Update on Benchmarks Reform in Derivatives

December 4, 2019

On 27 July 2017, the chief executive of the Financial Conduct Authority, Andrew Bailey, announced that the London Interbank Offered Rate (LIBOR) may not continue to be available after 2021. Since this announcement, a number of national working groups have been set up, and consultations carried out, to develop and select alternative risk-free rates (RFRs) to replace LIBOR.

An RFR for each of the five LIBOR currencies has now been selected: SOFR (for USD LIBOR), SONIA (for GBP LIBOR), SARON (for CHF LIBOR), TONAR (for JPY LIBOR) and €STR (for Euro LIBOR). However, the transition from LIBOR to these RFRs gives rise to a number of difficulties.

The first of these is that there is a significant economic difference between LIBOR and RFRs as LIBOR incorporates a credit risk, whereas RFRs are inherently risk-free (the spread adjustment issue). As a result, RFRs are lower than LIBOR, meaning adjustments to the RFRs are required to prevent lenders being unfairly penalised on replacement of LIBOR.

Another issue arises from the difference in the term of the rates (the term issue). LIBOR is a forward-looking rate, meaning the interest rate is set at the beginning of each relevant period. This differs from the backward-looking RFRs. This backward-looking nature of RFRs may lead to operational difficulties, as parties would need to calculate payments in arrears, shortly before the payment must be made.

ISDA July 2018 and May 2019 Consultations

The International Swaps and Derivatives Association Inc. (ISDA) published marketwide consultations in July 2018 and May 2019 to obtain the views of market participants on how to address the spread adjustment issue and the term issue in respect of contracts referencing any of the five LIBOR rates, with the exclusion of Euro LIBOR.

The majority of respondents to the consultations preferred a “historical mean or median approach” in relation to the spread adjustment issue, whereby the spread adjustment will be based on the mean or median spot spread between LIBOR and the RFR calculated over a lookback period. A five-year and 10-year lookback period was suggested.

In relation to the methodologies suggested to combat the term issue, the majority of respondents preferred “compounded setting in arrears” which involves compounding the daily values of the relevant RFR, before setting the rate for the relevant period a few days before payment is due.

In light of the findings of the consultations, on 18 September 2019, ISDA published a further marketwide consultation to consult on the final methodologies for the spread adjustment and the term adjustment.

ISDA September 2019 Consultation

Spread Adjustment

The majority of respondents (61 percent) preferred a spread adjustment based on a historical median over a five-year lookback period. Respondents considered a spread adjustment based on median rather than mean as a “simple, transparent and more stable method” that was less sensitive to outliers and requires less-complicated data treatment. The five-year lookback period was preferred to a 10-year lookback period, as respondents considered the shorter period to be more reflective of present-day market conditions and would not be skewed by the inclusion of data from the financial crisis.

Of those responding, 71 percent felt that the inclusion of a transitional period in spread adjustment calculations would not be beneficial due to operational difficulties and complexities, and 79 percent found no compelling reason to exclude negative spreads from the spread adjustments, as they reflect real market conditions.


Approximately 70 percent of respondents preferred a lag mechanism, whereby the relevant term for the RFR would be adjusted to prevent payments being made on the same date as the date on which the rate becomes known. More than half of the respondents (56 percent) felt the appropriate lag to be two banking days.

Of the potential mechanisms for adjusting the term, a clear majority of 56 percent preferred the backward-shift adjustment. This involves the observation period for the RFR being moved to an agreed number of days (i.e., two) before the payment date. The respondents considered this approach more consistent with the Overnight Index Swap market, and less likely to exaggerate RFR movements during the compounding interval.

In contrast, only around 1 percent of respondents preferred the lockout adjustment. This would involve the calculation period ending on the payment date, but with the RFR from two days prior being used for the last two days of the term.

The Road Ahead

Bloomberg and ISDA will work together to publish the final mathematical formulas for the spread adjustment and compounded-in-arrears term rate. Please note there is still no clarity regarding the convergence issues relating to the difference in approach proposed by ISDA and the loan market; i.e., the Loan Market Association in the EU and the Alternative Reference Rate Committee (ARRC) in the United States.

Further client alerts will be published as ISDA and/or the loan market publish further updates. For more information, contact the McGuireWoods London debt finance team.