ISDA Protocol Information
Important Information Regarding ISDA 2020 Protocol
ISDA has published the 2020 IBOR Fallbacks Protocol on October 23, 2020 (the “ISDA 2020 Protocol”) as a way for parties to efficiently and electronically amend their swaps, derivatives and other specified agreements with other adhering parties by incorporating new replacement rate fallbacks for certain benchmarks. The Protocol effective date is January 25, 2021. For those clients and counterparties that may have such agreements in place with MUFG that reference LIBOR or other affected benchmarks, we encourage you to reach out to your own advisors to discuss whether the ISDA 2020 Protocol may be part of an appropriate solution for you.
As part of its transition strategy, MUFG (including MUFG Union Bank, N.A. MUFG Bank, Ltd., MUFG Securities Americas Inc. and other affiliates) have adhered to the ISDA 2020 Protocol as of October 23, 2020. We continue to review the impact of cessation of LIBOR and other benchmarks across its legacy derivative products.
For further information on the ISDA 2020 Protocol or ISDA’s IBOR Fallback language and more, please refer to the ISDA website.
ARRC Urges Timely and Widespread Adherence to the Protocol
The Alternative Reference Rates Committee (ARRC) commends the International Swaps and Derivatives Association’s (ISDA) announcement today of the upcoming launch of its IBOR (interbank offered rates) Fallbacks Protocol (the Protocol) and IBOR Fallbacks Supplement (the Supplement), which focus on strengthening existing and new derivatives contracts with durable fallback language.
Recent Industry Updates
ISDA announced the launch of the IBOR Fallbacks Supplement and IBOR Fallbacks Protocol, providing a framework for transitioning USD LIBOR interest rate derivatives to SOFR. 257 derivatives market participants signed on to the Protocol during a two-week "escrow" period.
Following four Credit Sensitivity work shops,official-sector leaders released a letter stating they do not plan to recommend a credit sensitive supplement to SOFR or credit-sensitive rates. They plan to hold two additional working sessions to further discuss the subject and explore related commercial loan transition solutions.
Freddie Mac issued its first SOFR-linked credit risk transfer deal (STACR REMIC 2020-DNA5) that uses 30-day average SOFR, but Freddie Mac intends to transition the transaction to an IOSCO compliant one-month term SOFR if and when it becomes available.
View archived articles here
What is LIBOR and why is it important?
The London Interbank Offered Rate (LIBOR) is the most commonly used benchmark for short-term interest rates and often is referenced globally in documentation for derivatives, bonds, business loans and consumer financial products. The setting of LIBOR is made daily on London business days by submissions of the average rates at which LIBOR panel banks believe they can obtain wholesale unsecured funding in 5 currencies (USD, GBP, EUR, JPY and CHF) and 7 maturities (from overnight to 12 months). It is estimated that $200 trillion of financial instruments (loans, bonds, derivatives and consumer financial products) are tied to USD LIBOR and that matters to everyone – small businesses, corporations, banks, broker dealers, consumers and investors.
What is happening with LIBOR and why transition away from it?
In 2017, LIBOR’s regulator decided that it will not compel LIBOR panel banks to make LIBOR submissions after 2021. It is very likely that LIBOR may no longer be available after the end of 2021 and therefore LIBOR is expected to be phased out of use by financial market participants by the end of 2021. Transition to alternative benchmark interest rates is well underway, but much work lies ahead in order to implement a successful reference rate change by the end of 2021.
What is the role of the ARRC?
In 2014, the U.S. Federal Reserve and the New York Federal Reserve Bank (NY Fed) established the Alternative Reference Rates Committee (ARRC) to lead the transition away from LIBOR. The ARRC continues to lead the transition in the U.S. from LIBOR. It recommended the Secured Overnight Financing Rate (SOFR) as the replacement for USD LIBOR and encouraged the development of a SOFR futures market.
What is SOFR?
