Borrower Alert:

The ISDA IBOR Fallback Protocol and What it Means for You

Alright, we know you’re wondering what the heck the IBOR Protocol is and why you should care. It’s a topic that’s mind numbingly boring and confusing to even the savviest, but it’s important for borrowers to understand to avoid potentially negative financial impacts on their floating rate loans, swaps and rate caps down the road. With that being said, buckle your seatbelt and hang here with us over the following paragraphs for the skinny on the IBOR Protocol and how it could impact you.

First Off, What’s Happening?

As part of the process of lenders and financial markets transition away from LIBOR, the International Swaps and Derivatives Association (ISDA) has published its long-awaited 2020 IBOR Fallbacks Protocol (the Protocol) and related Amendments to the 2006 ISDA Definitions (the Amendments). These documents, together, represent a significant step toward the modification of interest rate swap and rate cap contracts toward the anticipated transition away from LIBOR.

What is the International Swaps and Derivatives Association (ISDA)?

The International Swaps and Derivatives Association (ISDA) is a trade collective made up of more than 800 market participants (bankers, lawyers, and large derivatives end-users, mostly) from almost 60 countries around the world. In 1992, the association developed a standardized contract called the ISDA Master Agreement, which is now used as the de-facto contract for interest rate swaps and rate caps. If you’ve ever bought an interest rate cap or entered into an interest rate swap, it’s highly likely that the legal contract you signed to manifest that transaction was an ISDA Master Agreement.

Curious on where rates are headed through all of 2021 and why? Check out our 2021 Interest Rate Outlook.

What is the ISDA Master Agreement?

The ISDA Master Agreement is an umbrella agreement which defines the overarching legal terms between you, as borrower, and the bank that sold you the swap or rate cap and which governs derivative transactions between the parties.  Each swap or rate cap transaction is memorialized in what’s called a “Confirmation” which defines the business details of the transaction and references the ISDA Master Agreement terms. Now that we’ve covered ISDA and what it is, let’s move onto LIBOR.

What Is LIBOR and Why Is It Going Away?

As discussed at length in some of our other publications, the London Interbank Offered Rate, better known as LIBOR, has been used since the mid-1980’s to price trillions of dollars’ worth of financial products: everything from securities, student loans, interest rate hedges, credit cards and mortgages.

For real estate specifically, LIBOR is a key component of interest rate calculations in floating and interest-only loans as well as fixed-rate loans locked via a swap rate. After the 2008 financial crisis, a worldwide LIBOR manipulation scheme by large banks was discovered, and a litany of scandals and billion-dollar fines ensued, prompting regulators to ask: Is LIBOR serving the true purpose for which it was intended? Is it the best we can do? In short, the answer was an unequivocal NO. As such, regulatory officials have been slowly but surely planning for LIBOR to be replaced and are steadily implementing a plan for a transition to “alternative benchmarks” by June of 2023.

Who’s running the LIBOR transition show? What Benchmark Will Replace LIBOR?

The Alternative Reference Rates Committee, aka “ARRC”: a group of bankers, attorneys and regulators, organized by the Federal Reserve Board and the New York Fed, to help ensure a successful transition from LIBOR to a more robust reference rate. The ARRC has recommended that the Secured Overnight Financing Rate (“SOFR”) replace LIBOR, but isn’t forcing anyone, legally, to use SOFR. Using SOFR in place of LIBOR is strictly voluntary. Other alternatives to LIBOR exist, like AMERIBOR, the ICE Bank Yield Index, and others and will likely be tapped to replace LIBOR instead of SOFR in certain circumstances.

The Meat of the Matter: How Does the Discontinuation of LIBOR Impact my Swap or Rate Cap?

As stated earlier, the vast majority of the world’s swap and rate cap transactions are documented under the standardized ISDA Master Agreement, which, when originally drafted, didn’t anticipate a move away from the use of LIBOR. As such, many borrowers who have entered into a swap or own a rate cap are now left to navigate a minefield of legal holes – many of which can have a negative financial impact – unless some change is made to the underlying ISDA Master Agreement to address the shortfall. The ISDA IBOR Fallback Protocol serves to address this gap.

