The $370 Trillion Benchmark Challenge

The transition from interbank offered rates, or IBORs, to new alternative risk-free rates (RFRs) has been likened to the move to a single currency in Europe.

To help market participants and others understand and address the many complex issues relating to this change, ISDA and other trade associations (AFME, ICMA, SIFMA and SIFMA AMG) have published a benchmark transition roadmap. This roadmap aggregates and summarizes the work conducted so far to select alternative risk-free rates (RFRs). It also sets out a number of potential challenges that firms might have to address as they transition to RFRs. The roadmap reflects over two years of work by public-/private-sector working groups to identify RFRs and plan for transition for each rate and by jurisdiction. If you aren’t familiar with this planning, or the challenges facing market participants, then you need to read this document.

So, what are the issues?

There are many. The sheer scale of IBOR exposures, for example – total outstanding notional exposure is estimated at over $370 trillion, spread over derivatives, bonds, loans and other instruments. Liquidity is another issue – more specifically, the need to establish derivatives markets in the new RFRs. Valuation complexities could emerge, such as those arising from the fact that RFRs do not include bank credit risk, which complicates the transition of legacy contracts that reference IBORs. Infrastructure issues also need to be addressed – for example, those relating to data, systems and operational procedures, trading and clearing.

The roadmap is just the first part of a comprehensive effort by ISDA and the other trade associations related to interest rate benchmark transitions. The associations will also initiate a global survey of buy- and sell-side participants and infrastructures later this month to delve into how firms use the IBORs, the extent of their readiness to transition across products, the challenges they expect to encounter, and the possible solutions they’re considering. The responses will feed into an in-depth report aimed at supporting industry interest rate benchmark transition planning efforts.

This survey will be a critical part of the outreach effort, and will complement and inform transition work being conducted by the public-/private-sector RFR working groups. It will help ensure all the important issues are identified and explored across diverse sectors of the market, helping to enable an orderly transition.

If you’re involved in benchmark transition work, we will need you to participate in our survey to identify issues and join in developing solutions. By working together, we can help ensure a successful transition, which will result in a safer and more efficient global financial market.

Brexit and the ISDA Master Agreement

It’s one of the more complex, technical issues related to Brexit, but it’s one that has focused the minds of derivatives professionals since the 2016 referendum result: what does the UK’s exit from the European Union (EU) mean for use of the English law ISDA Master Agreement?

At this point, we don’t have enough information to say for sure. If an agreement is reached between the EU and UK that preserves certain aspects of the current legal framework – for example, the automatic recognition of court judgements – then possibly not much. If there’s no agreement, then that automatic recognition between the EU and UK would fall away post-Brexit. Some firms in the EU and European economic area (EEA) may want to retain the convenience of automatic recognition across the EU/EEA by using the jurisdiction of an EU/EEA country.

Counterparties may also want to retain specific benefits of EU legislation – for example, protections under certain EU national insolvency laws that require use of an EU member-state-law agreement in order to receive those protections.

In response, ISDA is drafting French and Irish law governed Master Agreements as additional governing law options, along with French and Irish court jurisdiction clauses

So, what does all of this mean? As it currently stands, virtually all of the ISDA Master Agreements entered into between counterparties based in the EU or EEA are governed by English law. Counterparties typically also submit to the jurisdiction of the English courts. Because the UK is part of the EU and EEA, it means any English court judgement is automatically recognized and enforced across those member states. Without some type of deal that replicates the effects of EU/EEA membership, English law would become a third-country law after Brexit. One of the consequences is that English court judgements would not be automatically recognized in EU/EEA countries.

To be clear, this doesn’t mean an English court judgement won’t be recognized and enforced by an EU court after Brexit, and it doesn’t mean an English law agreement becomes less ‘valid’ or that EU/EEA counterparties won’t be able to continue to use English law Master Agreements. It does potentially mean more expense, more uncertainty and more red tape. Say an Italian and French counterparty are trading under an English law agreement with English court jurisdiction after Brexit; there’s a dispute and the English court makes a judgement in favour of the Italian counterparty. The Italian counterparty would need to get that English court judgement recognized by a French court in order to get it enforced – it’s an extra step in the process that could take years or, worse, result in another court deciding to reopen parts of the case.

