Response to ISDA's Consultation on Pre-Cessation Issues for LIBOR

July 29, 2019 Chatham Financial

Consultation on Pre-Cessation Issues for LIBOR and Certain Other Interbank Offered Rates (IBORs)

Executive Summary

Chatham understands that the transition to IBOR alternatives is fraught with uncertainties and unknowns, even as to the fate of LIBOR itself. Chatham commends ISDA for trying to address these uncertainties and unknowns. Chatham, however, believes that given the uncertainties as to what IBOR alternatives and spread adjustments will exist, as well as whether and how they will work in practice for end users, a flexible approach may best protect end users rather than specific pre-cessation protocols and triggers.

Chatham recognizes the primary issue: IBORs such as LIBOR could continue to be published but could degrade to a point where they are no longer representative of the market they were designed to measure. Chatham also recognizes that there are no agreed-upon standards by which a regulator could determine that a benchmark had become non-representative.

Chatham can envision a scenario where LIBOR, for instance, may have degraded but is still being published and still may function better than the available alternatives. In other words, for legacy contracts, relying on a degraded but still published LIBOR may cause fewer operational and legal issues than switching to an alternative.

Therefore, Chatham approaches the concept of pre-cessation triggers with caution. To the extent that an IBOR degrades and a better alternative exists, counterparties can always choose to negotiate a transition to a better alternative. Chatham is committed to working with our clients to bring about an end to survey-based legacy IBOR rates where possible; nevertheless, we recognize that while IBOR alternatives and IBOR alternative-based markets develop, Chatham believes the best way for end users to protect themselves may be to maintain flexibility.

 

Introduction

Chatham and its end-user clients use derivatives to hedge financial risks associated with interest rates, FX, and commodities. Because of the bespoke nature of this segment of the derivatives market, it requires special consideration, and it is important that ISDA explicitly recognize the needs of this segment.

Differences in the currently proposed fallback language for cash instruments published by the Alternative Reference Rates Committee (“the ARRC”) and for derivatives by ISDA create a divergence that introduces basis risk, operational difficulties, and accounting challenges. When entering into derivatives transactions to hedge cash instruments, best practices are predicated on having close alignment between LIBOR cessation triggers, replacement indexes, and spread adjustments.

Fallbacks to forward-looking term rates are currently being contemplated for cash instruments and retail products but not for derivatives. Market experience with compounded rates as IBOR replacements is limited. There is substantial uncertainty around the availability and viability of forward-looking term rates. Compounded SOFR (Secured Overnight Financing Rate) appears to be the favored choice of both the Federal Reserve Board of Governors (“FRB”) and ISDA, however, efforts to promote SOFR in the U.S. represent a significant reengineering of financial markets that may impose significant costs on end users and frustrate sound risk management practices.

End users may be in favor of term rates for their cash instruments due to their familiarity and the fact that current systems and market practices are based on forward-looking term rates—conceivably making a transition to term rates easier to administer than a transition to compounded rates. However, the uncertainties around the availability and viability of forward-looking term rates could force participants to use compounded rates, if they are the only reliable alternative available.

End users face a dilemma in evaluating fallback alternatives amongst those proposed by ISDA because the field of potential options appears artificially limited. If ISDA does not include forward-looking term rates for SOFR in its fallback waterfalls, end users may prefer to negotiate fallbacks to forward looking term rates for derivative contracts, if they are being used in cash or retail products and are robust/viable. Chatham recommends that ISDA thoroughly consider the implications if a small minority of market participants choose to negotiate fallbacks rather than adhering to a protocol. A lack of adoption by market segments could render the transition that much more challenging and should be considered in depth during the process of developing the new definitions and protocol.

It is also possible that LIBOR alternatives created by other market participants (e.g., AMERIBOR, ICE Bank Yield Index) could have utility as USD LIBOR replacements for cash instruments and derivatives used to hedge them. If they prove robust and viable, end users may seek to negotiate the use of these rates in cash instruments and derivatives used to hedge them, as they offer both term structures and a measure of credit exposure.

