Benchmarks Regulation and the transition from LIBOR: the ISDA 2018 Benchmarks Supplement Protocol is published

On 10 December 2018, ISDA published the ISDA 2018 Benchmarks Supplement Protocol (the "Protocol"). The Protocol is intended to help market participants to incorporate the recently published ISDA Benchmarks Supplement (the "Supplement") into certain derivative transactions. This briefing explains the background to the Protocol and the Supplement, describes how the Protocol works and considers its implications for the derivatives market.

Summary

• The Supplement was developed primarily to facilitate compliance with the EU Benchmarks Regulation but can also be used by market participants in connection with their transition away from inter-bank offered rates (such as LIBOR) to risk-free rates.
• The Protocol is a multilateral amendment mechanism that provides market participants with an efficient and user-friendly way of incorporating the Supplement into relevant transactions.
• Product types covered comprise interest rate, foreign exchange, equity and commodity derivative transactions.
• The Protocol uses the concept of "matching questionnaires" that has also been used in other recent ISDA protocols. Once two adhering parties have matched questionnaires, the Supplement is incorporated into relevant transactions in accordance with the terms of the Protocol.
• Adhering parties select in their questionnaires whether the Supplement will apply to legacy transactions as well as new transactions. Unless both parties select the legacy option, it will only apply to new transactions.
• In connection with the legacy option, an adhering party may need to consider whether the amendments made by incorporating the Supplement give rise to a new transaction and cause it to lose the benefit of any regulatory grandfathering.
• The Protocol allows for adherence on a counterparty-by-counterparty basis as well as on an all counterparties basis, allowing different elections to be made in respect of different counterparties.
• Agents can adhere on behalf of all of their principals or on behalf of specified principals only.
• The Protocol is open-ended, although ISDA can designate an adherence cut-off date on thirty days' notice.

What is the Supplement?

The Supplement was published in September 2018 and was developed primarily to facilitate compliance with the EU Benchmarks Regulation (the "BMR"). The BMR has been in force since 1 January 2018 and requires in-scope entities to have in place "robust written plans" detailing the measures that they would take if a relevant benchmark used in in-scope financial instruments were to change materially or cease to be provided, and to reflect those plans in contractual relationships with clients. This includes setting out specific fallbacks that would apply in such case.

Incorporation of the Supplement into the terms of relevant transactions would ensure that the necessary fallback arrangements are included. It covers interest rate products, equity derivatives, foreign exchange transactions, currency options and commodity derivatives and contains four annexes, each of which supplements the applicable ISDA definitions booklet.

The Supplement can also be used by market participants irrespective of whether they are subject to the BMR, as part of their preparation to transition away from inter-bank offered rates ("IBORs") (see "Further Considerations" below).

For more information on the Supplement, see our previous briefing.

What is the Protocol?

The Protocol is a multilateral contractual amendment mechanism that enables adhering parties to incorporate the Supplement into relevant transactions with multiple counterparties on the same platform, rather than having to amend contracts by way of a bilateral negotiation with each of those counterparties. As with other ISDA protocols, adherence is evidenced by the online delivery of an adherence letter to ISDA.

Once a party has adhered to the Protocol, it must then exchange completed questionnaires with each counterparty in respect of whose transactions the Supplement is to apply. The questionnaire specifies the delivering party's:

• name and Legal Entity Identifier;
• election as to whether the Supplement is to apply to all (including existing) transactions with the counterparty, or new transactions only (see "Legacy trade election" below); and
• contact details.

In order for the Protocol to apply to transactions between two adhering parties, the parties must have matched questionnaires. This means that the parties must have effectively matched on their legacy trade election (see "Legacy trade election" below).

The Protocol is available on ISDA Amend, a joint service provided by ISDA and IHS Markit through which market participants and their counterparties can interact on a secure online platform.

Adhering as an agent

When completing the questionnaire, an adhering party must specify whether it is adhering as principal or as an agent on behalf of multiple principals. Where adhering as an agent, a party may do so on an "all principals" basis or on a "named principals only" basis, giving agents the flexibility to enter into different arrangements on behalf of different principals.

Where a Confirmation evidencing a transaction has been executed by an agent on behalf of a principal, only the agent may use the Protocol to incorporate the Supplement into that Confirmation, not the principal itself. This is the case even if the principal has adhered to the Protocol in respect of other transactions.

Legacy Trade Election

The matched questionnaire approach was also used in the ISDA 2016 Variation Margin Protocol ("VM Protocol"), through which market participants can amend their derivative contracts to comply with margin rules. However, while the VM Protocol is rather complex and contains many multi-option elections, this Protocol is simpler and more user-friendly. The only election that parties are required to make relates to the scope of Supplement incorporation - parties must indicate whether the Supplement is to apply to new transactions only, or to both new and legacy transactions.

Whether a transaction is a new transaction or a legacy transaction depends on when it was entered into. Transactions entered into before the Implementation Date are "legacy" transactions and those entered into after the Implementation Date are "new" transactions. "Implementation Date" is defined as the date on which the later of the two matched parties delivers its completed questionnaire.

Key points relating to the legacy election are as follows:

• if an adhering party wishes to elect "new" for certain counterparties but "new and legacy" for others, it can do so by delivering different questionnaires to different counterparties;
• where one counterparty elects "new" and the other elects "new and legacy", the Supplement will apply to new transactions only;
• if "new" is initially elected and the parties thereafter wish to extend application to legacy trades as well, this can be done by the counterparties exchanging additional questionnaires with "new and legacy" selected;
• once the "new and legacy" option has been effectively elected by two adhering counterparties, it is not possible to change this to "new" only, as the Supplement will already have been incorporated into the relevant documentation;
• where the "legacy" option is selected, an adhering party may need to consider whether the amendments made by incorporating the Supplement give rise to a new transaction and cause it to lose the benefit of any regulatory grandfathering; and
• the legacy option will help entities which are subject to the BMR to comply with guidance provided by the European Securities and Markets Authority ("ESMA") in its "Questions and Answers on the EU Benchmarks Regulation" (the "ESMA Q&A"). In this, ESMA states that it expects supervised entities to amend in-scope contracts entered into before 1 January 2018 to reflect their robust written plans "where practicable and on a best-effort basis".

Novations

When a transaction incorporating the Supplement is novated, the Supplement will only continue to apply to that transaction if the entity to which it is being novated has either (i) adhered to the Protocol and exchanged matched questionnaires with the remaining party or (ii) incorporated the Supplement by other means.

Further Considerations

BMR Compliance: Although the BMR has been in force since January 2018, in accordance with guidance provided in the ESMA Q&A supervised entities have thus far only considered it necessary to amend contracts entered into before 1 January 2018 on a best-effort basis, and only where practicable to do so. The publication of the Protocol will facilitate such amendments, making it harder for in-scope entities to take the view that amending such legacy contracts is not practicable.

Transition from IBORs: Significant efforts are underway globally to transition financial markets away from reliance on LIBOR and other inter-bank offered rates ("IBORs") to alternative, nearly risk-free reference rates ("RFRs").

The Supplement does not identify specific benchmarks to replace LIBOR and other IBORs, but it does provide a waterfall of fallbacks by which parties can replace a benchmark if it ceases to be published. Ultimately, ISDA intends to update the 2006 ISDA Definitions to include fallbacks to selected RFRs, and work on this is ongoing, but in the meantime incorporation of the Supplement into transactions referencing an IBOR could form part of a wider strategy for the transition away from IBORs, even if it is not required by the BMR.

Authors: Kirsty McAllister-Jones, James Knight, Jonathan Haines