Consequently, some EU/EEA counterparties may want to retain that automatic recognition and enforcement when trading with each other. There are other reasons why entities may want to carry on trading under EU/EEA law agreements. For instance, EU/EEA credit institutions are required to insert contractual recognition of bail-in into third-country law governed contracts under Article 55 of the EU Bank Recovery and Resolution Directive – and without some type of deal, this would include English law governed ISDA Master Agreements after Brexit. This wouldn’t be an issue for agreements governed by the law of an EU/EEA member state.

That’s why ISDA is looking to add the new European governing law and jurisdiction options, in addition to existing English, Japanese and New York law choices. In order to be representative of the civil and common law systems across the EU, French and Irish law have been suggested. We are also looking into the possibility of designating the courts of an EU-27 member state for English law agreements.

Working groups have been set up, and are making good progress in considering the issues and identifying what changes might be necessary. This is all about preparing for an uncertain future. Post-Brexit, there will be excellent reasons to both continue using an English law Master Agreement and to use an EU-law-governed agreement. We want to be ready for all eventualities and provide the necessary tools to our members.

Derivatives Contracts Will Not Be Void Post-Brexit

There’s a lot of speculation and second guessing about the final form of Brexit and the impact on financial services. But on one thing we can be pretty certain: existing cross-border derivatives contracts between counterparties in the UK and the other 27 European Union (EU) member states will not suddenly become null and void after Brexit. In fact, parties should be able to continue to perform on their contractual obligations – including payments, settlements and collateral transfers – as before, irrespective of the form of the UK’s withdrawal from the EU.

Does that mean there’ll be no impact at all? No. As we flagged in an earlier post, legal analysis conducted by ISDA on six jurisdictions – France, Germany, Italy, the Netherlands, Spain and the UK – shows that some activities that may arise during the life of a typical derivatives trade might be affected. These activities, which include novations, some types of portfolio compression, the rolling of open positions and material amendments, could be classed as a regulated activity, requiring local permissions.

Assuming passporting between the UK and the EU 27 ceases to be available after Brexit, and firms do not have local permissions, then it could become more challenging for those activities to take place between the UK and the EU 27 – although the exact impact differs from country to country. Absent an exemption or an equivalence determination, it could mean that firms choose to transfer outstanding contracts to a locally authorized subsidiary in the relevant jurisdiction in order for those activities to take place without interruption, or otherwise seek a local license.

Either would be time consuming and no small undertaking. But it’s important that the two issues aren’t confused – difficulty in performing some activities like novations and compression is not the same as an inability to make payments or settlements. It doesn’t mean existing cross-border contracts would become invalid after Brexit. It does mean that all parties to EU 27/UK derivatives need to think about how their ability to manage positions might be affected post-Brexit.

This issue can be resolved as part of the withdrawal agreement, or otherwise through coordinated legislative action by the EU 27 and the UK that continues to allow all activities to be taken in relation to existing contracts. That would be equally beneficial to the EU 27 and the UK. For example, it will ensure that outstanding hedges between European pension funds and UK dealers, or between UK corporates and EU banks, can continue to be managed without interruption or the need to be transferred from one jurisdiction to another.

A First Step Towards the Future

Most people working in derivatives would probably agree that if the market was built from scratch today, the likelihood is it would look very, very different.

Rather than a patchwork of disjointed, manually intensive processes, there would be greater coherence and automation. Rather than each firm having to develop and maintain its own unique catalogue of data and definitions, there’d be a standard representation of trade events and actions that everyone used. And rather than having to reconcile trades after each step in the lifecycle to eliminate inconsistencies, actions and events could be applied to a single, central record that each counterparty would have access to.

