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

ISDA published its Benchmarks Supplement (the "Supplement") on 19 September 2018. This briefing gives the background to the Supplement, outlines its terms and considers its implications for the derivatives market.

Summary

• There has been considerable controversy in recent years over the use of certain inter-bank offered rates such as LIBOR, which has led to increased scrutiny and regulation of this feature of the financial markets.
• The EU Benchmarks Regulation regulates, among other things, the use of indices as benchmarks in financial instruments. The Regulation came into force on 1 January 2018.
• Article 28(2) of the Regulation requires certain regulated entities to provide for alternative benchmarks as substitutes for benchmarks which are no longer published.
• Participants in the derivatives markets can use the Supplement to comply with the requirements of Article 28(2) of the Regulation in relation to benchmarks in derivative contracts.
• In addition, market participants may want to use the Supplement as part of their preparation for the transition away from inter-bank offered rates, irrespective of whether the relevant contract is within scope of Article 28(2). For example, it is expected that LIBOR may be discontinued by the end of 2021, which will affect contracts referencing LIBOR even if they are not within scope of the Regulation.
• In certain scenarios, the Supplement provides fallbacks if either (a) the relevant benchmark ceases or will cease to be published or (b) either the benchmark or its administrator does not have the necessary regulatory authorisation, such that either or both parties (or the Calculation Agent) will not be permitted to use the benchmark to perform its obligations under the relevant trade.
• Market participants can adopt the Supplement as an alternative to renegotiation of terms on a case-by-case basis, which may be costly and time consuming.
• The Supplement applies determinations made by central banks or regulators as to alternative benchmarks and adjustments.
• The Supplement gives considerable discretion to the Calculation Agent to determine the alternative benchmark and the associated adjustment spread.
• ISDA is also developing a Protocol to facilitate efficient uptake of the Supplement, although this is not finalised yet.

Key points to consider

For market participants faced with the regulatory imperative to improve the robustness of benchmarks fallbacks and the practical need to prepare for the transition away from inter-bank offered rates ("IBORs"), the Supplement promises to be a helpful development. However, market participants will need to consider several key points in order to determine whether and how to use it.

• Which products are in scope of the BMR and need to comply with Article 28(2)?

• Which products are out of scope but rely on inter-bank offered rates?
• Which transactions and counterparties do they wish to use the Supplement for?
• What volume of transactions is involved?
• Are they comfortable with any risks of being bound by determinations of fallbacks and pricing adjustments made by either the Calculation Agent or a regulator?
• Are they prepared for the complexity, cost and risk of individual renegotiations?
• Should they wait for the planned protocol to become available or start updating transaction terms on a bilateral basis sooner?
• How are legacy trades to be treated for regulatory purposes?

What does the Supplement do?

The Supplement is primarily intended to facilitate compliance with the requirements of Article 28(2) of the EU Benchmarks Regulation ("BMR"), but it has been drafted so that market participants can use it to incorporate fallbacks for reference rates into derivative contracts, whether or not they or the contracts are subject to BMR.

Therefore, although publication of the Supplement is somewhat behind schedule for the purpose of compliance with BMR, it has broader relevance in the context of preparation for the transition away from IBORs.

In summary, it provides for fallbacks to apply to derivative contracts if either (a) a benchmark ceases or will cease to be provided or (b) a benchmark is not authorised or the administrator or sponsor of a benchmark is not approved or included in a register of permitted benchmarks as required under BMR.

These fallbacks do not specify particular replacement benchmarks to be used instead of IBORs, but they provide various means by which the parties can address the unavailability of a benchmark.

How is the Supplement to be used?

The Supplement is not automatically included in any ISDA definitions booklets. Therefore, in order to use the Supplement, parties to derivative contracts must specifically incorporate it into new trades or execute amendments in respect of existing trades.

ISDA is currently developing its Benchmarks Supplement Protocol which can be used to incorporate the Supplement into new trades under existing Master Agreements following adherence.

It is possible that the Protocol will also include an option to apply the Supplement to legacy trades entered into before the parties' adherence to the Protocol. This would enable parties to defer the decision to apply the Supplement to legacy trades pending further guidance or input from regulators as to whether Article 28(2) requires contractual fallbacks to be included in legacy trades.

Which types of trades are covered?