How Does the ISDA IBOR Protocol Address the Gap?

The ISDA IBOR Protocol provides a mechanism for you and the bank that sold you the swap or rate cap to bilaterally amend the transaction to incorporate new ISDA terms, which provide for a clear transition from LIBOR to SOFR upon the occurrence of certain objective, easily observable events – like LIBOR simply disappearing – allowing you to avoid the clumsy mechanics that existed before the Protocol.

How Do You Sign Up to Use the Protocol?

Your or the swap bank’s decision to use the Protocol is referred to as “adherence.” The process of adherence can be done directly through ISDA’s website. Adherence is free if done prior to January 25, 2021, and costs $500 thereafter per entity. That being said, there is currently no cutoff date, so you may adhere at any time. After your adherence, the Protocol amendments to your swap or rate cap contract will become effective on January 25, 2021.

Many lenders are being proactive in notifying their swap and rate cap customers of the existence of the Protocol and are encouraging them to adhere prior to January 25th to take advantage of the window to do so for free. Haven’t heard from your lender yet regarding the Protocol? While adherence is certainly a consideration for many borrowers, there are risks in doing so.

What are the Risks in Adhering to the Protocol?

While it seems that your adherence is a slam dunk, it isn’t. There are risks. Specifically:

  1. A mismatch between your loan and interest rate hedge. The reason you have a swap or a rate cap in the first place is because you hedged the financial risk inherent in a floating rate, LIBOR-based loan. Further, it’s important to remember that your loan agreement and your swap or rate cap contract are two separate, but related agreements. Just because you adhere to the Protocol, and thereby agree to amend your swap or rate cap to transition to SOFR in the future, it doesn’t mean that your loan agreement will also transition to SOFR nor do so at the same time as the rate cap or swap. Should your lender decide to transition from LIBOR to something other than SOFR, and you’ve adhered to the Protocol, you could be left in a situation where your floating rate loan is indexed to one benchmark, say AMERIBOR, and your rate cap or swap is indexed to SOFR. Such an outcome would result in a mismatch in the floating rates in each contract and ultimately leave you with a less effective hedge than you bargained for.
  1. A mismatch between SOFR and the LIBOR rate it replaces. By adhering to the Protocol, you’re agreeing to transition your swap or rate cap from LIBOR to SOFR in the future. While the ARRC, referenced above, is certainly doing its best to get SOFR ready for prime time, it’s just not there yet for a number of reasons and may not be so for many months. One possible outcome of adherence is a material mismatch between the numerical value of SOFR and LIBOR (e.g. 0.08% versus 0.15% respectively), which could result in unwanted credit spread adjustments – against you – by your lender.

What should you do now?

LIBOR’s sunset is coming – it’s a fact. As such, everyone agrees that existing LIBOR-based loans and interest rate swap and rate cap contracts will have to be modified, preferably in advance of the LIBOR transition deadline on June of 2023. While the Protocol provides a uniform, efficient way to amend a swap or rate cap, such a method doesn’t exist for loans. Before adhering to the Protocol, we suggest you consider the following:

  • Don’t take your lender’s word for it. Get educated or seek sound advice from a professional, like us at Derivative Logic, to give you a full list of pros and cons of adherence for your specific case.
  • Talk to your lender to gain a sense of how and when the loan will transition from LIBOR, and to which new benchmark it will transition. Many lenders, especially large banks, plan to transition their loans to SOFR and do so at a similar time that the ISDA IBOR Protocol outlines. Have you borrowed from a regional or community bank or non-bank lender? It’s likely that their choice of LIBOR replacement and timing won’t line up with your swap or rate cap.
  • If you’re feeling confident, head on over to ISDA’s Protocol Adherence website and start the process. You’ll find that it’s a bit clunky. Thus, reach out to us for help or allow us to do it for you.

Confused? Not sure where to start? Not understanding the basics of the LIBOR transition? We’ve got you! Sign up for our LIBOR Transition Webinar Series or give us a call.

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Source: Bloomberg Professional