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.