ISDA has now taken the first step to making this a reality with the rollout of a conceptual version of the ISDA common domain model (CDM). CDM version 1.0, published today, introduces the concepts to create a standard blueprint for events and actions that occur throughout the lifecycle of a trade. This is intended to be more than a data or product standard that focuses on one specific area or function: it gets to the very fabric of how derivatives are traded and managed across the lifecycle, and how each step in the process is represented.

This type of common representation is crucial if the industry is ever going to unlock the value presented by new technologies, such as distributed ledger and smart contracts. The current situation is simply unsustainable. Legacy infrastructures are old, complex and duplicative, and have been layered with additional processes – clearing, reporting, margining – in response to regulatory requirements. These infrastructures are reliant on manual intervention, and constant reconciliation is required to fix the mismatches caused by variations in how each firm records trade lifecycle events. It’s just not scalable, and it’s not fit for the 21st century.

At the same time, banks are facing increased capital requirements, high costs and pressure on profitability. New technologies offer the potential to fundamentally reshape this infrastructure by reducing operational risk, streamlining increasingly cumbersome and time-consuming processes and cutting costs. That’s why many banks have already invested in technology initiatives, and why a number of smart contract and distributed ledger proof-of-concepts have sprung up.

But automating a single business or function isn’t enough. Similarly, unilateral development of bespoke technologies will inevitably lead to the same disjointed and fragmented market infrastructure that we see today. In order to realize the full potential of these technologies, and to ensure they can work seamlessly across firms and platforms, we need to develop a common set of data and processing standards that everyone can access and deploy. Which is why our members – the very members who have invested in these technology initiatives, as well as the platforms that have launched them – are working with us on the ISDA CDM.

There are other advantages to the CDM, even without smart contracts and distributed ledger. Having a consistent representation of trade events and processes ensures firms do the same thing, in the same way, at the same time, which cuts down on the need for reconciliations. It also means regulatory updates could be made with reference to the standard blueprint, reducing time and effort to interpret and meet regulatory requirements, and ensuring accuracy and consistency in regulatory reporting.

In putting together the conceptual model for the ISDA CDM, we have leveraged our track record and expertise in developing standard legal documentation and product definitions, with the aim of creating firm foundations for industry transformation. We’ll now gather feedback from the industry – technology firms, infrastructure providers, end users and traders – and then develop a digital version of the ISDA CDM. We’ll also look to extend the model to other products and functional activities.

But this work cannot be done in isolation. In parallel, we’re working to consider the legal and governance issues relating to smart contracts, and are looking to update and future-proof our definitions to enable automation.

This is a first step in what will be a long journey, but we think it’s a journey that has to be taken. We need to ensure the derivatives market is fit for purpose for the 21st century.

Brexit and Contractual Certainty

There’s been a lot of recent focus on the impact of Brexit on the derivatives market. That’s no surprise. Derivatives are widely used by companies across Europe to create certainty and stability in their business, and to manage their risk.

ISDA has spent a lot of time looking at the contractual certainty of derivatives trades, and recently conducted analysis on one specific part of this issue: the ability of banks and investment firms to perform existing contractual obligations under transactions between the 27 European Union (EU) member states and UK counterparties that were entered into before Brexit. This analysis focused on six jurisdictions – France, Germany, Italy, the Netherlands, Spain and the UK.

The good news is that the analysis shows there is unlikely to be any impact on the performance of contractual obligations on existing trades – which includes payments, settlements, transfer of collateral and the exercise of pre-agreed options. That’s an important point: cross-border trades between EU 27 and UK entities won’t all of a sudden fall away after Brexit. However, certain events or actions that occur during the lifecycle of a transaction, and which are outside of contractual obligations, could be affected – although the exact impact differs country to country, based on the law of the applicable jurisdiction (EU 27 member state or UK).

For instance, a novation, certain types of portfolio compression, the rolling of an open position (extending the maturity of a trade), material amendments and some types of unwind may be classed as a regulated activity. That means that, without passporting rights under the Markets in Financial Instruments Directive (MIFID), investment firms, credit institutions and branches would either need to rely on an equivalence decision or an exemption, or obtain a local license in the relevant jurisdiction in order to continue to perform these lifecycle events. That could be time-consuming and pose a significant operational burden on firms, which could potentially result in disruption to financial markets.

