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ISDA Publishes Responses to Benchmark Consultation

The International Swaps and Derivatives Association, (ISDA) has published a statement summarising the preliminary results of a consultation on technical issues related to new benchmark fallbacks for derivatives contracts that reference certain interbank offered rates (Ibors).

The consultation, which was launched in July, covered the proposed methodologies for certain adjustments that would apply to the fallback rate in the event an IBOR is permanently discontinued. 

ISDA says it received 152 responses from 164 entities to theconsultation, from avariety of market participants, including banks, asset managers, pension funds, corporate entities, exchanges and clearing houses, global financial services firms, industry and trade associations and government entities from a variety of jurisdictions submitted responses. 

While ISDA stresses that the final decision is yet to be made by its Benchmark Committee, the overwhelming majority of respondents preferred the compounded setting in arrears rate’for the adjusted risk-free rate (RFR), and a significant majority across different types of market participants preferred the ‘historical mean/median approach’for the spread adjustment. It says the majority of respondents preferred to use the same adjusted RFR and spread adjustment across all benchmarks covered by the consultation (and potentially other benchmarks). 

Of the respondents who instead preferred the ‘forward approach’ for the spread adjustment, more than half indicated that the historical mean/median approach was their second choice and that they supported it as well. “Only a very small percentage of respondents indicated that they would be opposed to using the historical mean/median approach for the spread adjustment, whereas more respondents indicated that the forward approach would be problematic,” ISDA says. 

Finally, from a qualitative perspective, respondents cited a number of disadvantages of the forward approach and fewer disadvantages of the historical mean/median approach. 

Based on feedback, ISDA says it expects to proceed with developing fallbacks for inclusion in its standard definitions based on the compounded setting in arrears rate and the historical mean/median approach to the spread adjustment for all of the benchmarks covered by the consultation. It stresses, however that it continues to analyse responses to the specific questions about the historical mean/median approach (for examplethe appropriate length of the look-back period, whether the calculation should be based on a mean or median and implications for various types of transactions) and suggestions from respondents about potential variations of that approach to assess what additional feedback may be necessary. 

By the end of December 2018, ISDA says it hopes to publish anonymised and aggregated results of this analysis, and a summary of the feedback, together with the ISDA Board Benchmark Committee’s final decision on the approach to the adjusted RFR and spread adjustment to use for developing fallbacks. As part of that decision, the Benchmark Committee will set out the details related to the adjusted RFR and spread adjustment that remain outstanding and describe the steps that will be taken to finalise those details. 

Before implementing fallbacks in the 2006 ISDA Definitions, the association will publish the developed approach to the adjusted risk-free rate and the spread adjustment for review and comment. “ISDA expects this review period to occur sometime during the first half of 2019, it states. “ISDA may also solicit feedback from market participants on any outstanding details during this period.” 

Preliminary feedback from respondents to the consultation indicates that the compounded setting in arrears rate and the historical mean/median approach to the spread adjustment may also be appropriate for USD Libor, and potentially other benchmarks (including EUR Libor and Euribor), however, as previously stated, ISDA will launch supplemental consultations in early 2019 to gather feedback from all market participants before moving forward with fallbacks for benchmarks not specifically covered by the recently completed consultation. 

“The development of robust contractual fallbacks for derivatives that reference Libor and other key Ibors is critical to ensure financial stability in the event an IBOR ceases to exist. We are very pleased with the breadth of responses for our consultation,” says Scott O’Malia, ISDA chief executive.

ISDA has been leading an industry effort to implement robust fallbacks for derivatives contracts referenced to certain Ibors since 2016, at the request of the Financial Stability Board’s Official Sector Steering Group (FSB OSSG). The FSB’s objectives were for market participants to understand the fallback arrangements that would apply if key Ibors were permanently discontinued, and for the arrangements to be robust enough to prevent potential serious market disruption.

If an IBOR is not available (including if it is permanently discontinued), current fallbacks under the 2006 ISDA Definitions require the calculation agent to obtain quotes from major dealers in the relevant interdealer market. If an Ibor has been permanently discontinued, it is likely that major dealers would be unwilling and/or unable to give such quotes. Even if quotes were available in the near-term after a permanent discontinuation, it is unlikely they would be available for each future reset date over the remaining tenor of long-dated contracts. It is also likely that quotes could vary materially across the market. 

Following consultation with industry participants, regulators and the FSB OSSG, the fallback rates will be the risk-free rates (RFRs) identified as alternatives for the relevant Ibors as part of global benchmark reform efforts. These fallbacks will be included in the ISDA definitions for interest rate derivatives and will apply to new Ibor trades. ISDA will also publish a protocol to allow participants to include the fallbacks within legacy Ibor contracts, if they choose to. 

The adjustments reflect the fact that the Ibors are available in multiple tenors – for example, one, three, six and 12 months – but the RFRs are overnight rates. The Ibors also incorporate a bank credit risk premium and a variety of other factors (such as liquidity and fluctuations in supply and demand), while RFRs do not. The adjustments to the RFRs are intended to ensure legacy derivatives contracts referenced to an Ibor continue to function as close as possible to what was intended if a fallback takes effect.

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Colin Lambert

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