The IBOR fallbacks ISDA is consulting on are for the IBOR definitions for GBP (such as GBP-LIBOR-BBA) CHF and JPY (not yet for USD or EUR) and so they would apply to new confirmations for deals done after they become effective; and they could be included in existing deals if the parties sign up to the expected ISDA protocol. They are all based on the overnight risk-free rate – so, for GBP, this means SONIA. It complements the consultation on term SONIA reference rates which began this week (see below).
Starting with an overnight risk-free rate means taking two steps: (a) using it to produce a rate for the IBOR leg for the calculation period and (b) adding on a margin to reflect bank risk. Possibilities for the first of these include:
- simply using the overnight rate on day 1 for each day in the calculation period;
- compounding the overnight rates on each date in the calculation period – which could only be done once the period had finished (this is backwards-looking SONIA, which is the current convention for GBP OIS swaps (more on these below)); or
- taking a comparable period ending before the start of the calculation period and compounding the overnight rates in that – which means you know it on day 1 but it’s artificial because it’s based on historic market conditions.
For the risk-free-to-bank-risk adjustment, it proposes various ways of using market data around the time the IBOR is discontinued to produce an add-on. This will not vary – i.e. it is not going to be dynamic, but in reality the spread does vary, and so with a fixed spread a bank lender’s profit would increase in good times (when it can borrow relatively cheaply) and be hit in bad times. Standard loan documentation (e.g. the “market disruption” clause in the leveraged LMA document) has long provided that if a reasonable percentage of the syndicate (30% or so by value usually) declare they cannot fund at LIBOR, the rate switches to cost of funds, so borrowers take that risk (and never seemingly ask for a discount if the banks can fund below LIBOR). We can expect lenders to want this yield protection position to continue.
The consultation ends on 12th October 2018.