The Supplement covers interest rate products, equity derivatives, foreign exchange transactions, currency options and commodity derivatives. It has four annexes, one for each of the following definitions booklets:

• 2006 ISDA Definitions;

• 2002 Equity Derivatives Definitions;
• 1998 FX and Currency Option Definitions; and
• 2005 Commodity Definitions.

It does not include provisions supplementing ISDA definitions booklets in respect of credit derivatives, fund derivatives or inflation derivatives.

This briefing focusses primarily on the annex for the 2006 ISDA Definitions (the "2006 Definitions Benchmarks Annex").

Particular concerns arise with the 2006 ISDA Definitions. Firstly, they are used to document a very large number and a broad range of derivative transactions, therefore the impact of any problem with a relevant benchmark could be substantial and widespread. Secondly, the current fallbacks under the 2006 ISDA Definitions typically require the Calculation Agent for the relevant trade to obtain quotations from reference dealers in the relevant market. If the relevant benchmark is no longer published, dealers may not be able to provide such quotations on an ongoing basis, and significant market disruption could result.

How will the Supplement implement replacement rates for IBORs?

The Supplement does not specify replacement benchmarks to be used instead of IBORs, but it provides various alternative fallbacks to enable the trade to continue in scenarios where an IBOR used as a benchmark has ceased to be available or cannot be used for regulatory reasons.

These "Alternative Continuation Fallbacks" are set out in a waterfall which determines their priority (see the table below). However, above that waterfall are any applicable "Priority Fallbacks" for the relevant benchmark. The Priority Fallbacks will be the risk-free rates that are to be embedded in the amended definitions of benchmark rates which ISDA aims to include in updated definitions booklets (e.g. SONIA for GBP-denominated floating rates). See "Related Developments" below.

What are the key terms of the 2006 Definitions Benchmarks Annex?

The 2006 Definitions Benchmarks Annex sets out the consequences of certain "Benchmark Trigger Events" in relation to "Relevant Benchmarks". Please see below for a summary of the Benchmark Trigger Events.

If a Relevant Benchmark (e.g. an IBOR) ceases to be published, the 2006 Definitions Benchmarks Annex will apply the Priority Fallbacks in priority to the Alternative Continuation Fallbacks set out below.

In addition, the Supplement deems the terms of the ISDA 2013 Discontinued Rates Maturities Protocol to apply in order to allow the possibility of using linear interpolation as a straightforward remedy where a maturity is withdrawn, rather than triggering an Index Cessation Event.

For regulatory events which render a benchmark or its administrator non-compliant, the Supplement applies the Alternative Continuation Fallbacks without applying the Priority Fallbacks.

What is a Benchmark Trigger Event?

Under the 2006 Definitions Benchmarks Annex, either an Index Cessation Event or an Administrator/Benchmark Event will constitute a Benchmark Trigger Event.

An "Index Cessation Event" is essentially a public statement to the effect that the administrator of the benchmark is permanently or indefinitely ceasing to provide it and that at that time there is no successor administrator who will continue to provide it. That statement could be made by the administrator, its supervisor or the central bank of the benchmark's currency, or by certain insolvency officials or courts.

An "Administrator/Benchmark Event" requires the delivery of a notice by one party to the other citing publicly available information that reasonably confirms that one of the specified events related to regulatory compliance and authorisation either of the administrator or the benchmark has occurred and that either or both of the parties or the Calculation Agent will not be permitted to use the benchmark to perform its obligations under the relevant transaction. An Administrator/Benchmark Event may therefore be a regional event driven by regulatory requirements in a particular jurisdiction or in particular jurisdictions.

What are the consequences of a Benchmark Trigger Event?

A Priority Fallback will typically not be included in the contractual terms until ISDA has amended definitions booklets to embed the specific alternative risk-free rates that have been identified to replace certain IBORs.

If there is no Priority Fallback, the Supplement applies a waterfall of the Alternative Continuation Fallbacks. During the period from the Benchmark Trigger Event to the relevant "Cut-Off Date", the parties agree to use commercially reasonable efforts to reach an outcome under the waterfall which would allow the trade to continue.

If more than one Alternative Continuation Fallback would allow the trade to continue, the first in the waterfall will apply, and if none would allow the trade to continue, the parties have the right to terminate the trade. See the table below.