While end users understand the desire of the FRB to encourage the creation of liquidity for risk-free rate alternatives such as compounded SOFR, the FRB and ISDA should state clearly to the public that market participants are free to develop and adopt other LIBOR alternatives. In fact, given uncertainties of how SOFR-based rates will work in practice, we suggest the FRB and ISDA encourage end users’ ability to choose rates that best suit their needs and actively participate in efforts to determine which rates best fit end users’ needs.

The nature of the bespoke market is that market participants are free to negotiate rates that best suit their needs. However, communications from the FRB, ARRC, and ISDA appear to encourage market participants to adopt compounded versions of SOFR. This has created uncertainty for end users and could discourage the development of IBOR alternatives that may better suit the hedging needs of end users, such as, for example, forward-looking SOFR term rates.

Considered in this light, pre-cessation triggers may not solve a problem, as much as layer on another level of complexity and uncertainty for end users.

 

Responses to Questions

Question 1: Would you be content to have any contracts that continue to reference the Covered IBOR after the supervisor of the Covered IBOR’s administrator makes a statement that the Covered IBOR is no longer representative? If so, why and under what circumstances?

The number of different market segments, asset types, and financial products that currently exist and have exposure to the IBORs mean there is no easy answer to this question. To answer, the question of whether there are effective alternatives to the IBOR that has been declared no longer representative must be considered. The best alternatives have the following characteristics:

  1. Has adequate liquidity so that bid-ask spreads are reasonable,
  2. Is operationally similar to the IBOR it replaces, e.g., if it has a forward-looking term structure it will likely be operationally easier to implement than a compounded in arrears term structure, and
  3. Contains a credit component or can be combined with some other credit component to effectively hedge credit risk.

Given the potentially abbreviated timetable for IBOR transitions, it is possible that some or all of these criteria may not be met, particularly in the case of an abrupt discontinuation. For many of the transactions on which Chatham advises, there are currently no viable alternatives to the Covered IBORs, nor a realistic timetable for such viable alternatives.

The current reality, therefore, for end users is that there is no reasonable alternative but to continue to reference the Covered IBORs. The tenor of these contracts and current state of market development for IBOR alternatives means that it is likely, if not inevitable, that there will still be legacy contracts referencing the IBORs at the point that a supervisor of a covered IBOR states a particular IBOR is no longer representative.

Chatham encourages supervisors to be cognizant of this fact, and to make sure that they work with benchmark providers and calculation agents to ensure that there is some runoff period following any announcement that an IBOR is no longer representative.

Question 2: What actions would you take if the supervisor of a Covered IBOR administrator makes a statement that a Covered IBOR is no longer representative but the Covered IBOR continues to be published? Please differentiate between ceasing use of that Covered IBOR in new derivative contracts and negotiating amendments to existing derivative contracts. Please comment on LIBOR in particular and explain whether your answers differ across Covered IBORs. Would the facts and circumstances surrounding the supervisor’s assessment and statement affect your actions? If so, how?

There is still a great deal unknown about how IBOR replacements and spread adjustments will work in practice, and if they can fulfill the same market functions that the IBORs currently fulfill. Combined with the fact that Chatham and our clients are involved with many different types of products and asset classes, it is impossible to provide a single answer to this question.

The decision of what actions to take if a Covered IBOR administrator makes a statement that a Covered IBOR is no longer representative would depend upon a combination of what language had previously been agreed to in the contract between counterparties, the product type and asset class involved, and the availability, effectiveness, and liquidity of potential alternatives. Such actions may also be influenced by the triggers and replacement IBOR provisions in underlying loan documents, where derivative transactions need to behave similarly to the loan with respect to IBOR replacement. Chatham clients who rely on hedge accounting will be particularly motivated to ensure that the hedging instrument performs congruently with the risk being hedged under the relevant loan(s). As a result, the actions to be taken with respect to the amendment of existing documents and for purposes of future derivative contracts will largely be informed by client- and trade-specific considerations.

Given the uncertainties, Chatham currently counsels its clients to maintain flexibility in order to be able to manage the risks that might flow from a situation where an IBOR was declared no longer representative.

Question 3: Do you expect to amend or close out your derivative contracts referencing Covered IBORs prior to the possibility of a statement that a Covered IBOR is no longer representative? Please specifically comment on whether you expect to have exposure to LIBOR post-2021.

