One of the 5 actions that we recommended Financial Institutions (FI) take immediately to successfully transition away from LIBOR is to review the fallback language for new financial contracts to ensure they will continue to be effective in the event that LIBOR ceases to be produced. We have observed that some FI’s are operating under contracts that contain fallback language that did not account for the potential permanent cessation of LIBOR – this needs to be addressed now.
When reviewing fallback contract language there are 3 variables that need to be evaluated:
- The first is the “trigger,” which refers to the conversion from LIBOR to a new alternative reference rate
- The second is the alternative rate that will replace LIBOR
- The third is the spread adjustment that will be added to the new replacement rate to account for credit risk and other factors such as liquidity and term premium.
The fallback language will differ depending on the nuances of the financial instrument and the market in which it operates. For example, fallback language for a securitized product might differ from a floating rate note. Despite these differences across products, the Alternative Reference Rates Committee (ARRC) has released the following guiding principles for LIBOR fallbacks for USD denominated cash products that should be treated as best practice:
- Principle 1: Contract Language Evolution and Moving from Discretionary to Specificity – This principle recommends that Firm’s minimize the time before moving to robust contract language. Efforts should evolve iteratively, utilizing industry information and corresponding developments from other products. This principle also recommends keeping options for flexibility or discretion to a minimum to reduce the likelihood of disputes.
- Principle 2: Consistency between Asset Classes as Appropriate – Suggested contract language should resemble contract language in other products as appropriate – language used in cash products should correspond to derivatives where it makes sense to do so. In doing so, market participants will aim to minimize basis risk between outright positions and hedges. Firms should also seek to align language across regions and jurisdictions.
- Principle 3: Feasibility and Fairness of Implementation – The amended contract language should be practicable. Calculation methodologies to determine successor rates such as spread adjustments and term structures should be feasible from an operation perspective. New fallback language should incorporate feedback from a variety of participants.
- Principle 4: Rate, Spread and Term Structure Adoption – The new contract language should specifically allow for a spread adjustment to minimize valuation changes or to seek net present value neutrality. The language that enacts a trigger should be clear and specific. The choice of successor rate and spread adjustment should be clear enough that it can be effectively communicated to borrowers and lenders.
The level of effort required to effectively review, renegotiate and amend fallback language in the contracts governing financial products will depend on the size and complexity of the organization. For larger FI’s we recommend beginning this review immediately while continuing to monitor market developments and emerging practices to ensure new language aligns with market peers and regulatory expectations.