Close
What would you like to look for?

13 January 2021

LIBOR Replacement for Derivatives Contracts: The Time to Act Is Now

The London Interbank Offered Rate (LIBOR) is a benchmark interest rate at which panel banks lend one another unsecured funds on the London money market. The official LIBOR interest rates are announced once a day by the ICE Benchmark Administration (IBA) in London.

LIBOR is arguably the most important and widely used interbank offered rate (IBOR) in global financial markets. Due to significant manipulations of LIBOR, the UK's Financial Conduct Authority (FCA) chief executive Andrew Bailey announced already on July 27, 2017 that the FCA would no longer require that banks that are members of the LIBOR panel be obliged to communicate a daily rate after 2021. Supervisory authorities have since taken the position that LIBOR should no longer be available as a reference rate for interest rate calculations in the affected financial contracts from the end of 2021 at the latest and a transition to alternative risk-free rates should be completed by such date.

On November 18, 2020, the ICE Benchmark Administration (IBA) announced that it will consult on its intention to cease the publication of LIBOR in Swiss francs (CHF), euros (EUR), British pounds (GPB) and Japanese yen (JPY) at the end of 2021. Nevertheless, LIBOR interest rates are currently still widely used, in particular in the interest rate derivatives, loan agreements and for floating rate notes. In particular for Swiss financial market participants, the CHF-LIBOR is still the most important benchmark on which many financial contracts are based.

Introduction of Alternative Benchmarks

In view of the LIBOR discontinuation, national authorities and working groups in the relevant markets have identified their own alternative risk-free rates to replace LIBOR. 

In Switzerland, the competent national working group recommends to replace CHF-LIBOR with the Swiss Average Rate Overnight (SARON). SARON represents the overnight interest rate of the secured money market for CHF. It is based on transactions and quotes posted in the Swiss repo market. SIX Swiss Exchange Ltd is the Benchmark Administrator of SARON and is responsible for its calculation and publication.  

LIBOR-Linked Derivatives 

According to the Guidance 08/2020 of October 16, 2020 of the Swiss Financial Market Supervisory Authority (FINMA), over-the-counter (OTC) derivatives are the largest stock of legacy LIBOR-linked contracts in Switzerland. A survey conducted by FINMA in June 2020 shows that the volume of contracts for OTC derivatives linked to LIBOR that extend beyond 2021 amounts to over CHF 11.5 trillion cumulated for all LIBOR currencies (CHF, EUR, GBP, JPY and USD). Accordingly, FINMA considers the end of LIBOR to be one of the principal operational risks for its supervised institutions and recommends that such institutions adequately address the risks associated with the discontinuation of LIBOR. 

Derivatives contracts referencing a LIBOR rate instead of a risk-free rate which are entered into with a term beyond the LIBOR discontinuation must be migrated to other contracts based on alternative risk-free reference rates before or upon the discontinuation of the LIBOR in order to achieve a predictable outcome and avoid litigation risks. Such pre-existing contracts may be transitioned to an alternative risk-free interest rate by either (i) renegotiating such contracts with the counterparties or (ii) agreeing to fallback clauses

Fallback Clauses

Fallback clauses should define (i) which events trigger the transition to the alternative risk-free interest rates; (ii) which alternative risk-free interest rates apply upon a trigger event; and (iii) the method that will apply with respect to the transition to the relevant fallbacks. 

Parties to derivatives contracts have the following options to include fallback clauses in their transaction documents:

  • ISDA IBOR Fallbacks Protocol and Supplement

On October 23, 2020, the International Swaps and Derivatives Association (ISDA) launched the IBOR Fallbacks Protocol for pre-existing LIBOR-based contracts and the IBOR Fallbacks Supplement for new LIBOR based contracts.

The parties to pre-existing legacy LIBOR-linked derivatives contracts may adhere to the ISDA Fallbacks Protocol which will enable market participants to incorporate the revisions into their legacy non-cleared derivatives trades with other counterparties that choose to adhere to the protocol. By adhering to the protocol, market participants agree that their legacy derivatives contracts with other adherents will include the amended floating rate option for the relevant IBOR and will therefore include the fallback. Adherence to the ISDA IBOR Fallbacks Protocol also results in the inclusion of the ISDA fallback clauses under the Swiss Master Agreement for OTC derivative instruments published by the Swiss Bankers Association.

The ISDA IBOR Fallbacks Protocol has been open for adherence since October 23, 2020 and will become effective on January 25, 2021. Derivatives contracts pre-existing on that date will incorporate the new fallbacks if both counterparties have adhered to the protocol. The protocol, however, will remain open for adherence after this effective date.

FINMA recommends that the affected supervised institutions sign the ISDA IBOR Fallbacks Protocol ideally prior to January 25, 2021.

As regards new LIBOR based contracts, the fallback clauses will be included in a supplement to the 2006 ISDA Definitions by amending the 2006 ISDA standard definitions for interest rate derivatives accordingly. As a consequence, after the entry into force of the supplement which will also be on January 25, 2021, all new cleared and non-cleared derivatives that reference the 2006 ISDA Definitions will automatically include the fallbacks.

  • Bilateral Agreements

As an alternative approach to including fallback clauses in pre-existing transaction documents, parties to derivatives contracts may enter into bilateral amendment agreements

FINMA's Recommendations for Tough Legacy Transactions

If pre-existing LIBOR based derivatives contracts are neither renegotiated nor adjusted by including fallback clauses with one of the methods specified above, there is a serious risk of legal disputes with associated loss potential according to FINMA.

Accordingly, FINMA published a LIBOR transition roadmap on December 4, 2020 (FINMA Guidance 10/2020). For tough legacy transactions, FINMA recommends that the affected supervised institutions follow the transition roadmap in order to be prepared for a discontinuation of the LIBOR by the end of 2021: 

  • By January 31, 2021: No new transactions based on CHF or EUR LIBOR that mature after the end of 2021 and do not provide for robust fallback clauses should be concluded. The same objective should also be pursued for new transactions based on GPB, JPY or USD LIBOR.
  • By March 31, 2021: Based on a complete assessment of their inventory of existing CHF and EUR LIBOR contracts, the affected supervised institutions should have determined which contracts and what volume are potentially "tough legacy" because they mature after 2021 and do not contain robust fallback clauses. Detailed project plans and a progress monitoring procedure should be defined in order to reduce the volume of such contracts to a minimum by the end of 2021. To achieve this, FINMA recommends that at least initial contact is made with the counterparties of potential tough legacy contracts by March 31, 2021 at the latest in order to start the renegotiation process or the insertion of fallback clauses.
  • By June 30, 2021: By implementing the plans set out above, the affected institutions should be able to assess whether the objective of reducing the volume of tough legacy transactions is achievable. For all contracts for which no solution is apparent, a risk assessment should be made.

Summary

To be prepared for the LIBOR discontinuation, we recommend the affected supervised institutions following the transition roadmap of FINMA precisely. This means for parties to pre-existing LIBOR based derivatives contracts that they should adhere to the ISDA Fallbacks Protocol before January 25, 2021. In cases where parties to derivatives contracts referencing LIBOR rates fail to agree to the inclusion of fallback clauses, they should fully pursue the steps as set out in FINMA's transition roadmap regarding tough legacy. Otherwise they risk being exposed to an unpredictable outcome and litigation risks with associated loss potential. 

For further information, please contact the Banking & Finance Team.

Authors: Adrian Dörig, Christian Schneiter

Category: Banking & Finance

Authors