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 available:
- EU Benchmarks Regulation primer
- Sonia (the Sterling overnight index average) primer part one
- Sonia – what next? Primer part two
- The secured overnight financing rate (SOFR)
- How Asia is preparing for the end of Libor
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."
"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 Libor."
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 whole.
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 on.
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.
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," he continued.
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."
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 involved.
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 value.
"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 fallbacks
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 2020.
"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,” adds O’Malia.
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 do.”
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