What is the order of priority of fallbacks?

The Alternative Continuation Fallbacks apply according to a waterfall in the following order:

• The parties try to agree the action to be taken to account for the Benchmark Trigger Event.
• If the parties have specified any index as an "Alternative Pre-nominated Index" in the terms of the transaction as a fallback for the affected benchmark, that Alternative Pre-Nominated Index will apply. An Alternative Pre-nominated Index means an index, benchmark or other price source specified by the parties as an Alternative Pre-Nominated Index and which is not subject to a Benchmark Trigger Event. In most existing trades, the parties will not have included an Alternative Pre-nominated Index, therefore this fallback is currently relatively unlikely to apply.
• If an "Alternative Post-nominated Index" exists, it will apply. This is essentially an index which is designated by either: (i) a "Relevant Nominating Body", which can either be a relevant central bank or regulator or any working group officially endorsed by that central bank or regulator, or the Financial Stability Board; or (ii) the administrator or sponsor of the Relevant Benchmark, provided that such index is substantially the same as the Relevant Benchmark.
• The Calculation Agent identifies a commercially reasonable alternative for the affected benchmark (a "Calculation Agent Nominated Replacement Index").

In addition, in the case of each of Alternative Pre-nominated Index, Alternative Post-nominated Index and Calculation Agent Nominated Replacement Index, if the fallback is to a risk-free rate, the terms of the transaction will need to build in an additional payment or spread to ensure, to the extent reasonably practicable, that the change in benchmark does not affect the economic value of the trade to one party or the other. This is explained further below.

In each case, after taking into account any such adjustment payment or spread the Calculation Agent will need to make any amendments necessary to reflect the move to the replacement benchmark. These could include differences in calculation period and method - e.g. the alternative is compounded in arrear at the end of the calculation period where the original index was an up-front term fixing.

Adjustment payments and adjustment spreads

The alternative risk-free rates are conceptually different from IBORs, particularly in that they do not include any credit risk premium and they are typically based on overnight rates rather than forward-looking term rates. Therefore a move to a risk-free rate as the replacement benchmark in any given trade may cause a transfer of economic value from one party to the other. An Adjustment Payment or Adjustment Spread is aimed at eliminating or reducing such a transfer of economic value from one party to the other as a result of the replacement of the benchmark. An Adjustment Payment is an additional cashflow added to the terms of the trade, whereas an Adjustment Spread is a spread applied to the risk-free rate in the calculation of cashflows. An Adjustment Spread may be expressed as a methodology for calculating the spread rather than a fixed figure.

Parties may have different views on what the Adjustment Payment or Adjustment Spread should be, particularly since the use of risk-free rates and the associated adjustments is a new development in the market. If the parties do not manage to agree, it falls to the Calculation agent to determine an Adjustment Spread (subject to the dispute rights set out in 2006 Definitions Benchmarks Annex). The Calculation Agent must do so on the basis of certain relevant market data and any spread methodology recommended by a Relevant Nominating Body in relation to the replacement of the Relevant Benchmark.

One exception applies in relation to an Alternative Post-Nominated Index. In that case, if a Relevant Nominating Body has specified a spread or methodology, that spread or methodology will apply unless both parties agree otherwise. This may mean that some parties prefer not to apply the Supplement universally or to all counterparties, as it effectively hardwires designated adjustment spreads into this fallback.

When does the fallback take effect?

The relevant trade will be amended in accordance with the applicable Alternative Continuation Fallback from the Business Day after the Cut-Off Date.

The parties can agree a Cut-Off Date, but in the absence of agreement, the following will apply:

• Following an Index Cessation Event, the Cut-Off Date will be the later of (a) 15 Business Days following the day on which the public statement is made or the information is published and (b) the first day on which the Relevant Benchmark is no longer available.
• Following an Administrator/Benchmark Event; the Cut-Off Date will be the later of (a) 15 Business Days following the day on which the required notice from one party to the other is effective and (b) the date that the relevant regulatory licence becomes required or the date on which it is suspended or withdrawn, if applicable law says the benchmark cannot be used as a result.

The aim of these provisions is that the parties will always have at least 15 business days in order to apply the waterfall of fallbacks before they have the right to terminate.

