IBOR transition ISDA launches new modular approach to compounding overnight floating rate options

Overview

On 13 May 2021, ISDA published Supplements 74, 75 and 76 to the 2006 ISDA Definitions (2006 Definitions). The Supplements allow market participants to document OTC derivative transactions referencing overnight risk-free rates (RFRs) or a SONIA compounded index as the Floating Rate Option (FRO) thereunder and apply a tailored compounding approach to the RFR so that: 

• the compounding method matches that of any linked cash product;
• Floating Amounts are calculated and notified a specified number of days prior to each
  Payment Date; and
• the daily value for the relevant RFR can be capped and/or floored.

Supplements 74 and 75 are for use where an RFR is referenced as a transaction's primary Floating Rate Option, rather than as a fallback rate. Provisions relating to RFRs as fallbacks for interbank offered rates were incorporated into the 2006 Definitions by Supplement 70 to the 2006 Definitions (Supplement 70).. Supplement 75 also contains new Confirmation templates for use when documenting the new compounding approaches.

Supplement 76 introduces similar provisions and a further Confirmation template that can be used where the FRO in question is a SONIA compounded index. ISDA has also published, but not yet fully populated, a matrix (the Compounding Matrix) setting out default market conventions applicable to each RFR where relevant elections have not been made in the Confirmation. The majority of the default positions are blank at present and will be populated once market conventions are established.

The Supplements and the Compounding Matrix became effective on 13 May 2021 and are available to ISDA members on the ISDA website. All of the new provisions will be incorporated into the forthcoming 2021 ISDA Definitions. 

The Supplements can also be used to incorporate corresponding averaging conventions, which are outside the scope of this briefing. Capitalised terms that are not otherwise defined in this briefing have the meaning given to them in the 2006 Definitions.

Supplement 74: new overnight Floating Rate Options

Supplement 74 (the Overnight RFR Supplement) introduces into the 2006 Definitions twelve new FROs for overnight RFRs, including SONIA, SOFR, and €STR. Unlike other RFR FROs documented under earlier Supplements to the 2006 Definitions, absent amendment, the new FROs are not compounded. They can therefore either be used in their non-compounded form or tailored to apply a particular compounding approach by using the provisions in Supplement 75, which is discussed below.

The Overnight RFR Supplement sets out a waterfall of fallback rates for each new FRO, which broadly mirror the RFR fallbacks applicable under Supplement 70. For example, under the Overnight RFR Supplement, if SONIA becomes permanently unavailable, it falls back to the replacement rate officially recommended by the Bank of England (the GBP Recommended Rate), as SONIA's administrator. If both SONIA and the GBP Recommended Rate were to become permanently unavailable, the final fallback would be to the (unadjusted) UK Bank Rate.

Similar fallback waterfalls apply in respect of SOFR and €STR where they become permanently unavailable.

Where a particular rate is temporarily unavailable, the last published figure for that rate is to be used.

Supplement 75: tailored compounding approaches

Prior to 13 May 2021, ISDA had already published several "self-compounding" RFR FROs, which compound interest over each Calculation Period. However, these FROs do not include any lookback or similar adjustment, meaning that, given the overnight nature of the RFRs, the applicable Floating Amount cannot be calculated until the end of the Calculation Period.

Supplement 75 (the Compounding Supplement) incorporates into the 2006 Definitions new provisions and new Confirmation templates that together allow market participants to tailor the new non-compounded RFR FROs such that (i) the RFR compounding method matches that used under any linked cash product, and (ii) the Floating Amount is calculated and notified a specified number of days in advance of each Payment Date, giving the Floating Rate Payer sufficient time to arrange payment.

The new provisions allow for the following compounding/payment approaches to be applied to a referenced RFR: 

• lookback (also sometimes known as "lag");
• observation period shift;
• lockout; and
• payment delay.

In each case, the applicable number of lookback, shift, lockout or delay days is to be specified in the relevant field of the applicable Confirmation. Each of the approaches is considered in turn below.

Compounding with lookback

Under the lookback approach, the rate attributed to a particular business day (an Observation Day) in a Calculation Period is the rate observed for the day falling a specified number of business days prior to that Observation Day. The RFR rates for each Observation Day are compounded to determine the Floating Rate applicable to the Calculation Period.

Under this approach, the weighting attributed to the rate for a particular Observation Day is determined by looking at business days in the Calculation Period. For example, the rate attributable to 24 December 2020 would be the rate observed for 17 December 2020 (five business days prior). As 25 December 2020 is not a business day, the weighting given to the 17 December rate would be "2" in the compounding formula, meaning that simple interest would apply. This is different from the weighting approach used under the observation period shift approach discussed below.

Market participants can document transactions using the lookback approach by using the new Confirmation template at Exhibit IV-A to the 2006 Definitions and making the following elections: 

• specifying the applicable RFR in the "Floating Rate Option" field;
• selecting "Compounding with Lookback" in the "Compounding" field; and
• specifying the number of days' lookback in the "Lookback" field.

Where Compounding with Lookback has been elected but the number of days' lookback has not been specified, the default lookback under Supplement 75 is five business days. Once market conventions are established and the Compounding Matrix has been populated, the lookback specified in the Compounding Matrix will override the current position (if different). 

A lookback of five business days aligns with current market practice in the cash markets, but differs from the two business day observation period shift discussed below that applies where an adjusted RFR is used as a fallback to a discontinued IBOR under Supplement 70.

