Much has been made of the race to replace Libor across the
world, as the financial sector prepares for the future without
the 'world's most important number'. As important in this
debate as what rates will replace Libor, and specifically how,
is the question of what to do about the trillions of dollars of
contracts that reference Libor in their standard documentation
after it expires.
The answer is fallback contract language, often simply
referred to as fallbacks.
This latest primer takes a look at fallbacks, specific
language, triggers and variations, and concerns.
If you are looking for more information on certain aspects
of the Libor transition, we have a number of options
What are fallbacks?
Fallbacks contain draft language that will incorporate
certain triggers into contracts in the case of the permanent
cessation of Libor. Despite the (very?) likely termination of
Libor at the end of 2021, financial institutions of all sizes
in jurisdictions across the world continue to draft contracts
that refer directly to the rate. Add to this the legacy
contracts that have expiration dates past that of various
IBORs, and the enormity of the task becomes apparent.
Outlining the gravity of the situation for the US market
alone, the head of fixed income at one US bank says: "The
reality is that the liquidity in the US dollar market today,
if we look at LCH funds or any other metric of volumes, is in
"Libor is still the predominate index. We have some
clients trying to be proactive by ensuring that any new
Libor-based business has appropriate fallbacks, but even
today there are not very many contracts that don't reference
Why are fallbacks necessary?
When, and if, these various IBORs expire, there will be
hundreds of thousands of contracts that will contain no
benchmark interest rate from which to make calculations. This
would be hugely damaging to the financial industry as a
What do contracts fall back to?
In the vast majority of cases, inserted fallback language
will revert to the appropriate risk-free rate (RFR) in the
jurisdiction/currency that the contract was established. For
example, for regular Libor-based issuances in pound sterling,
the fallback will trigger a switch to the sterling overnight
index average (Sonia), whereas in USD the secured overnight
financing rate (SOFR) will be triggered. For issuances in
euro, it will be the euro short-term rate (€STR), and so
What are the concerns?
The problems with installing appropriate fallback language
are expansive and varied. Reverting to the new rate
automatically introduces all of the same issues that are
associated with attempts to switch to RFRs in each
jurisdiction, of which there are many.
For example, and perhaps paramount, IBORs in their current
form are available in a number of forward-looking iterations,
whereas the identified replacements are only overnight rates.
GBP Libor has different rates of; overnight, one week, two
weeks, one month, two month, three months… and so on,
up until one year.
See also: Bank of China sells Asia's first SOFR
According to George Bollenbacher, head of fixed income at
Tabb Group, there is no consensus yet on how to address the
issue of aligning term rates with overnight rates.
"With SOFR I don't think there is a generally accepted
solution about how you take an overnight rate and give it a term structure," he says. "At
all the meetings I've been to there has been a tremendous
amount of discussions about how to get a term structure, and
a number of people in positions of authority saying that term
SOFR can be achieved and that there will be enough volume.
But I am yet to hear market participants agreeing that they
are going to get significant term repo volume to the extent
that we will get a rate like that that matters, there is not
a lot of pressure to come up yet with a term structure yet,"
It is also a vast task for all involved.
"There is a significant amount of work around legal
contracts and repapering agreements, so whether
it’s things such as International Swaps and
Derivatives Association (Isda) master agreements for
derivatives, bond indentures, prospectuses or loan
agreements, almost all forms of templates for new business
are going to have to be updated," says Michael Sheptin, who
co-leads EY's US IBOR services. "But what's more challenging
is the legacy portfolio."
Read more on SOFR in our sister publication
Another concern is ensuring that there are no net gains or
losses incurred during this process. Reverting from USD Libor
to SOFR should not result in a profit for anyone
Sandie O’Connor, former chief regulatory
affairs officer at JPMorgan Chase and one time chair of the
Alternative Reference Rates Committee (ARRC), says that when
Libor ceases to exist, and legacy contracts need to be
converted, the guiding principle should be minimal transfer
"There should be no windfall gain or loss and for any
constituency, the reality is that we have to come together to
agree across product sets what is the right trigger, what is
the right fallback and then ultimately, what will be the
right conversion spread on day one, and how it will be
calculated," she says.
Is synchronising fallbacks important?
Very. Within each industry and jurisdiction there are a
number of working groups and trade organisations that are
working towards establishing recommended fallback language
for their sectors. This will make the adjustments and
transition smoother. Those that use the formally offered
common language will have the support of said organisations
in the event of any contractual dispute.
The derivatives sector has led the way here. Isda has
played a crucial role in the development of fallbacks to
replace IBORs in existing and legacy contracts for
derivatives, largely because of its master agreements, which
can be amended en masse via protocol. "We have all these
legacy contracts that we need to make safer," says Scott
O'Malia, ISDA’s chief. "We are working hard to
create robust fallbacks."
From Practice Insight: Banks lobby for consistency on Libor
The association regularly releases consolations on its
language, covering a variety of outcomes, and will have
finalised language by the end of 2019, with implementation in
"Given the differences between the IBORs and the relevant
RFRs identified as fallbacks, it is also imperative that the
market agrees a common approach to adjusting the RFRs to
mitigate potential disruption after a fallback takes effect,"
It's crucial to get on with this mammoth task. MetLife, an
early adopter to SOFR that broke ground with a bond of its
own in August 2018, has put personnel and office management
at the forefront of its transition plan. According to senior
managing director Jason Manske, the firm has taken a
federated approach, accumulating the necessary relevant
expertise and putting staff together in working groups.
Libor exposure is arising from investing and hedging
activity, and the firm is working on fallback language within
existing capital markets contracts.
"We have set up an IBOR transition working group, headed
up by risk management and legal. As our business is life
insurance we have a lot of very old policies. Someone has to
look at old systems, inputs and models and work out now what
type of Libor exposure we are assuming," he says. "There is
Libor exposure in vendor contracts, there are penalty rates
based on Libor, we have got to review them all."
MetLife uses third party software, which runs faster than
vendors’, and Manske suggests that as the firm
continues the transition it will also utilise third party
providers to complete a lot of the work.
"Grab a lawyer early on," says Manske. "All the other
partners: accounting, IT, risk, compliance, they all need to
be brought up to speed and involved early on. Between them
they will point out five things the firm has forgotten to
The priority is to have fallback language that works, but
it won't happen overnight.
Read more on Libor reform in our sister
publication Practice Insight