Following up on our past posts, this update on the transition away from LIBOR (London Interbank Offering Rate), and other interbank offering rates (“IBOR”) denominated in other currencies, we discuss in this post the International Swaps and Derivatives Association (“ISDA”) Summary of Responses to the ISDA Consultation on Final Parameters for the Spread and Term Adjustments, (the “Summary of Responses”) published on November 15, 2019.
The Summary of Responses was a reaction to the ISDA’s Final Parameters Consultation, (the “Consultation”), which sought feedback on the adjustments that will be made to derivatives fallback language with IBOR’s discontinuation and the new use of risk-free rates (for example, the Secured Overnight Financing Rate (“SOFR”) in the United States). The Consultation posed various questions of implementation choices with respect to historical mean/median approach to spread adjustments and the compounded setting in arrears rate.
First and foremost, the vast majority of responses preferred calculation of a spread adjustment based on a historical median over a five-year lookback period. Respondents favored this simple approach as it would not require complicated compiling of data observations. It also is seen as more stable, objective and accurate in representing market conditions.
In addition, over 70% of the respondents opposed including a transitional period in the calculations of the spread adjustment, or of excluding outliers in the calculation of the spread adjustment. Similarly, over 75% of respondents preferred to include negative spreads in the calculation of the spread adjustment, and implement an overall negative spread adjustment. Respondents felt that negative spreads and outliers are valid parts of the data and should be included in the rate calculation.
The respondents also preferred an adjustment to the compounded setting in arrears rate with an adjustment option by reference to the city or to banking days for which the risk-free rate is published. This would address possible disruptions in payments and settlements and take into account the different time zones in cross-border transactions.
Finally, a majority of respondents preferred a backward-shift adjustment, seeing this as more consistent with market standards and less likely to inflate broad swings in rates during the calculation period.
Using this feedback, ISDA plans to use these preferences to publish the final mathematical formulas for the spread adjustment and the compounded in arrears rate, with an adjustment period before implementation of the fallback language in the 2006 ISDA Definitions.
“The LIBOR Transition” is a periodic series of updates discussing reference interbank offering rates, such as LIBOR, and the challenges involved in navigating a successful transition from their use as reference rates of choice in the market. Our most recent posts are available: “The LIBOR transition tax consequences of switching from LIBOR” and “The LIBOR Transition – ARRC’s LIBOR Fallback Language for Residential Mortgages”.
Norton Rose Fulbright has assembled a group of its lawyers from around the globe to stay on top of these issues and assist clients in the transition to new reference rates. More information can be found on our Norton Rose Fulbright web site.