RFR Fallback Spreads and the ISDA Protocol

LIBOR was a forward-looking rate that priced in bank credit risk, while its replacements — SOFR in dollars, SONIA in sterling — are backward-looking, nearly risk-free overnight rates. Simply swapping one for the other in an old contract would change its economics: SOFR sits meaningfully below LIBOR most of the time, so a borrower paying "SOFR" instead of "LIBOR" would suddenly pay less, and a lender would receive less, with no negotiation. The ISDA protocol fixed this by defining a fallback spread — a fixed number of basis points added to the risk-free rate — calibrated so that, on average over a historical lookback window, the new all-in rate matched the old one at the moment of transition.

The spread was set once, per tenor, using the median difference between LIBOR and the compounded risk-free rate over a five-year historical window, then locked permanently. Because it is frozen rather than recalculated daily, the fallback rate can drift away from what LIBOR "would have been" as market conditions change — the point was fairness at the transition date, not an ongoing replica of LIBOR's dynamics.

For three-month dollar LIBOR, the ISDA-published spread is approximately 26 basis points: a legacy loan that read "three-month LIBOR + 200bp" now reads "compounded SOFR + 226bp," with the extra 26bp meant to bridge the credit-risk gap that used to live inside LIBOR itself.