Compounding with observation period shift

The observation period shift approach is similar to the lookback approach, but the weighting attributed to a particular rate is determined by looking at business days in the observation period, rather than the Calculation Period; the Calculation Period is "shifted" back by five business days and it is the business days in that shifted period that are relevant for weighting purposes. 

For example, under this approach, the rate attributable to 24 December 2020 would still be the rate observed for 17 December 2020 (five business days prior). However, 25 December 2020 is not relevant for weighting purposes; the relevant date for weighting purposes is 18 December 2020, which is a business day. Therefore, under this approach the rate attributable to 24 December 2020 would be given a weighting of "1" in the methodology, rather than "2" as would be the case under the lookback approach described above. The result would therefore be similar to that obtained using lookback, but not exactly the same.

Market participants can document transactions using the observation period shift approach by using the new Confirmation template at Exhibit IV-B to the 2006 Definitions and making the following elections: 

• specifying the applicable RFR in the "Floating Rate Option" field;
• electing "Compounding with Observation Period Shift" in the "Compounding" field; and
• specifying the number of days' shift in the "Observation Period Shift" field.

Where Compounding with Observation Period Shift has been elected but the number of days' shift has not been specified, the default shift at present is five business days. Once market conventions are established and the Compounding Matrix has been populated, the shift specified in the Compounding Matrix will override the current position (if different).

A shift of five business days aligns with current market practice in the cash markets, but differs from the two business day shift that applies where an adjusted RFR is used as a fallback to a discontinued IBOR under Supplement 70. 

This approach can also be used where the parties prefer or need to fix the rate for a particular Calculation Period in advance. This can be achieved by using the Confirmation template at Exhibit IV-B and specifying "Set-in-Advance" as applicable in the appropriate field, thereby shifting the observation period back an entire Calculation Period. This will be a useful option in transactions such as forward rate agreements, under which the rate needs to be set at the start of each Calculation Period.

When combined with an appropriate Reset Date and Observation Period Shift, the "Set-in Advance" option also allows market participants to replicate the current fixing times for IBORs, which fix at the start of, or just before, the Calculation Period.

Compounding with lockout

Under the less common lockout approach, the parties specify a number of days prior to the end of the Calculation Period during which the RFR rate will not be observed; instead, the rate attributed to each day in the lockout period is the rate observed for the day immediately before that period, providing certainty as to the daily rate for the final days of the Calculation Period. The weighting given to a rate is determined by looking at business days in the Calculation Period, including during the lockout period. Market participants can document transactions using the lockout approach by using the new Confirmation template at Exhibit IV-C to the 2006 Definitions and making the following elections:

• specifying the applicable RFR in the "Floating Rate Option" field;
• electing "Compounding with Observation Period Shift" in the "Compounding" field; and
• specifying the number of days' shift in the "Observation Period Shift" field.

Compounding with payment delay

Under this approach, the rate attributed to each day within a Calculation Period is the rate observed for that day, and calculation of the Floating Rate is carried out on that basis as usual, but the Payment Date is delayed by a specified number of business days. This approach can already be achieved by referencing one of the self-compounding RFR FROs and electing for "Payment Delay" to apply. Historically, this approach has commonly been applied to standard overnight index swap (OIS) transactions.

Supplement 75 extends this form of OIS compounding so that it can also be used with the new RFR FROs, through new provisions that can be used in conjunction with the lookback, observation period shift and lockout provisions. This means that contracting parties can use the new Confirmation templates to specify one of the three compounding approaches discussed above and also incorporate a payment delay if necessary. The new Supplement 75 OIS compounding provisions are also compatible with the cap and floor provisions discussed below, in contrast to the original "Payment Delay" provisions, which are not. This means that, where a cap or a floor is required, the new Supplement 75 Payment Delay provisions must be used.

Market participants can build the Supplement 75 payment delay provisions into their transactions by incorporating the "Delayed Payment" field from Exhibit IV-D into the applicable Confirmation and specifying the required number of days' delay.

Capping and/or flooring the daily RFR

Each of the approaches discussed above allows for the daily RFR value to be capped and/or floored at a particular level. This is particularly useful for derivative transactions which are linked to RFR-referencing loans, which commonly floor the daily interest rate at zero. It is also possible to specify a negative floor, which may be required where a linked product features a zero floor applicable to an adjusted RFR, inclusive of a credit adjustment spread. Matched provisions can be achieved by flooring the derivative RFR at the negative of the credit adjustment spread.

In order to apply a cap and/or floor to the daily RFR rate, parties can use the applicable Confirmation template, specify "Daily Capped Rate and/or Daily Floored Rate" as applicable, and insert the applicable rate in the appropriate field(s). Where the parties prefer to floor the overall Floating Amount for a Calculation Period as a whole, rather than the daily RFR rate, the existing Zero Interest Rate Method can be used. There is no option in the 2006 Definitions to floor the base compounded RFR only, excluding the Spread, but this optionality is expected to be included in the forthcoming 2021 Definitions.

Summary

As regulators continue to advocate the use of RFRs as primary rates in new derivative transactions, the Supplements afford market participants flexibility and provide standardised drafting solutions for using and compounding overnight RFRs. 

Furthermore, availability of the new Supplements is widely expected to increase the volume of derivative transactions referencing overnight RFRs, which will help to provide the liquidity needed to establish robust RFR-based term rates, which are seen by many as critical for certain products. 

ISDA has confirmed that all Supplements to the 2006 Definitions will be transposed into the forthcoming 2021 Definitions, which are expected to to be available for use from 4 October 2021.

Authors: Amelia Howison, James Knight, Kirsty McAllister-Jones