Learn 10 actions to help overcome legal and contractual issues, and remediate legacy transactions associated with the IBOR transition.
The London Interbank Offered Rate (LIBOR) has been used extensively as a reference rate in a range of financial products and instruments for more than 40 years – exposure to LIBOR is estimated to be more than $400t. The Financial Conduct Authority (FCA) announced that it will not compel banks to submit LIBOR quotations after 2021. With the heightened risk of imminent discontinuation of LIBOR, financial market participants are accelerating their efforts to transition from LIBOR to Alternate Reference Rates (ARRs). This transition is expected to be one of the most significant changes for the financial services industry. The unprecedented scale of this industry-wide transition will pose considerable challenges, including potential financial, legal, operational, conduct and reputation risk.
What is fallback language and why is it important for the IBOR transition?
“Fallback language” refers to the contractual provisions that lay out the process through which a replacement rate can be identified if a benchmark (e.g., USD LIBOR) is not available. In other words, the fallback language within a contract acts as a “how-to” guide for identifying replacement rates (hereafter referred to as “benchmark replacements” or “replacement rates”) should the original benchmark be unavailable.
Fallback language comprises three key components: fallback trigger event, benchmark replacement, and benchmark replacement adjustment. In addition to the fallback language, firms will need to consider other key contractual features that may impact the IBOR transition, including maturity date, firm’s role in the contract, benchmark use, amendment and consent provision, governing law and jurisdiction, and force majeure provisions.
Robust fallback language is required in financial contracts to enable a smooth transition in the event of a benchmark cessation event. By “robust,” we mean language that offers an unambiguous and actionable path to benchmark replacement, which is likely not the language found in most contracts today.
We see many challenges with historical fallback language. Typically, it was written to provide an interim solution should a rate be temporarily unavailable, rather than considering a permanent benchmark cessation. Even more concerning, fallback language often lacks clarity in selecting replacement rates and can result in economically undesirable outcomes and conduct and legal risk.
Language also varies between derivatives and cash products and, even further, between different cash products. This variation drives uncertainty, so firms may be faced with a contract-level review to determine how to remediate impacted transactions.
To address this, industry bodies are working to develop robust fallback provisions for IBOR-referencing transactions. For over-the-counter (OTC) derivatives, ISDA plans to amend the ISDA 2006 definitions – or all new transactions once implemented. ISDA will also provide a protocol for counterparties to implement robust fallback language for legacy transactions. For cash products, national working groups, such as the US ARRC, have published proposed fallback language to implement new transactions referencing IBOR.