The Looming End of LIBOR – Fallback Protocols and Transition to Alternative Reference Rates
Discontinuation of LIBOR: Replacement by Alternative Reference Rates
As of today, the London Interbank Offered Rate (LIBOR) is arguably the most important benchmark rate used for myriad loans, deposits, derivatives, debt securities and other investments denominated in USD, EUR, GBP, CHF, and JPY. Due to a history of manipulations of LIBOR, in November 2020, the UK's Financial Conduct Authority (FCA) and the ICE Benchmark Administration (IBA) published information on the discontinuation of most LIBOR rates as of the end of 2021.
With a view to replace LIBOR, national banks, regulators and other stakeholders in the markets affected have developed their own alternative reference rates (ARR) to replace LIBOR. In Switzerland, the National Working Group on Swiss Franc Reference Rates (NWG) has developed the Swiss Average Rate Overnight (SARON) as the new proposed benchmark rate for Swiss Franc denominated financial contracts.
Unlike LIBOR, SARON is a backward-looking rate, reflecting both concluded transactions and binding quotes of the underlying Swiss repo market. SIX Swiss Exchange is the benchmark administrator for SARON and is tasked with its calculation and publication.
LIBOR-pegged Contracts are Widespread
Pursuant to FINMA's Risk Monitor 2020, the use of LIBOR reference rates for financial instruments is still widespread. In June 2020, there were LIBOR pegged financial instruments worth at least CHF 14 trillion in circulation which will only expire after 2021 (legacy contracts). Out of these, financial products worth in excess of 2 trillion CHF are specifically referenced to LIBOR in CHF. According to FINMA's view, the discontinuation of LIBOR could have a serious impact on the market, posing one of the principal operational risks faced by its supervised institutions.
FINMA stresses that LIBOR pegged legacy contracts should either be re-negotiated with the counterparties, thereby entering a bilateral amendment agreement defining an alternative ARR, or the counterparties should agree on the implementation of a fallback protocol. If the counterparties decide to do the latter, such protocol should determine:
- the events triggering the transition of the contract to an ARR;
- the ARR applying when a trigger event takes place; and
- • the method used when transitioning to the relevant fallbacks.
The ISDA Fallbacks Protocol and Documentation
Depending on the nature of the legacy contract, fallback protocols are available. This is notably the case for derivatives.
In October 2020, the International Swaps and Derivatives Association (ISDA) has made it possible for counterparties to seek adherence to the IBOR Fallbacks Protocol for legacy derivative contracts pegged to LIBOR. At the same time, the ISDA has published several template amendment agreements which can be used by the counterparties to amend their legacy contracts in a bespoke manner. For new cleared and non-cleared derivative contracts based on LIBOR, ISDA has opened thepossibility for counterparties to adhere to the IBOR Fallbacks Supplement whose fallback clauses will be included in a supplement to the 2006 ISDA Definitions.
The ISDA Fallbacks Protocol and the ISDA Fallbacks Supplement will enter into force on 25 January 2021 if both counterparties to a contract are adherents. Adherence to the ISDA Fallbacks Protocol will also result in the inclusion of the ISDA fallback clauses under the Swiss Master Agreement for OTC Derivatives (SMA) as published by the Swiss Bankers Association SBA.
The FINMA Transition Roadmap
FINMA strongly encourages counterparties to adhere to a fallback protocol or to re-negotiate their legacy contracts in due course. After having released recommendations for supervised institutions repeatedly, notably FINMA Guidance 03/2018 – LIBOR: Risks of Potential Replacement and FINMA Guidance 08/2020 – LIBOR Replacement for Derivatives, FINMA published Guidance 10/2020 – LIBOR Transition Roadmap (Transition Roadmap) in December 2020.
In its Transition Roadmap, FINMA defined 5 steps which should be achieved by the supervised institutions on certain dates the latest. The adherence to these steps will be monitored closely by FINMA, especially with respect to the most affected supervised institutions. In brief, the measures proposed by FINMA are the following:
By 25 January 2021:
The affected supervised institutions should have signed the ISDA 2020 IBOR Fallbacks Protocol.
By 31 January 2021:
- The supervised institutions should make sure that across all product types, no new transactions based on LIBOR are entered into if they mature after the end of 2021 without containing robust fallback clauses.
- If they are lenders, the affected supervised institutions should be able to grant loans that are not based on LIBOR. This can be achieved by giving borrowers the possibility to choose another rate (fixed interest and/or an ARR such as SARON).
By 31 March 2021:
Based on a full evaluation of their inventory of existing LIBOR contracts, the supervised institutions should have determined which contracts and what volume constitute potential legacy contracts in the sense that they mature after 2021 and do not contain robust fallback clauses.
To achieve this, at least initial contact should be made with the counterparties of such legacy contracts, so that the process of renegotiation or inserting robust fallback clauses can be launched. Other solutions (such as a premature termination or sale) are also deemed possible by FINMA.
By 30 June 2021:
- The supervised institutions should have implemented the system and process changes necessary to enable transition to ARR and the application of fallback rates.
- It should be clear whether the objective of reducing the volume of legacy contracts will be achievable. For all contracts without a solution, a risk assessment should be available per contract and specific measures should be taken to mitigate the related risks.
- Generally, the supervised institutions should only use ARR in new CHF, EUR, GBP, JPY and USD contracts.
By 31 December 2021:
- All relevant systems and processes should function without reliance on LIBOR.
- All new transactions with variable interest in CHF, EUR, GBP, JPY and USD should be based on ARR.
In order to successfully prepare for the discontinuation of LIBOR and to avoid legal and reputational risk, FINMA's Transition Roadmap and the dates mentioned therein should be observed carefully. If not already done so, the supervised institutions should adhere to the ISDA Fallbacks Protocol before 25 January 2021. Guidance is available from several industry groups. Next to the ISDA Fallbacks Protocol and the other ISDA documents, the SBA has released an amendment agreement for its Swiss Master Agreement for OTC Derivatives. Moreover, the NWG has issued guidance for the transition of CHF LIBOR to SARON.
Where the counterparties cannot agree on the implementation of fallback protocols, they should follow the steps for legacy contracts as outlined in the Transition Roadmap. Thereby, they should set up and implement a robust strategy to sustainably and timely reduce their exposure to LIBOR referenced contracts.
For more information, please contact:
Dr. Kaspar Luginbühl (Partner, Zurich)
Stéphanie Hodara El Bez (Partner, Geneva)