These types of lifecycle events are frequent, and allow counterparties to manage their exposures and risk. Portfolio compression, for instance, allows firms to reduce the size of their derivatives books by tearing up multiple trades and leaving target risk profile – a concept included in the European Market Infrastructure Regulation and MIFID as a key systemic risk-reduction measure. Transitions from the IBORs would also require an amendment of contracts.

Given the significant volume of derivatives trades between counterparties in the EU 27 and the UK– and the fact that these lifecycle events are common and required by regulations in some cases – it’s critical that firms in both the EU and the UK are able to carry out the full range of actions that have been agreed between. It’s clearly in everyone’s interest – whether they are located in Munich, Milan or Manchester – that performance of these lifecycle events on existing cross-border trades isn’t interrupted post-Brexit.

As a result, we think it’s important that provisions are put in place that allow EU and UK counterparties to manage their transactions after Brexit. We would encourage policy-makers to consider all available options now, including coordinated legislative action, insertion of language into a separation agreement, or ultimately wording within the EU-UK withdrawal agreement that allows entities to continue to perform a wide range of lifecycle events. This isn’t about winners or losers. It’s about ensuring the safety and efficiency of this market post-Brexit for both EU and UK counterparties.

Some Thoughts on Noble

Credit events in the credit derivatives market often spark a lot of debate, but the issues relating to a possible restructuring of a Noble loan have been particularly hotly debated by the industry. That’s resulted in plenty of column inches in the media, which is good: it’s important that these events are discussed and deliberated, and the issues are widely broadcast to the broader industry.

On the issue of Noble, however, there are a couple of important facts we think need to be clarified. First, the determinations on whether a credit event has occurred aren’t made by ISDA. They are actually made by industry Determinations Committees (DCs) each comprising 10 sell-side and five buy-side participants. These 15 firms vote on whether a credit event has occurred depending on the publicly available information, the criteria set out in the Credit Derivatives Definitions and the rules on governance set out in the DC rules. ISDA acts as secretary to the DCs and administers the process – we don’t have a vote and we don’t make the decisions.

Saying ISDA makes the decisions is akin to saying ICE Benchmark Administration (IBA) decides what the LIBOR rate should be. After all, it’s now called ICE LIBOR and is published on the IBA website. But IBA administers the process – the actual LIBOR rates are based upon submissions from LIBOR contributor banks.

Second, some of the stories imply that the DC rules failed to provide for the Asia ex-Japan DC’s decision to dismiss. That’s incorrect. As the DC statement of August 10 states, the DC felt it did not have sufficient information to determine the DC question one way or the other, because it was not able to get hold of the underlying loan documentation and details of the guarantee. Market participants crave certainty, and so the lack of public information on the Noble loan and guarantee has created confusion and frustration in the market. The rules do allow the DCs to dismiss a question, which requires an 80% supermajority vote, and provide for the bilateral triggering of contracts in the event a question is dismissed. Now, people can argue that a different outcome would have been preferable, but they can’t argue that the potential for a dismissal isn’t set out in the rules as they stand.

Credit market participants have not had to bilaterally trigger a credit derivatives contract for some time. The complexity, operational risks and potential for disputes that it creates was one of the reasons why the DCs were established in the first place back in 2009. ISDA’s members played an important role in facilitating the determinations framework, and, in our role as secretary, we’ve worked with each of the five regional DCs to improve the transparency and governance of the DC process. There’s likely to be plenty of feedback from market participants on changes that could be made to avoid bilateral triggering exercises in future. ISDA will pull that industry comment together, and will feed it back to the DCs. Where we can lead industry debate and propose solutions, we will. It’s in everyone’s interests for this market to work as safely and efficiently as possible.




VM Rules: Almost There

Six months ago, the industry was facing the possibility of real disruption. With the variation margin ‘big bang’ set for implementation on March 1, but with only a fraction of the necessary changes to documentation completed, there was a very material risk that a large part of the market wouldn’t be able to trade.