As noted in our response to question 1, being able to close out or amend derivative contracts referencing covered IBORs depends on many factors. If effective IBOR substitutes develop and are viable, we expect that some of our clients would amend their derivatives contracts. And, while most of our clients prefer not to have to close out any of their derivatives contracts, close out remains a possibility as well, especially if clients expect negotiation of fallback language to be difficult or impossible with certain counterparties. However, given the current state of market development, we expect many of our clients will continue to have significant exposure to LIBOR post-2021.

Question 4: Do you expect any impediments to taking the steps you would want to take? How could ISDA mitigate these impediments? What other entities could mitigate these impediments and how could they do so?

Yes, Chatham sees several significant impediments. To date, the process for identifying IBOR alternatives, particularly for LIBOR, has been difficult to navigate. Because of the concerns regarding the manipulation of LIBOR, it is understandable that a primary focus of regulators has been on identifying rates that are based upon a robust pool of transactions such as SOFR. However, market participants face a different challenge in finding alternative rates that most effectively mirror the IBOR to be replaced, have the lowest barriers to implementation, and can be effectively used to hedge credit risk. End users are also likely to be motivated to ensure that IBOR replacement does not result in value transfers to their bank counterparties who may have greater leverage in negotiating alternative rates and corresponding spread adjustments.

The potential gap between the needs of regulators and end users could complicate the transition to IBOR alternatives if it turns out there are significant challenges in using IBOR alternatives for hedging.

ISDA and other entities could help mitigate these impediments by convening forums or working groups that specifically focus on the utility of the proposed IBOR alternatives for end users as well as expressing openness and encouragement for the development of potential alternatives that might have greater market utility for end users.

ISDA IBOR Fallbacks
Question 5: Would it be appropriate to include a pre-cessation trigger regarding ‘representativeness’ with the triggers for permanent cessation in the amendments to the 2006 ISDA Definitions and in the protocol that ISDA intends to publish to introduce the IBOR fallbacks? Please explain your answer.

In line with the answers above, the utility of a pre-cessation trigger based on representativeness depends upon whether the alternative rates and spread adjustments that would be triggered by a determination of “non-representativeness” would provide an effective and viable alternative to sticking with the current referenced IBOR. Moreover, the utility of defining a pre-cessation trigger may be influenced by whether such trigger is objectively measurable or is based on debatable subjective determinations.

Given the existing uncertainties regarding alternative rates and spread adjustments, Chatham does not universally recommend including pre-cessation triggers at this time and believes that the decision to move to an alternative rate and spread adjustment should be left to negotiation between counterparties and the client’s decision of whether to include a pre-cessation trigger given the current state of the market.

Question 6: Is inclusion of the trigger necessary to enhance existing controls and mechanisms already in place contractually and/or under existing law or are these controls and mechanisms sufficient?

Until there is greater certainty regarding how IBOR alternatives and spread adjustments will work in practice, Chatham believes it is sufficient to allow potential counterparties to negotiate pre-cessation triggers. Introduction of potentially more uncertainty and complexity through additional protocols and schedules may not help end users who may prefer to maintain flexibility rather than sorting through additional complicated protocols and mechanisms.

Question 7: What problems could arise if such a trigger were not included in amendments to the 2006 ISDA Definitions and in the protocol that ISDA intends to publish to introduce the IBOR Fallbacks? Please specifically consider and comment on (a) the potential for a CCP to exercise its discretion to change a reference rate if it determines that a Covered IBOR is no longer sufficiently robust or no longer fit for purpose; (b) management of a legacy portfolio of derivatives referencing an IBOR if use in new contracts is also prohibited by regulation (at least for entities in certain jurisdictions); and (c) derivatives that hedge cash instruments that may have pre-cessation triggers and fallbacks.

Question 8: What problems could arise if such a trigger were included? Please also consider derivatives that hedge cash instruments that do not have pre-cessation triggers and fallbacks. Please consider the implications of linking the fallbacks for the permanent cessation of a Covered IBOR with the agreement to convert the Covered IBOR to the corresponding adjusted RFR plus a spread upon a pre-cessation trigger.

Response to Questions 7 and 8: Since counterparties have the ability to negotiate pre-cessation triggers, Chatham believes that appropriate pre-cessation triggers could be negotiated by counterparties for particular use cases where they are appropriate.

