.
Adherence itself will take place in the usual manner, with parties submitting completed adherence letters with appropriate representations and elections to an ISDA repository for matching with other submitting counterparties. The intention is that the Protocol will remain open for adherence after the effective date.
As adherence to the Protocol will impact different products and portfolios in the firm, it may not be an easy decision to make whether or not to adhere but ultimately someone needs to make the decision either way. Who is that person?
For agents (primarily asset managers) this is complicated by the fact that adherence will impact different clients' portfolios in different ways and they would need to consider the impact on each client before deciding whether or not to adhere to the Protocol on a client's behalf – and that decision could ultimately prove to be mistaken in retrospect if the assumptions adopted when making the decision turn out to be incorrect. Blanket adherence on behalf of all clients without consideration of the impact on any individual client would seem to be a pretty risky approach given the duties that asset managers owe to their clients.
In some situations one or more parties may have agreed not to change the terms of a transaction without the consent of a third party such as a trustee or without rating agency consent. In that situation consent should be sought prior to adherence.
As mentioned above, there is likely to be a strong expectation across the industry for there to be widespread, if not near-universal, adherence.
In our view, however, those in the industry need to be very careful not to advise or require their counterparties, clients or other market participants to adhere to the Protocol. Adherence may not be in any individual party's best interests, and any pressure placed on counterparties to adhere could potentially lead to claims and disputes going forward.
Hedge accounting treatment (or potentially the loss of it) needs to be considered both for Protocol adherence as well as for bilateral trading out of an IBOR.
The potential for a life-cycle event being triggered for clearing or margining obligations under applicable regimes also needs to be considered in the context of the bilateral trading out of an IBOR.
The Supplement and the Protocol raise some unusually complex issues, involving not only legal but also complex economic risk analysis. If you would like us to assist your firm in understanding the effect of the Protocol we would be happy to talk to you.
Our colleagues in Fieldfisher Consulting, Haseeb Haque and Ashwani Roy, are able to run financial impact analyses across actual or sample portfolios.
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