Fortunately, regulators across the globe provided forbearance that allowed parties to continue trading under their existing documentation, providing extra time for firms to continue the lengthy and complex process of amending or creating credit support annexes (CSAs) with in-scope counterparties. That extra time was critical, as final national rules had only been published just months earlier in some cases, leaving a very small window for firms to complete what was essentially a colossal repapering exercise.

With the forbearance set to expire in certain jurisdictions, including the US, on September 1, the industry is in a much better position than it was earlier this year. At the end of February, the estimated proportion of required CSA amendments that had been completed stood at one third. That had reached 90% by the week ending August 11. The 60-odd percentage-point increase represents tens of thousands of newly amended CSAs, each requiring hours and hours of complex bilateral negotiations with counterparties to agree the changes.

That doesn’t mean the job is done, and it doesn’t mean the industry is getting complacent. There’s still a tail of mostly smaller firms that needs to be worked through in the coming weeks and months. These include those counterparties that were operationally unable to support the new regulatory compliant terms until recently, or those cases where bilateral negotiations to amend CSAs have been particularly complex. ISDA will continue to monitor progress right through to September 1, and will share those results with regulators.

But there’s little doubt the extra six months was absolutely vital and averted what could have been a big problem on March 1. Regulators deserve credit for addressing the concerns by providing forbearance – and the industry has worked diligently to make the necessary changes during that time.

The question is what happens to those trades executed after March 1, in line with the regulatory forbearance, but where CSAs have not yet been amended? The industry is working on the basis that those trades will need to be unwound if they are not subject to regulatory compliant variation margin CSAs by September 1. Given firms lack a contractual mechanism to unilaterally force their counterparties to unwind, it will take time to negotiate the terminations – but firms want to be able to demonstrate they’ve been working to tackle the issue in advance.

The rollout of the variation margin requirements doesn’t mark the end of the non-cleared margin implementation effort. The European Union (EU) will bring physically settled FX forwards into scope of the non-cleared margin rules from January 3 – the only jurisdiction to do so – which will result in another wave of CSA negotiations. While a small number of so-called phase-two firms will post regulatory initial margin from September 1, a larger number of counterparties are set to follow suit in September 2018, 2019 and 2020. On top of that, ISDA is preparing to launch the next iteration of the ISDA Standard Initial Margin Model – ISDA SIMM 2.0. That goes hand in hand with the successful operation of the ISDA SIMM governance structure – the mechanism for industry feedback and regulatory review has worked as planned.

ISDA’s work will persist as the rules continue to evolve. That includes the monitoring of preparations for the EU FX and phase-three initial margin implementation deadlines, the development of any necessary documentation solutions, and ongoing updates to the ISDA SIMM. ISDA is committed to working with the industry to develop solutions to help firms with their compliance efforts.

The Legal Aspects of Smart Contracts

A lot has been said and written about the potential for smart contracts in the context of derivatives. On our part, we think smart contracts have the potential to unlock value in the derivatives market by offering significant cost and efficiency benefits.

But what exactly do we mean by a smart contract? Is it a fully digital version of the legal agreements we use in the derivatives markets today? Or is it a piece of software that can automate the execution of certain operational actions within those existing paper contracts, but without actually replacing them?

ISDA last week published a paper in conjunction with Linklaters that attempts to answer these questions. The paper delves into the definitions of smart contracts, outlines how they might be used in a derivatives context, and highlights the legal issues they raise.

We have a strong and tested legal framework for derivatives, the ISDA Master Agreement, which has been honed over more than 30 years. But translating that directly into a smart contract context isn’t straightforward. While certain operational clauses – those related to payments or deliveries, for instance – might lend themselves to being automated, others are more subjective or require interpretation or discretion, and will therefore prove more challenging.

ISDA is now taking a critical step in the process by reviewing and updating the ISDA documents and definitions, with the aim of standardizing and formalizing certain clauses to enable them to be more easily represented and executed by smart contract code. This work to future-proof our legal documents will start with the 2006 Definitions for interest rate and currency derivatives.

