Derivatives and floating rate notes disclosure
Globally, financial benchmarks are being reformed. In many jurisdictions, Risk-Free Rates (RFRs) are replacing certain Interbank Offered Rates (IBORs), including the London Interbank Offered Rate (LIBOR). In other jurisdictions IBORs are being reformed and will continue to exist albeit in a new format.
On 5 March 2021, various industry and regulatory bodies made key statements on the future cessation of certain IBORs. In particular, the UK Financial Conduct Authority (FCA) noted that all 35 LIBOR tenors would either permanently cease, or continue on an unrepresentative manner after the following dates.
31 December 2021
- All GBP, EUR, CHF and JPY LIBOR settings
- 1 week and 2 month USD LIBOR settings
30 June 2023
- Overnight and 1, 3, 6, and 12 month USD LIBOR settings
The FCA also noted that 1, 3, and 6 month LIBOR settings would continue for GBP, JPY, and USD after these dates, on a synthetic basis. Use of these synthetic LIBORs will be limited to a set of “tough” legacy transactions where other viable alternatives are not available.
It’s important for you to consider how benchmark reform and IBOR cessation announcements may impact any products you hold, may acquire or any transaction that you have or may enter into with us or any other company where such product, service or transaction references an impacted IBOR. You should also consider the potential inability of a bank to continue to offer products that reference an impacted IBOR.
In addition to the general disclosure above, please note the following specific disclosures.
These disclosures do not constitute legal advice relating to the use, change or reform of any IBOR and you should conduct your own investigations to ensure you understand the IBORs referenced in any product or transaction that you may use, the reforms and the consequences thereof. You should also take into account that the replacement of an IBOR, or potentially the change of value in an IBOR, in any type of product or transaction may also carry tax, accounting and regulatory risks.
We encourage you to seek independent expert advice, which may include legal, financial, tax, accounting or regulatory advice.
Financial benchmark reform will impact derivatives. If you enter in to a derivative which references an impacted IBOR (especially a derivative that references LIBOR and has an expiry date after December 2021 for GBP, JPY, CHF or June 2023 for USD), the transaction will need to be adjusted to accommodate the cessation of LIBOR.
It’s possible that the adjustment may impact the value, cost, and/or performance of the transaction.
International Swaps and Derivatives Association (ISDA) updates
To support this change, on 23 October 2020, ISDA supplemented existing definitions with robust fallback language for prescribed IBORs. This supplement and the associated protocol covers derivatives and other contracts that reference ISDA definitions.
- IBOR Fallbacks Supplement (PDF 874KB)
This amends the 2006 ISDA Definitions to incorporate new fallbacks for prescribed IBORS. The updated definitions apply to all new trades referencing the prescribed benchmarks that are transacted after 25 January 2021.
- IBOR 2020 Fallbacks Protocol (PDF 669KB)
This incorporates the new fallbacks from the IBOR Fallbacks Supplement into existing legacy contracts referencing the prescribed IBORs prior to 25 January 2021.
ISDA confirmed that the FCA announcement constitutes an 'Index Cessation Event' under the IBOR Fallbacks Supplement and IBOR 2020 Fallbacks Protocol. The Spread Adjustment for each LIBOR tenor was fixed accordingly and will take effect from the Cessation Date.
Other helpful information about fallbacks
- ISDA Fact Sheet - Understanding IBOR Benchmark Fallbacks (PDF 104KB)
- Bloomberg Fact Sheet - IBOR Fallbacks (PDF 373KB)
- Bloomberg LIBOR Transition Webinar - ISDA Fallback Rates
Floating rate notes (FRNs)
It remains uncertain how the industry will transition legacy FRNs referencing an impacted IBOR to a new rate.
If not transitioned, it is likely that the FRN will fall back to the last available interest rate and be considered fixed at that rate for the duration of the FRN. Where the FRN is transitioned to a new rate, it is likely that even if the new rate is a synthetic IBOR, the methodology of that new rate will differ from the impacted IBOR, which may result in consequences for you.
If you purchase FRNs with coupon payments calculated from an impacted benchmark, especially LIBOR and your FRN has an expiry date after December 2021 for GBP, JPY, CHF, or June 2023 for USD, then you should review the product disclosure information to:
- understand how the issuer proposes to manage the transition
- understand the fallback language included in the documents.
You should also consider any mismatch there may be with the IBOR fallback provisions in the FRN versus the IBOR fallback provisions in any related hedge arrangements you have entered into. If there is a material interest rate mismatch, this may undermine the effectiveness of the hedge (also known as basis risk).
You should ensure that you are familiar with the provisions of any loan agreement that you have, including the interest rate fallback provisions or any “Replacement of Screen Rate Clause”, that may be included (see below).
Generally, the existing interest rate fallback provisions in loans were designed to deal with a temporary cessation of a benchmark rather than a permanent cessation.
The interest rate fallback provisions in a loan document may not be robust enough to survive a permanent cessation of the benchmark, or may fall back to a rate that you did not envisage at the time that you entered into the loan, or to a rate that is materially different to the current rate of the loan.
In loans the ultimate fallback rate is often what is known as the lender’s cost of funds.
A loan agreement may also include provisions to replace the benchmark in certain instances. The Loan Market Association (LMA) and the Asia Pacific Loan Market Association (APLMA) have published a “Replacement of Screen Rate Clause”, which permits flexibility in the choice of a replacement benchmark upon certain trigger events and specifies the elements required for lenders to make changes.
To date, the interest on loans is based on term rates and calculated in advance. It is not clear whether forward looking benchmarks will be developed for these products. Even if they are, it remains uncertain if they will be ready for use prior to the cessation of benchmark rates, in particular LIBOR. This means that the benchmark which your loan references may be replaced with a backward looking Risk Free Rate (RFR).
You should also consider any mismatch there may be with the IBOR fallback provisions in your loan agreement vs the IBOR fallback provisions in any related hedge arrangements you have entered into. If there is a material interest rate mismatch, this may undermine the effectiveness of the hedge (also known as basis risk).
Find out more on LMA’s website lma.eu.com/libor.