As the LIBOR transition continues to pick up speed and new Alternate Reference Rate (ARR) linked products become available, firms are actively converting their existing contracts to transition away from the London Interbank Offered Rate (LIBOR). Even if companies are prioritizing the amendment of contracts to remove LIBOR exposure or cancelling and reissuing deals without LIBOR exposure, there may still be contracts that rely on fallback language and monitor temporary or permanent cessation triggering event.
Relying on fallbacks, both amendment and hardwire approaches, requires firms to be able operationalize these fallbacks in the downstream processes and technology as well as to monitor and execute upon the trigger events.
When the time comes, do you know what switch to flip to make sure your company is not left in the dark? Are you certain that, when you flip the switch, the lights will still come on? Those are the questions that are being asked across the industry as firms pivot from preparation to execution of their LIBOR transition journey.
What this means
Before firms can begin to develop their plans to operationalize fallbacks, it is important that they have identified impacted LIBOR contracts, extracted and reviewed contract terms, and amended contract language where possible. For more insight into the process of preparing and reviewing contracts, check out these other blog posts:
- The Prelude to a Contract Remediation Journey
- Search and Extract Gold (or Coal) From Financial Contracts
- How to Build a Contract Remediation Factory
- Communicating and Negotiating Contracts with Client
- Don’t Just Sign, Set and Forget Your Contract – Systemize and Stimulate It!
After a thorough review of contracts populations is complete, operational readiness is the next concern. To operationalize fallbacks, an operational process, supported by requisite infrastructure, should be in place to allow business and operations teams to convert contracts from IBORs in a controlled manner.
These six activities can help facilitate the execution of fallbacks in a timely manner upon the occurrence of a trigger event:
- Define a consistent strategy for index replacement
Classifying contracts into normalized transition buckets based on fallback terms and triggers is an important prerequisite. Equally important, a defined library of triggers describing examples and approaches to manage the execution (including benchmark replacement waterfalls) that could lay the foundation for an effective execution. Without a consistent strategy for the operationalization of fallbacks, the complexity resulting from the variety of products and clients across business units could easily lead to missed components of the portfolio.
- Ensure Operational Readiness
In addition to contracts, other aspects of operational readiness are important support the ability of companies to enact upon the trigger event. Firms should confirm that all models, data, systems, training for client communication, and other business infrastructure elements are implemented and tested before upcoming events.
- Define the appropriate operating model to monitor for trigger events
No discussion of trigger monitoring can occur without recognizing the two main types of trigger events that are expected to guide the transition. Permanent cessation triggers are expected to come from an authoritative body such as the FCA or ICE and notify market participants of the impending cessation of LIBOR. Contract language that references an event where “… the Benchmark Administrator has ceased to provide the Benchmark permanently or indefinitely…” is one of the common examples of ARRC-endorsed trigger event language found in contracts. These reflect definitive moments in time before which LIBOR existed as a trading term, and after which LIBOR no longer exists.
On November 30th, 2020, the IBA announced that it would consult on when to end USD LIBOR tenors and proposed ceasing 1-Week and 2-Month USD LIBOR tenors at the end of December 2021, and cease overnight, 1-Month, 3-Month, 6-Month, and 1-Year USD LIBOR tenors on June 30th, 2023. The consultation window closes on January 25th, 2021 and the results will be shared shortly thereafter. In this scenario, when the IBA announces definitive dates for permanent LIBOR cessation, a pre-cessation trigger event will have occurred. Contract language that addresses this often reads, “… at such a time that the Benchmark Administrator will cease to provide the Benchmark permanently or indefinitely….” Though LIBOR would exist beyond the date of the pre-cessation announcement, the announcement’s effect as a fallback language trigger event is key, not just for transition timeline planning reasons. Per the ISDA IBOR Supplement and protocol released on October 23, 2020, the Credit Adjustment Spread (CAS) for fallback calculation is fixed on the day of the fallback trigger. Bloomberg Index Services Limited (BISL) has already begun publishing the fallbacks that ISDA references in the updated definitions as part of IBOR Supplement. Should the FCA or IBA announce in Q1 2021 that specified LIBOR indices and tenors would cease to be published on a set date in in the future, the date of the announcement locks in the CAS that would be used going forward to transition legacy contracts. Monitoring for these trigger events becomes critically important to transitioning legacy contracts and modeling financial impacts.
- Enact the fallback operationalization plan and begin the transition of contracts
Once the trigger event is confirmed and the applicable successor rate and spread adjustment is defined, it is crucial to build an operating model that describes the various roles and responsibilities between the lines of business, with a central monitoring team as well as the appropriate legal and downstream operation teams. Process flows and operating procedures should be documented to inform the waterfall of actions and communications, including an escalation procedure for ambiguous situations that require legal consultation. Though some triggers are likely to be clear (such as a statement from the FCA), others, such as early opt-in market conditions, may be less clear. Every day spent deliberating over whether a trigger event has occurred is a day that the market is moving on without your firm.
- Enact the fallback
Communications to clients and counterparties can start as early as when the contract is first reviewed for potential fallback impacts and continues through contract amendment and fallback execution. Firms should consider when to notify the clients of a trigger event occurrence, the existence of early opt-in conditions, and the determination of the successor rate via the streamlined amendment process. Well prepared and consistent messaging is important during the execution of the fallbacks to maintain the trust of clients and firms’ positions in the market.
- Track progress of fallbacks as they get executed
While all fallbacks are being executed and transactions are being converted to the new ARRs, a comprehensive method to track progress and visualize the impacts on the portfolio across the enterprise is essential in order to provide firms with a view of potential risks for specific lines of business, products, and regions.
Steps to Better Management of Triggers
Firms can better manage their transition triggers (including preparation, monitoring, and coordination) to facilitate the execution of fallback by taking steps including:
- Development of a comprehensive strategy. Support the bucketing of contracts based on fallback language and trigger terms. Determining the appropriate strategy for each alignment of products/indices/contract terms can give firms confidence that all scenarios are accounted for.
- Creating a trigger management playbook. This includes the operating model across the various stakeholders, roles and responsibilities, process flows and operating procedures.
- Coordinating trigger management activities of activities and track progress of conversions. This includes the establishment of a command center that could monitor and communicate trigger events but also coordinate and track the downstream the fallback execution activities.
- Supporting client communications. Create communications plans, develop and implement training for employees, create communications materials and support the distribution and tracking of communications activities.
The LIBOR transition is not far off. Firms would need an effective trigger management strategy to avoid disruption and maintain continuity with clients and regulators. Please contact me directly if you wish to discuss this or any other aspect of the LIBOR transition.