Question 9: Do you think inclusion of a pre-cessation trigger would positively or negatively affect industry take up of the permanent cessation fallbacks? Please specifically comment on adherence to the protocol to amend legacy derivative contracts.

Chatham believes that counterparties themselves are in the best position to determine whether a pre-cessation trigger is necessary based upon the facts and circumstances of a particular use case.

Question 10: What problems could arise if such a trigger were not included in amendments to the 2006 ISDA Definitions and in the protocol that ISDA intends to publish to implement the IBOR Fallbacks?

Given the unknowns of how IBOR alternatives and spread adjustments will work for particular use cases, it is hard to identify the specific problems that would arise from not including a pre-cessation trigger in the amendments to the 2006 ISDA Definitions and in the protocol that ISDA intends to publish to implement the IBOR Fallbacks. As noted above, these problems would, in many instances, likely be specific to particular use cases and could also be addressed through negotiation of pre-cessation language, where appropriate, by counterparties.

As an alternative, ISDA could potentially publish a protocol including pre-cessation triggers and related fallbacks that allows adherents to (a) exclude certain transactions, (b) only include certain transactions, (c) require both counterparties to agree to include the pre-cessation trigger and related fallback through a “matching” function and/or (d) allow both counterparties to agree to exclude the pre-cessation trigger and related fallback through a “matching” function. Additional variations of the foregoing may also be possible. Any amendments made pursuant to such a protocol would apply in addition to the permanent cessation triggers and ISDA IBOR fallbacks and would be implemented in a way that does not add optionality to inclusion of those fallbacks upon the occurrence of a permanent cessation of a Covered IBOR in existing transactions between adhering parties.

Question 11: Would such a protocol be helpful to address concerns regarding ‘non-representative’ benchmarks? If so, which of the approaches listed above (and/or variations of these approaches) do you prefer?

The alternative protocol proposed above has benefits in that it moves away from a one-size-fits-all approach towards a flexible approach that helps counterparties negotiate appropriate language for particular use cases. However, Chatham believes that such a protocol would likely prove cumbersome and operationally challenging for many end users, thereby limiting the usefulness of this approach

Chatham generally prefers approaches (b) (“only include certain transactions”) and (c) (require both counterparties to agree to include the pre-cessation trigger through matching) since these options make it less likely that end users will inadvertently include the pre-cessation trigger. However, with respect to option (b) (“only include certain transactions”), it is not clear what criteria are envisioned to be used for those transactions that should be included, versus those that should not. Chatham believes one interpretation is that parties would only choose to include those derivatives transactions that hedge cash products containing the same or similar pre-cessation triggers as would be contained in the ISDA protocol. However, we can envision that market participants could come up with many other criteria for making such a determination. This seems to introduce complexities that, again, may cause operational difficulties meaning it would be unlikely to be used by end users.

Option (c) (“require both counterparties to agree to include the pre-cessation trigger and related fallback through a “matching” function”) does have the advantage of requiring consent from both counterparties, allowing end users to protect themselves. However, both option (b) and option (c) would also require the opposing counterparty to agree to include the same transactions or match, and  this could result in longer negotiations or other operational difficulties. Therefore, the alternative protocol proposed above may still be complicated and operationally difficult enough such that end users may avoid it.

Question 12: Please comment on the relative disadvantages and advantages of such a protocol as compared to inclusion of a pre-cessation trigger in the 2006 ISDA Definitions and the protocol that ISDA intends to publish to implement the IBOR Fallbacks without any ability to elect for or against inclusion of such a pre-cessation trigger.

The advantage of such a protocol would be that it would give counterparties more flexibility to customize the triggers for their derivatives to match the triggers in their cash products. The disadvantage, however, is that such a protocol would presumably require counterparties to complete an extra step and potentially pay an extra fee in addition to what would be required to incorporate the 2006 ISDA Definitions (for new transactions) or adhere to the IBOR Fallback protocol (for legacy transactions). In addition, the added complexity of having to include or exclude certain trades, or the need for both parties to agree on including a pre-cessation trigger, could prove cumbersome and operationally difficult for many end users. Chatham’s experience with earlier ISDA protocols is that the more operationally difficult and cumbersome that a protocol is, the lower the uptake of that protocol by the end-user community.