We’re also looking at how the existing Financial products Markup Language messaging standard could be used in the smart contract space. To lead these developments, a new ISDA legal working group has been set up specifically to focus on smart contracts and distributed ledger. This is in addition to another ISDA initiative to establish the common data and process standards to help drive interoperability of these new technologies.

As in the past, ISDA is working to educate the market, but also to establish industry consensus on the application of operational and non-operational (or discretionary) contract elements. There will be instances where specific elements of the contract can be fully automated, but other elements where natural human language must be applied. Our working groups will unpack these issues, and ISDA is committed to developing industry consensus so there is continuity across platforms.

That would unlock significant efficiencies for derivatives market participants. ISDA’s work to future-proof its documentation is a crucial step to making that happen.

Unlocking Value via Process Standards

At the end of May, I wrote a derivatiViews post laying out ISDA’s ambitious vision for the future of derivatives market infrastructure. The system as it stands is creaky, over-complicated and outdated, increasing cost and compliance burdens for all market participants. New technologies can alleviate many of these problems, but first we need a reform of current standards and practices.

I am happy to report that, in the short time since that blog was published, progress toward this goal has started to pick up speed. ISDA is working with the wider industry to solve one of the major infrastructure problems – the lack of commonality in market processes and events. There is no concrete, shared description of even the most basic market activities that we all take for granted, like posting margin or novating a trade. That means each firm has tended to develop its own policies and procedures for each event, and has represented them differently in internal systems.

When regulators introduce new rules, each institution goes away and implements the text by mapping it to its own internal systems, meaning each firm could view the same requirements through a slightly different lens, creating inconsistencies in how data is represented and what is reported.

ISDA has begun categorizing these core events and actions in the trade lifecycle into a common terminology that can be translated into standardized, machine-readable code. From here, they can be collected into a common domain model (ISDA CDM). This will offer market participants a common representation of fundamental industry processes and concepts – breaking down each event into a ‘before’ and ‘after’ state, and precisely defining the change that occurs between the two. Individual firms won’t need to spend time and effort on developing their own definitions of basic tasks – they can all simply pluck the same definition from the ISDA CDM. That will free up resources for activities that deliver added value to their clients.

It sounds simple, but it’s a huge task. Getting everyone to agree on a set of definitions, and encouraging widespread adoption, will be challenging. That’s why ISDA, with its reach across the market and history of introducing common standards, is the perfect organization to push this work forward.

In September, ISDA should have developed an initial CDM design, and will then decide the format and mechanism for its wider publication. Within the same time frame, we also expect to have expanded the supporting business case for adoption of the ISDA CDM.

The short-term benefits of such a CDM are numerous. When new regulations are introduced, supervisors can communicate their requirements by reference to the CDM and remove much of the current pain around interpretation. If the CDM needs updating, then this could be arranged through discussion with the market to ensure the model remains reflective of industry practice. This would improve consistency of implementation, and transparency.

In the longer term, the establishment of common definitions for key lifecycle events should help facilitate the implementation of shared data storage facilities, distributed ledger technologies and smart contracts. This will enable a single, central, secure representation of each trade, through which trade events can be automated via the standard processes contained in the CDM. This will eliminate the need for constant reconciliation between counterparties, which does so much to gum up current infrastructures.

We will shortly be releasing a whitepaper that will look at the use of distributed ledger and smart contracts from a legal perspective – this will set out the different smart concepts in play, and describe some of the legal and operational challenges involved in bringing them into use.

All of this will be done with a careful eye on compliance, and on optimizing new regulatory obligations. We will also keep the global regulatory community updated on our progress, and we hope to bring in their expertise to help overcome some of the possible hurdles in the road ahead.

As I mentioned in May, this is a bold vision, and will require plenty of tough decisions to be made by the industry. There are a host of operational and legal issues to overcome. But we can’t stay still and accept things the way we are now. We need to push forward and help design a derivatives market that is fit for the demands of the 21st century.

