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Although it may not rival the annus mirabilis of 1905 in the history of science,1 the week of July 9, 2018 will certainly stand out for its high concentration of newsworthy pronouncements and initiatives in interest rate benchmark reform. During that week, the Financial Stability Board (FSB) published a statement on the role of overnight risk-free rates vs. term rates in interest rate benchmark reform, the UK Financial Conduct Authority's Chief Executive Andrew Bailey gave a speech on transitioning to a world without LIBOR, the US Commodity Futures Trading Commission (CFTC) hosted a meeting of its Market Risk Advisory Committee (MRAC) focusing on LIBOR reform and its impact on derivatives markets,2 and the International Swaps and Derivatives Association (ISDA) launched a consultation paper on the choice of methodology to determine fallback rates for derivatives referencing certain Interbank Offered Rates (IBORs). This legal update distills some key themes from these events, with a focus on the interdependence between the derivatives and cash markets for interest rate instruments.

Overnight vs. Term Rates

In its July 12 statement, the FSB explains the rationale for its view that transition efforts should focus on overnight risk-free rates (RFRs), rather than forward-looking term rates (FLTRs) derived from them, as the primary fallbacks for replacing IBORs. While acknowledging the possible need for FLTRs in certain market sectors (e.g., to enable cash flow planning in advance of an interest payment), the FSB expresses concern that inappropriately widespread adoption of FLTRs as IBOR replacements could be inconsistent with financial stability goals. Thus, "[i]f future use of term rates is relatively narrow compared with current use of IBORs, for example if it is concentrated largely in a segment of the cash rather than derivative markets, this more limited use would be compatible with financial stability."

FLTRs measure a forward expectation of overnights RFRs over a designated term. The FSB views such term rates as by their nature reliant on liquidity in derivative markets for RFRs.  (This is because the trading prices of overnight index swaps (OIS) and futures are likely sources from which such term rates could be derived.)3 Therefore, the FSB does not expect RFR-derived FLTRs to be as robust as the RFRs themselves. It appears that the FSB considers the appropriate role for FLTRs to be in facilitating the transition from IBORs "in those cases where it is not practicable to use either the compounded overnight RFR observed over the contractual reference period and calculated at the end of the period shortly before payment is due, or a measure of observed RFRs set at the beginning of the interest period."

Linkage between Cash and Derivatives Markets

According to the FSB statement, market feedback suggests that an important factor in the choice of an interest rate benchmark is being able to transact at the tightest spreads. The FSB suggests that a concentration of liquidity in derivatives markets on overnight RFRs would tend to attract other markets to adopt the same rates in order to facilitate hedges and maintain consistency across cash products and derivatives contracts. 

In his July 12 speech, Mr. Bailey, who is also a co-chair of the Official Sector Steering Group of the FSB, elaborates on the FSB statement's discussion of the interaction between cash and derivatives markets through hedging. He observes that it is probable that, due to their greater anticipated liquidity, OIS-based derivatives linked to RFRs would provide the cheapest hedges, thereby incentivizing cash markets to adopt the same rates. Like the FSB, Mr. Bailey reports that certain segments of the cash market may nonetheless prefer FLTRs, and he raises the possibility that "perhaps a small part of the derivatives market which directly hedges cash market instruments" will be based on FLTRs.4 

Complacency and the Path Forward

In his speech, Mr. Bailey warns against misplaced confidence in LIBOR's survival, cautioning that the "biggest obstacle to a smooth transition is inertia." Mr. Bailey cites the paucity of actual transactions and increased reliance on expert judgment as factors that cast doubt on whether LIBOR can be sufficiently representative to meet the requirements of the EU Benchmark Regulation. In his view, the smoothest means for the transition is to begin moving away from LIBOR in new contracts, rather than to rely on fallbacks, where the switch to the new reference rate would occur at an unpredictable time. Mr. Bailey questions the feasibility of a synthetic LIBOR, in particular of reliably measuring term credit spreads for banks on a daily basis. He states that, as in the ISDA consultation, the term credit spread would almost certainly need to be fixed.

