Blog Post

Preparing Your Contracts for LIBOR: What You Need to Know Part 1

August 14, 2020

After more than 40 years, the industry-wide standard for calculating interest rates — the London Interbank Offer Rate, or LIBOR is being put to bed. Today, LIBOR is tied to over $350 trillion in financial contracts, and yet the Financial Conduct Authority (FCA) has announced that it will phase out the use of LIBOR by the end of 2021.

Plenty of time for legal professionals to transition away from a decades-long standard, right?

Maybe not. The scope of the transition may be enormous, but it’s not impossible to manage — especially not with the right strategy to guide your efforts and the right tools to help you carry them out.

So, what will really happen to contracts tied to LIBOR that mature past 2021?

Simply put, each of these contracts will expose your organization to greater and greater risk.

If enough banks stop submitting LIBOR estimates after end-2021, then the rate will simply cease to exist. However, there hasn’t been a ban on banks submitting LIBOR estimates, either; if a handful of banks continue to submit estimates, it could create a so-called “zombie LIBOR.” Contracts that continue to reference a zombie LIBOR rate won’t accurately represent the cost of funding and are likely to experience excessive volatility.

What about contracts with fallback language?

Fortunately, many contracts include fallback language specifying how to select an alternative reference rate (ARR) should the LIBOR be temporarily unavailable. Unfortunately, contractual fallback language doesn’t always offer a straightforward way to select a benchmark replacement. Even when it does, switching to an ARR can change the underlying economics of a contract, potentially causing one party to pay less or receive more, or vice versa.

Checking for weak fallback language isn’t a simple task, either. The language often differs between derivatives and cash product contracts and even varies amongst different cash products. As a result, reviewing contracts for weak fallback language can become a tedious, granular task.

Chief Executive of the FCA Andrew Bailey put it best in his 2018 speech at Bloomberg, London:

“Fall back language to support contract continuity or enable conversion of contracts if LIBOR ceases is an essential safety net – a ‘seat belt’ in case of a crash when LIBOR reaches the end of the road. But fall backs are not designed as, and should not be relied upon, as the primary mechanism for transition. The wise driver steers a course to avoid a crash rather than relying on a seatbelt.”

Why is the FCA dropping this problem in my lap?

There are a lot of good reasons why LIBOR is going away.

Revelations in 2012 revealed that financial institutions were manipulating LIBOR for their own gain, spurring investigators to take a closer look at the popular benchmark rate. When they did, they uncovered several failures inherent to LIBOR.

Banks are not borrowing from one another

The LIBOR is based on interbank lending, but modern banks aren’t borrowing from one another that much these days. Thus, the sample size used to calculate LIBOR is too small to be reliable.

Banks are guessing at theoretical interest rates

Since few actual transactions underpin LIBOR today, bank experts are submitting their LIBOR rates based on theoretical estimates.

The LIBOR is still vulnerable to manipulation

Because bank experts are submitting their estimated lending rates to fill in LIBOR’s small sample, it’s still relatively straightforward to manipulate the rate. Although such manipulation isn’t likely taking place today, it would only take a few unethical LIBOR panel banks to rig the rate.

All together, these weaknesses mean that organizations with LIBOR exposure need to prepare. Legal teams already have a lot on their plate, but end-2021 will be here in a flash; planning ahead is the best approach.

Will COVID-19 have an impact on the transition?

The COVID-19 pandemic has destabilized the global economy, causing many to expect a recession. As a result, there has been some speculation that financial authorities will delay LIBOR transition activities to avoid further stress to the economy, including the date of the phase-out itself.

While this remains a possibility, the FCA stated that “the central assumption that firms cannot rely on LIBOR being published after the end of 2021 has not changed and should remain the target date for all firms to meet.”

However, the FCA did concede that the far-reaching impact of COVID-19 is likely to affect the ARR working group’s transition milestones, such as the creation of term rates, spread adjustment methodologies, and so on. Unfortunately, this will make it more challenging to implement a comprehensive transition in time for end-2021.

Although COVID-19 has added to firms’ workloads, the uncertainty it has provoked makes it all the more essential that firms carry out their LIBOR transition smoothly and on schedule. Firms should regularly monitor statements made by their relevant ARR working group and other financial authorities, adjusting their transition plan accordingly.

Stay tuned for part two of our series, where we will go into detail on how to prepare your contracts for the transition.