Benchmark Transition Plans will be Critical

Last week saw the US Alternative Reference Rates Committee (ARRC) – a US public-private sector working group led by the Federal Reserve – select its choice for a risk-free rate that could be used as an alternative to US dollar LIBOR for certain derivatives and other contracts in the future. The next step is to think about how to encourage its use and to transition to the new rate – and that’s the really tricky part. Certainty will be critical: market participants will need a clear plan.

The ARRC isn’t the only public-private sector group to be going through this process. Similar initiatives to identify and transition to alternative risk-free rates are progressing in the UK and Japan – part of a broader project to enhance financial benchmarks, which also includes work by benchmark administrators to strengthen the methodology for existing IBOR rates and an initiative led by ISDA to identify robust fallbacks that would apply to IBOR-linked derivatives contracts should an IBOR rate permanently stop being published.

Together, the transition to risk-free rates and the development of IBOR fallbacks will affect trillions of dollars in notional in interest rate derivatives trades. So it’s important that people understand what these developments are and what they mean. It’s also vital that market participants can implement the changes in a way that creates most certainty and least disruption – both now and down the line.

The transition to risk-free rates is particularly challenging, because each case is unique – there’s unlikely to be a one-size-fits-all transition plan that suits all rates and all jurisdictions. Despite this, we think there are some high-level principles that can guide market adoption.

First, it’s critical that the alternative rate is sufficiently liquid to support its role as a key market benchmark. If not, the priority should be to encourage trading in the underlying rate first, before any benchmark transition occurs.

A liquid basis market to enable the hedging of basis risk between the existing interbank rate and the selected rate is also a necessary prerequisite before any transition occurs. As a third principle, formal public-private cooperation should continue (or begin in jurisdictions other than the US, UK and Japan) to ensure the transition is implemented as smoothly as possible. These transitions should allow sufficient time for market participants to make the necessary changes to systems, processes and documents.

It’s also important that authorities and industry participants try to anticipate the future shape of the market. There needs to be a clear understanding of what end users want to achieve and the risks they want to hedge to determine whether there will be a continuing demand for the old benchmark rates. End-user outreach will therefore be vital.

Finally, serious consideration must be given to whether the transitions should apply to legacy trades. Switching the reference rate for existing transactions would likely result in shifts in valuations, which could be disruptive to the market. As a result, we expect the public-private sector transition plans will target new trades only.

Last year, the ARRC proposed a paced transition plan that is largely consistent with these principles. It emphasizes the building of liquidity in the new rate before encouraging market participants to use it for trading. It also highlights the importance of building a market for hedging basis risk between the existing and new rate. Critically, it only refers to transitioning new contracts to the alternative rate, rather than forcing the transition of legacy contracts.

Another question is, what happens to existing and future IBOR contracts should the IBOR rate be permanently discontinued? That’s the focus of a separate ISDA-led working group. Together with the Financial Stability Board, the working group is looking to identify robust fallbacks for key IBORs that can be written into derivatives documents – likely to be the relevant risk-free rates chosen by the respective public-private sector working groups.

Unlike the work to transition to risk-free rates, which will likely focus on new contracts only, we think there’s a logic to identifying a robust fallback for all key IBOR contracts, both new and legacy. That’s because if a tail event occurs and an IBOR rate stops being published, it makes sense for everyone to be using the same, published fallback rate. Certainty regarding which rate to reference would be just as important for legacy contracts.

If that is indeed the case, then ISDA could publish a protocol to help firms alter their legacy contracts to incorporate the fallbacks in an efficient way. This would only work if everyone changes their contracts, though. If only part of the market makes the change to their legacy contracts, firms would face significant basis risk. As all ISDA protocols are voluntary, there would likely need to be regulatory action to ensure everyone makes the change.

This is just part of ISDA’s broader work on benchmarks. Along with being an observer on three public-sector risk-free rate working groups and leading the initiative to develop IBOR fallbacks, we’re also working with the industry to help prepare for compliance with the EU Benchmarks Regulation from the start of next year.

We’ll continue to focus on this area and will inform members and industry about forthcoming changes and implications. As part of that, we’ll shortly be holding a benchmark symposium in New York on July 12. We hope to see you there!