In his opening statement to the MRAC meeting, CFTC Chairman J. Christopher Giancarlo emphasizes that the discontinuation of IBORs is a certainty, and that the transition to risk-free rates will require thoughtfulness and preparation in order to support financial stability. Mr. Giancarlo remarks on the CFTC's role in policing against manipulation of benchmarks and attributes the susceptibility of LIBOR to manipulation in large part to its "eroding foundation" – the diminished reliance of money center banks on unsecured inter-bank lending. Mr. Giancarlo envisages that transition efforts will be led by the private sector, both buy-side and sell-side, with the official sector playing a role to monitor, assist and "if appropriate, give a shove or two." In his opening statement, CFTC Commissioner Brian Quintenz points out a concrete way in which the CFTC could assist the transition: by providing regulatory certainty about the treatment of legacy LIBOR-based contracts that are amended to reference the new RFRs, including how margin, clearing and trading requirements would apply to the amended contracts. On July 12, the Alternative Reference Rates Committee sent a letter to US regulators requesting clarification on these and other issues under Title VII of the Dodd-Frank Act.

ISDA Consultation

The ISDA consultation seeks market input on some technical issues relating to various alternative methodologies for determining the term and credit spread adjustments that will apply to RFRs when, under planned amendments to the 2006 ISDA Definitions, the RFRs are used as fallbacks in the definitions of certain "floating rate options" (i.e., the reference interest rates used in calculating, e.g., the floating payments under an interest rate swap).

Under the planned amendments, the relevant floating rate options will be revised to include fallbacks that will be triggered upon the permanent discontinuation of the related IBORs, as evidenced by a public statement by the administrator of the IBOR or the administrator's regulatory supervisor. The revised floating rate options will be published in a Supplement to the 2006 ISDA Definitions that parties can incorporate by reference in transactions entered into on or after the date of the Supplement.  The consultation also states that ISDA expects to publish a voluntary protocol to facilitate amendment of legacy derivative contracts (i.e., those entered into before the date of the Supplement) between adhering parties to include the new fallback-containing floating rate options. 

The consultation describes and requests feedback on four possible approaches to term adjustments — a spot overnight rate, a convexity-adjusted overnight rate, a compounded setting in arrears rate, and a compounded setting in advance rate — and three possible spread adjustment methodologies — a forward approach (based on a forward spread curve), a historical mean/median approach, and a spot-spread approach. The term adjustments aim at comparability between an IBOR, a term rate with an associated tenor, and the overnight RFR used in the IBOR's fallback. However, the term-adjusted RFRs should not be confused with FLTRs, which are disfavored in the FSB statement.  Responses to the ISDA consultation are requested by October 12, 2018.

1 In 1905, Albert Einstein published seminal papers on Brownian motion, the photoelectric effect, special relativity and mass-energy equivalence.

2A webcast, agenda and other documents from the MRAC meeting are available here.

3 The FSB observes, however, that in some currencies it may be possible to create a term rate from transactions in other markets, such as cash products and foreign exchange swaps.

4An example may be helpful in making these relationships more concrete. In an OIS, the parties agree to swap a floating interest rate based on a compounded average (i.e., a geometrical average) of the overnight index rate over the calculation period (say, three months) in exchange for a fixed rate.  See, e.g., Interim Report and Consultation of the Alternative Reference Rates Committee at 9 (May 2016). If a loan paid interest quarterly, computed as the compounded RFR over the three-month interest period, such loan might be hedged by the borrower entering into the aforementioned OIS as the floating rate receiver. If an active trading market developed in OIS of this type, one could observe bids and offers for the fixed leg of a one-period three-month OIS. With appropriate averaging and statistical filtering, one could then arrive at a benchmark that measures the rate for the fixed leg of the OIS. This rate, which would be observable at the start of the three-month period, is an example of an RFR-derived FLTR. If this rate were used as the interest rate for a loan, an appropriate hedge might be a swap in which the borrower pays fixed in exchange for receiving the "swap rate" of the three-month compounded RFR OIS. Unlike the previous example, this interest rate is not computable by applying arithmetic operations to the RFRs, but requires observation of prices for OIS that reference the RFR.