In June 2017, the ARRC identified SOFR as the recommended alternative reference rate for USD LIBOR. SOFR is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities (each a repurchase or repo transaction). While LIBOR is not fully transaction based, SOFR is based on an overnight repo market with ~ $1 trillion of transactions per day. The NY Fed is the administrator and producer of SOFR. Publication of SOFR began in April 2018. Trading and clearing of SOFR based futures began in May 2018 and SOFR-based swaps in July 2018.
How is SOFR calculated?
SOFR is calculated as a volume-weighted median of transaction level tri-party repo transaction data, General Collateral Finance repo transaction data and data on bilateral U.S. Treasury repos cleared through Fixed Income Clearing Corporation's delivery-versus-payment service provided by DTCC Solutions LLC. SOFR is published each business day on the NY Fed’s website.
Does the ARRC have a timeline for the adoption of SOFR?
Yes. The ARRC published a Paced Transition Plan which outlines key milestones until the end of 2021 to promote SOFR’s adoption. It can be found at: https://www.newyorkfed.org/arrc/sofr-transition#pacedtransition . In 2019, the ARRC also issued a complementary Incremental Objectives document which outlines key priorities and milestones to be met in 2019 to support and prepare market participants for the transition. The 2019 Incremental Objectives can be found at https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2019/ARRC_2019_Incremental_Objectives.pdf
For existing contracts referencing LIBOR and transitioning to SOFR, do any adjustments need to be made to SOFR to make the economics of the transaction comparable to those based on LIBOR?
Use of a SOFR-based rate, by itself, likely will result in somewhat different economics from a transaction using a LIBOR-based rate (although the degree of difference will vary by transaction and be based on several factors). That is because LIBOR is based on short-term loans between banks that are unsecured, while SOFR is based on overnight repo transactions between banks or nonbanks secured by U.S. Treasury securities.
One of the consequences of moving from LIBOR to SOFR is that an unintended “value transfer” may occur. The ARRC has addressed the value transfer that is expected to occur by recommending a credit spread adjustment be added to SOFR (the credit spread adjustment).
The ARRC is in an active consultation phase with market participants in order to help inform how a credit spread adjustment that will supplement the SOFR-only value should be calculated. Some market participants may be satisfied with the ARRC recommending a static, one-time credit spread adjustment to be added to SOFR when a SOFR-based financial transaction is created, while other market participants are interested in developing a credit sensitive or “dynamic” spread adjustment that would make a SOFR-based transaction perform more like its LIBOR-based predecessor and possibly reduce an unintended value transfer between the parties.
However, even with a credit spread adjustment, no replacement benchmark is likely to be neutral to all parties; some will benefit and others will not.
Has the ARRC recommended a spread adjustment methodology for cash products referencing Libor?
The ARRC announced on April 8 that it is recommending a spread adjustment methodology based on a historical median over a five-year lookback period calculating the difference between Libor and SOFR. The ARRC’s methodology matches the methodology recommended by ISDA for derivatives.
According to the ARRC, this would make the spread-adjusted version of SOFR comparable to Libor and consistent with ISDA’s fallbacks for the derivatives markets. The ARRC previously advised that its spread adjustment would be static (there would be only one static spread adjustment for each applicable tenor) and it would be fixed at a specified time at or before Libor’s cessation.
For consumer products, the ARRC additionally is recommending a one year transition period to this five-year median spread adjustment methodology.
On May 6, the ARRC announced it will hold open until June 8 a supplemental consultation, seeking feedback on further technical questions related to the spread adjustment methodology related to cash products referencing USD LIBOR. The consultation invites participants to consider, among other things, the option of using the same spread adjustment values that will be used by the International Swaps and Derivatives Associations across all of the different fallback rates, rather than using the same adjustment methodology to calculate a different spread adjustment for each potential fallback rate.
Additional information can be found here
What happens to existing transactions and contracts?