The Cut-Off Date will also be altered to enable ongoing disputes in relation to determinations by the Calculation Agent to be resolved, subject to a backstop of four days following notification of the dispute if the dispute is not resolved.

What happens if no fallback applies?

If the terms of a trade are not amended under any of the Alternative Continuation Fallbacks by close of business on the Cut-Off Date, either party has the right to terminate the trade on a no-fault basis.

The termination right is on the basis that from the business day following the Cut-Off Date an Additional Termination Event is deemed to have occurred under the ISDA Master Agreement with two Affected Parties and as though the only Affected Transactions are those in respect of which the Benchmark Trigger Event has occurred. If the 2002 ISDA Master Agreement is used, the Additional Termination Event is treated as a Force Majeure Event, as though the Waiting Period expired on the Cut-Off Date.

It is not entirely clear how market participants will value the terminated trade in practice, given that the market for trades of the type in question will have been curtailed by the relevant Benchmark Trigger Event.

What applies in the interim when determinations are to be made?

The Supplement also sets out "Interim Measures" to address a scenario where a determination is required to be made following a Benchmark Trigger Event (e.g. on a Reset Date for an interest rate swap) but no fallback yet applies. Generally, if the original benchmark is still available and can be used, the original terms applying to determination will continue to be used until and including on the Cut-Off Date. Otherwise the rate will be determined pursuant to any agreed fallbacks intended to be used where there has been no Benchmark Trigger Event (e.g. the usual screen rate fallbacks in the 2006 ISDA Definitions).

If none of the above produces a level for the Relevant Benchmark, the Supplement includes provisions allowing parties to use the last published rate on the last day on which the rate was published or can be used under applicable law or regulation.

Other annexes

The other annexes are less detailed than the 2006 Definitions Benchmarks Annex, since the relevant definitions booklets already include some relevant fallbacks which can be employed or adapted.

2002 Equity Derivatives Definitions

This Annex provides for the consequences of an "Index Cancellation Event" (using the existing definition in the 2002 Equities Definitions) and an Administrator/Benchmark Event.

Upon an Index Cancellation Event or an Administrator/Benchmark Event, the terms of the trade will be adjusted to reference the specified Alternative Pre-Nominated Index, if any, provided that such adjustment is subject to any Adjustment Payment being agreed by the second Exchange Business Day following the relevant event.

Otherwise, the consequences set out in the confirmation will apply, provided that, if no consequences are specified for an Administrator/Benchmark Event, the consequences specified for an Index Cancellation in the 2002 Equity Derivatives Definitions apply to the Administrator/Benchmark Event and the Administrator/Benchmark Event is an additional "Index Adjustment Event" for the purpose of Section 11.1(b) of the 2002 Equity Derivatives Definitions.

Effectively this extends the Index Cancellation provisions of the 2002 Equity Derivatives Definitions to cover an Administrator/Benchmark Event without the parties having to add new fields to the confirmation.

1998 FX and Currency Option Definitions

Since the 1998 FX and Currency Option Definitions already specify certain fallbacks for a "Price Source Disruption", this Annex provides for certain transactions that:

• the fallbacks for Price Source Disruption that are specified in the confirmation will also apply in the case of an Administrator/Benchmark Event; or
• if the confirmation does not specify such Disruption Fallbacks, certain existing fallbacks in the 1998 FX and Currency Options Definitions will apply to the trade upon an Administrator/Benchmark Event.
  

2005 Commodity Definitions

This Annex provides for, amongst other things, an Administrator/Benchmark Event. It provides that:

• the Disruption Fallbacks specified in the confirmation will apply in the case of an Administrator/Benchmark Event; or,
• if the confirmation does not specify such Disruption Fallbacks, certain existing provisions of the 2005 Commodity Definitions are invoked.

Related developments

ISDA is working on amended definitions booklets to embed the specific alternative risk-free rates that have been identified to replace certain IBORs.

In connection with those amendments, in July 2018 ISDA began a consultation on technical issues relating to adjustments to those risk-free rates. The consultation is open until October 2018.

Further considerations

Where the relevant derivative trade forms part of a broader transaction, such as structured funding transactions or hedging for loans or structured finance transactions, the parties will also need to consider whether the fallbacks under the Supplement are consistent with other parts of the transaction's structure or the risk that is being hedged.

Authors: Anne Tanney, James Knight and Jonathan Haines.