Question 13: Would you prefer using such a protocol as opposed to template language for bilateral incorporation in derivative contracts to address concerns regarding ‘non-representative’ benchmarks, and other pre-cessation concerns you may have?

Entities transacting with multiple counterparties will likely prefer the convenience and efficiency of a protocol, but Chatham expects many end users will instead prefer template language for bilateral incorporation, as this will be operationally easier for end users facing only one or a few counterparties, and will also give end users the most flexibility to customize language to fit their particular needs.

Question 14: Do you have any other suggestions for flexible solutions to include pre-cessation triggers and corresponding fallbacks in derivative contracts on a voluntary basis that are less burdensome than template language for bilateral incorporation?

Chatham does not have further suggestions. As noted above in several answers, given the unknowns as to what IBOR alternatives will be available, whether they will be effective, and whether they will be viable, the best approach for many end users will be to maintain flexibility to address the coming changes as more becomes known. Adopting further triggers or protocols wholesale may introduce further complexity and uncertainty for end users. Consequently, they would be unlikely to be adopted by end users.

If the Covered IBOR continues after counterparties convert to the adjusted RFR plus a spread, the counterparties would be able to determine whether they are receiving/paying more or less on the basis of the adjusted RFR plus the spread by comparison with the unrepresentative Covered IBOR that continues to be published.

Question 15: Would it be appropriate to use the adjusted RFR plus a spread under these circumstances or could it be problematic? Please explain.

Given the uncertainties involved in IBOR transitions, a dynamic spread may provide a better bulwark against value transfer than a static spread. In such a situation as the one posited in this question, we would expect that many clients would seek to reference the spread between the “RFR plus a spread” and the unrepresentative Covered IBOR if the Covered IBOR continues to be published.

Question 16: Is there a way to mitigate against any concerns regarding the fact that counterparties could determine this?

As noted in our response to question 15, we expect that counterparties may seek to reference the spread between the “RFR plus a spread” and the unrepresentative Covered IBOR.

Question 17: If you would not want to replace references to the Covered IBOR with references to the adjusted RFR plus a spread under these circumstances, what other amendments to existing derivative contracts would you want to make following such a statement?

As mentioned above in several answers, this would depend upon the facts and circumstance of a particular client’s situation. Chatham believes it is important for end users to maintain flexibility at this point.

If the supervisor of the administrator made a statement that a Covered IBOR is no longer representative and, as a result, derivative contracts are amended to reference the adjusted RFR plus a spread calculated by reference to historical data at the time the relevant regulator makes such a statement, and the Covered IBOR is subsequently permanently discontinued following an ‘index cessation event’ (as set out on pages 2 to 3 above), the spread that would apply for the permanent cessation fallbacks would differ from the spread that applied for the pre-cessation fallbacks (i.e. because the spread would be fixed at different times by reference to historical data available, in the case of the pre-cessation trigger, when the non-representativeness statement is made and, in the case of the permanent cessation trigger, when the statement regarding permanent cessation is made).

Question 18: In this scenario, should the spread adjustment following permanent discontinuation of the Covered IBOR automatically change to the ‘permanent cessation’ spread (i.e., a spread calculated by reference to historical data at the time the announcement is made in respect of permanent cessation)? Alternatively, should it remain at the spread adjustment for the ‘pre-cessation’ event?

Question 19: Would it be problematic to have multiple spread adjustments apply based on when the fallbacks took effect (i.e., prior to cessation or upon cessation)?

Question 20: If adherents to a protocol of the type described in questions 11-14 above exclude a pre-cessation trigger for fallbacks in certain contracts and/or with certain counterparties, should they agree that the spread adjustment related to the pre-cessation trigger would nevertheless apply if a permanent cessation occurs?

Response to Questions 18, 19, and 20: As noted above in several answers, this would depend upon the facts and circumstance of a particular client’s situation. Chatham believes it is important for end users to maintain flexibility at this point.

As also noted above, the more complex the options provided by ISDA in terms of protocols and fallbacks, the more operational difficulty that end users are likely to have in sorting through and utilizing those options.

 
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