A transaction that references LIBOR or another interbank offered rate (IBOR) and matures or expires after the time LIBOR is expected to be unavailable likely will need to be amended. This will be an expansive task given the large number of contracts referencing LIBOR. MUFG is working within its internal IBOR Transition Program to identify those contracts and prepare for their amendment.
What is happening to new transactions entered into now and in the near future?
Many continue to reference LIBOR. The ARRC, as well as trade associations and industry working groups, have developed and continue to work on contractual language to be included in contracts known as “fallback provisions” that specify what will happen when the benchmark rate it now references (such as LIBOR) is no longer available.
What is a fallback provision?
It is simply a provision in the agreement for a loan, bond, derivative or another financial instrument specifying a new interest rate benchmark or negotiation process to be followed by the transaction’s parties to determine a replacement rate if the interest rate used in that contract becomes unavailable. The ARRC has recommended fallback provisions for new USD LIBOR-dependent syndicated and bilateral loans, floating rate notes, securitizations, and residential adjustable rate mortgages to help transition away from LIBOR when it becomes unavailable. Those recommended provisions can be found at https://www.newyorkfed.org/arrc/fallbacks-contract-language . Including a fallback provision in new and existing financial contracts would simplify the transition from LIBOR to an alternative reference rate.
Given that SOFR is an overnight rate, will forward looking term SOFR be available?
SOFR is solely based on overnight transactions and does not yet have a forward term rate structure. The ARRC’s Paced Transition Plan calls for the creation of a forward-looking term SOFR structure based on SOFR-linked derivative markets before the end of 2021. Without a forward term SOFR structure, the alternative SOFR interest calculation methods now prevalent in the market are a compounded or simple average of historical overnight SOFR set in arrears. One limitation in using these calculation methods is that the parties to a transaction will not know the interest rate to be applied during an interest accrual period before the period begins. Not knowing the amount of the next interest payment may create operational issues for some corporate treasurers and others. The NY Fed is now publishing indicative forward looking term SOFR on its website. However, these indicative rates are not intended to be used in financial instruments. See https://www.federalreserve.gov/econres/notes/feds-notes/indicative-forward-looking-sofr-term-rates-accessible-20190419.htm.
Where can I get updates regarding the ARRC and the IBOR transition process?
The ARRC periodically publishes a newsletter providing key news updates relating to the LIBOR transition in the U.S. and other markets. The ARRC’s current and past newsletters can be found at https://www.newyorkfed.org/arrc/announcements.
What is the current status of initiatives of the International Swaps and Derivatives Association (ISDA) for fallback language supporting LIBOR transition for derivatives (non-cash products)?
ISDA has proposed amendments to its 2006 Definitions for derivatives contracts to incorporate fallbacks to one or more “risk free” reference rates (each a fallback rate) for certain key IBORs (relevant IBORs). ISDA will also publish the 2020 IBOR Fallbacks Protocol (the Protocol) to enable market participants to amend their legacy uncleared derivatives and other contracts to include these new fallback rates. The Protocol will generally cover relevant IBOR transactions governed by ISDA master agreements, ISDA credit support documentation, subject confirmations, certain local law swaps and derivatives master agreements, repurchase agreements and securities lending agreements. ISDA will also publish contract templates that parties may employ to bilaterally incorporate Protocol terms or otherwise amend their contracts, and will also publish forms to enable parties include or exclude certain master agreements or transactions from the scope of coverage of the Protocol.
Once agreed, the new fallback rates will apply in the event the relevant IBOR now referenced in a contract is permanently discontinued (and/or, in the event of certain LIBOR reference rates, in the event of a “pre-cessation” event of those relevant IBORs, explained below), such that the first fallback will be to a term adjusted risk-free rate for the relevant currency, plus a spread. Based on a series of market consultations, the new ISDA definitions and Protocol will also include fallback rates in the event of a “pre-cessation” event for certain LIBOR rates, including GBP, EUR, CHF, FRA, JPY and USD-LIBOR. A “pre-cessation” event is a public statement or publication of information by the regulatory supervisor for the administrator of LIBOR (currently, the UK Financial Conduct Authority) announcing that the LIBOR in the relevant currency is no longer, or will no longer be capable of being representative, or is non-representative, of the underlying market. Such announcement may be earlier in time than the end of 2021.
