The end of Libor looms near: Are your "fallbacks" in place?

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What is LIBOR?

The London Interbank Offered Rate (LIBOR) is a short-term interest rate benchmark that tracks the cost of unsecured borrowing for large banks. It is used as a reference rate for derivatives, loans, securitizations, deposits and other products. Each day between 11 and 16 of the so-called "contributor" or "panel" banks submit their calculations for such interest rates. The top and bottom calculations are removed, and the remaining submissions are averaged to produce the daily LIBOR. It is calculated and published daily across five currencies (GBP, USD, EUR, JPY and CHF) and seven maturities (overnight, one week, and 1, 2, 3, 6 and 12 months) by the Intercontinental Exchange Benchmark Administrator (ICE BA).1 LIBOR has been the most important benchmark for several decades and over 400 trillion USD worth of financial contracts reference it.2

Why change it?

As the LIBOR is a forward-looking rate, meaning that it is a calculated prediction, it was susceptible to certain input-related problems and prior to 2019 the panel banks based their submission on the following LIBOR Submission Question:

"At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 am?"3

This means that the final submission was very much dependent on expert judgement even if the panel banks had certain procedures for determination in place, and was thus open to manipulation. In 2012 the U.S. Commodity Futures Trading Commission issued an order to Barclays to pay a 200M USD fine.4 Subsequently, several investigations were opened across a number of jurisdictions and reports emerged indicating that LIBOR manipulation has been a standard practice for a long time.5 6 Additionally, in the wake of the financial crisis it became apparent, that the banks were not truly lending and borrowing at the unsecured rates they were submitting, meaning that LIBOR had little connection with real-life transactions.

When is the replacement going to happen?

This prompted financial authorities worldwide to start looking for alternatives, and in 2017 the UK’s Financial Conduct Authority (FCA) announced that by the end of 2021 the compulsory submissions of panel banks for LIBOR will be discontinued. In the absence of compulsory submissions LIBOR will likely become unreliable or will cease to exist completely.

Additionally, the Regulation (EU) 2016/1011 of the European Parliament and of the Council also referred to as EU Benchmarks Regulation or EU BMR, which came into effect on 1 January 2018, has imposed strict standards on indices used as benchmark in financial instruments and contracts. As of 1 January 2020 the transitional period under the BMR has elapsed, meaning only EU BMR compliant benchmarks may be used in new financial instruments and contracts within the European Union.

What is LIBOR being replaced with?

Central banks and other governmental and intergovernmental bodies are working on the development of alternative near-risk-free reference rates (RFRs), which should replace LIBOR. In contrast with LIBOR and other IBORs, RFRs are backward looking, meaning that they are based on actual transactions in the respective market and not the predictions for the future and are therefore much less susceptible to manipulation. RFRs will not have different maturities, as they are overnight rates, calculated only on the basis of the previous day and they will be published at different times, whereas LIBOR was published at the same time. Some RFRs are based on secured rates and some are not. The following table7 sets out some principle characteristics:

Country/Area United States United Kingdom Euro area Switzerland Japan
Alternative rate SOFR (secured overnight financing rate) SONIA (sterling overnight index average) €STR (euro short-term rate) SARON (Swiss average overnight rate) TONA (Tokyo overnight average rate)
Administrator Federal Reserve Bank of New York Bank of England ECB SIX Swiss Exchange Bank of Japan
Secured Yes No No Yes No
Overnight rate Yes Yes Yes Yes Yes
Available now? Yes Yes Yes Yes Yes

 

However, some IBORs will survive the reform provided they are compliant with the EU BMR. For example, EURIBOR, a widely used benchmark, is considered BMR-compliant and supervised entities are able to use EURIBOR in financial instruments and contracts.

How to prepare for the change? – The fallback provisions

Fallback language or fallback provisions are contractual provisions in financial contracts intended to address the unavailability of a certain benchmark interest rate, such as LIBOR. Fallback provisions were traditionally used to address the temporary unavailability of the benchmarks caused by technical or other disruptions, and usually resulted in the interest rate becoming fixed at the most recent determined rate. Contracts containing traditional fallback provisions are commonly referred to as "legacy contracts".8 As these types of provisions are ill-suited for the LIBOR replacement, several regulatory and supervisory bodies across continents9 10 have published guidelines and principles on drafting fallback provisions in order to help the participants in financial markets and are continuously amending and improving them. Additionally, EU BMR explicitly calls for appropriate fallback language in Article 28 paragraph 2.

Firstly, it is important the event triggering the replacement of LIBOR should be objectively defined, so its determination is straightforward. This event may be the cessation of LIBOR or other benchmarks but it is wise to include pre-cessation triggers as well, so as to avoid the use of a benchmark, which is no longer representative. Secondly, fallback rates should be determined using a waterfall method, so that several potential fallback rates are provided and the actual fallback rate is determined on the condition that it exists and is compliant at the time of the replacement event (e.g. if the first potential fallback rate cannot be used, the second one listed is considered etc.).11 Provisions should also seek to minimize any potential transfer of value between the parties when fallback is applied, preferably by including adjustment spreads on the fallback rate.12 Finally, fallback provisions should not be construed in a restrictive manner, preventing the parties to the financial contract from amending the contract in accordance with their interests in the future.

Conclusion

The LIBOR replacement continues to be a stressful period for many financial market participants and many questions, especially regarding the appropriate replacements rates have not been answered yet. While the financial authorities and administrators are working on improving alternative benchmarks, it is important for all market participant to be prepared for the coming replacement The sooner the appropriate measures are taken, the easier the transitional period will be.

The DLA Piper has launched a LIBOR transition practice and is able to assist with complete scope of transition-related questions – from discovering potential issues and audit preparation to effective document compliance. As lawyers are actively involved in and/or are monitoring developments of industry working groups across jurisdictions, they are able to provide state-of-the-art advice on the subject matter.


1 https://www.theice.com/iba/libor.
2 BIS Quarterly Review, March 2019, page 29 <https:>.
3 https://www.theice.com/iba/libor.
4 https://www.cftc.gov/PressRoom/PressReleases/pr6289-12.
5 https://www.informath.org/media/a72/b1.pdf.
6 https://www.theguardian.com/business/2017/jan/18/libor-scandal-the-bankers-who-fixed-the-worlds-most-important-number.
7 Adopted from BIS Quarterly Review, March 2019, page 35.
8 ECB, Guiding principles for fallback provisions in new contracts for euro-denominated cash products, January 2019, page 6 <https://www.ecb.europa.eu/pub/pdf/other/ecb.sg3guidingprinciples201901.en.pdf>.
9 ARRC recommendations regarding more robust fallback language for new issuances of LIBOR floating rate notes <https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2019/FRN_Fallback_Language.pdf>.
10 ECB, Guiding principles.
11 ARRC recommendations, page 12.
12 ECB, Guiding principles, page 10.