The amended ISDA definitions and the Protocol are projected to be published at the end of July 2020, with an effective date around November 2020 (four months following publication, such date being the protocol effective date). Parties may adhere later in time than November, but their adherence will serve to amend protocol covered agreements executed prior to the protocol effective date, and upon cessation, will have the effect of applying the relevant spread adjustment. Adherence to the Protocol will be deemed effective on the implementation date, the date ISDA accepts both adherence letters following the later of two parties’ adherence. The reference rate amendments contemplated in the Protocol will be effective on the later of the implementation date and the protocol effective date.
As mentioned above, most of the relevant IBORs’ fallback rates will include a spread adjustment in order to endeavor to preserve the economic effect of the original swap transaction. The spread component will be determined by Bloomberg® on the date of the public statement or publication of information that constitutes permanent cessation (or pre-cessation, as the case may be), and will be based on a historical median over a five-year lookback period calculating the difference between the relevant IBOR and its risk-free rate replacement.
ISDA is in the process of completing its ISDA 2020 IBOR Fallbacks Protocol FAQ. The FAQ and additional information will be made available by ISDA to the public on its website in July 2020. [https://www.isda.org/protocols]
How is the market reacting to SOFR?
Since the initial publication of SOFR in April 2018, the total notional amount of SOFR-linked cash (loans, bonds, securitizations, consumer mortgages, etc.) and derivative products has continued to increase. See the ARRC’s current and past newsletters at https://www.newyorkfed.org/arrc/announcements for further information regarding market developments related to SOFR-linked products.
Is MUFG actively working on the transition away from LIBOR?
Yes. Even though LIBOR may continue to exist until December 31, 2021, planning has already begun to migrate away from LIBOR to one or more replacement rates. We are assessing impacts, managing the LIBOR transition and seeking to mitigate risks. Our clients will hear more from us as transition tools, methods and timing become clearer.
What is the current status of regulatory relief being sought from the Commodity Futures Trading Commission (CFTC) by the ARRC Regulatory Working Group?
MUFG is also tracking potential relief and clarification with respect to IBOR transitions and timelines. For example, in order to facilitate the orderly transition from LIBOR and other qualifying interbank offered rates to alternative reference rates, the ARRC Regulatory WG requested that the CFTC’s s Division of Swap Dealer and Intermediary Oversight (DSIO) provide relief with regard to certain Commission regulations. Further relief and clarification are pending.
The DSIO’s No-Action letters issued to can be found here
What should my firm do right now?
(1) Learn more about LIBOR cessation, transition and replacement rate developments; (2) analyze its LIBOR exposure with a focus on financial instruments maturing beyond 2021 and what effect the discontinuation of LIBOR might have on that exposure; (3) engage with its counterparties, vendors and financial institutions to begin the process of identifying and amending LIBOR-dependent contracts to which it is a party; and (4) consider the impact that a change to a replacement rate may have on accounting, tax, IT, systems and operations.
Follow these links for news and other resources from some of the key industry participants in LIBOR transition:
Disclaimer: The information provided on this website is provided for informational purposes only, is not intended to be exhaustive and does not constitute, and should not be relied upon as, legal, regulatory, financial, tax, accounting or other advice. MUFG is not providing any such advice and you should consult with your own advisors on the impact of the potential cessation of LIBOR on your business and affairs. The areas and issues covered by this website are continually evolving and you should consult the relevant sources. Links to some of the relevant working and trade groups are incorporated in the information included on this website.