Blog Post

Preparing Your Contracts for LIBOR: What You Need to Know Part 2

August 21, 2020

In part one of our series, we went into detail on what the LIBOR transitions means. In part two of our series, we will walk you through a step by step process to help you prepare your contracts for the LIBOR transition.

1. Assess your contracts

Collect your contracts into one place

Taking stock of your contracts and assessing your portfolio’s exposure to the LIBOR transition will be the first step to determining what you’ll need to start 2022 off smoothly. Unfortunately, for some organizations, this can be a Herculean task.

Not all organizations have solid contract management practices in place. Strong contract management is always going to be a valuable asset, even beyond the LIBOR transition. Use the transition as an opportunity to raise your contract management practices to a healthier level.

Assessing your organization’s position in the contract management maturity model (CMMM) is a great place to start.

While reaching level 5 in the CMMM should be the ultimate goal for any organization, being prepared for the LIBOR transition requires at least reaching level 3. Specifically, you will want to have a contract repository — a centralized, secure location to store all of your contracts and their pertinent details. Doing so will enable you to both review your exposure and begin preparing your contracts for the LIBOR transition in later steps. Consider using a contract management system (CMS) to build your repository, as this will facilitate any contract management tasks you’ll need to complete before transition.

Identify exceptions

Next, you’ll need to identify which contracts should be examined more thoroughly. A good place to start is to look for contracts that do not include fallback language, as these are the most likely to pose a risk to your organization after the LIBOR transition.

These types of contracts are a priority, but equally disruptive are contracts with inadequate fallback language. Determine which contracts include language that is at best intended for a temporary switch to an ARR.

Fallback language should explicitly address three items:

  • The fallback trigger event
  • The benchmark replacement rate
  • The benchmark adjustment — since LIBOR captured bank credit risk while ARRs do not, it will be necessary to include a spread adjustment.

Any contract that lacks one of these items or contains ambiguous language should be flagged for further review. Later in the transition process, you’ll develop more thorough model fallback language to apply to your contracts.

Next, regardless of which ARR is designated for after the LIBOR transition, identify those contracts whose economics are at significant risk of changing in favor of one party or the other. Since the methods for calculating LIBOR and ARRs are different, one party may pay or receive more than the other.

It’s especially important to pay attention to contracts with parties that have less bargaining power, such as small firms. These groups will be the most vulnerable to and affected by the transition, and may file claims against the other party if they believe they have been unfairly treated.

Additionally, identify which contracts are being used as hedging instruments. Under International Financial Reporting Standards (IFRS), certain changes in the terms of hedging instruments (such as the use of an ARR) will de-designate the hedging relationship. From an accounting perspective, this may result in greater volatility in your organization’s financial statements.

Build a transition team

To reduce your exposure to the LIBOR transition, it will be important to assign an individual or group the responsibility of overseeing transition activities. The size and structure of this group will vary depending on the nature of your organization, but here are a few examples of the sorts of key stakeholders who should be involved.

  • A member of senior management, such as a Chief Financial Officer.
    • Given the scope of the LIBOR transition and how widely its impact will affect financial organizations, senior management will need to be apprised of their firms’ transition strategy. Additionally, there will need to be a stakeholder with the authority to make decisions that may significantly affect the future of your organization.
  • Legal team members
    • General counsels will spearhead transition activities. Reviewing fallback language, assessing clarity, identifying contracts that require renegotiation — the bulk of transition activities will fall under the purview of your organization’s general counsels. Because this group plays such an important role, you may wish to bring in outside consultants to support their efforts.
  • IT team members
    • If your contractual data is integrated with your organizations’ systems, then it’s critical that IT members are looped in to ensure that any new instruments and rates function within the system as expected.
  • Accounting team members
    • The LIBOR transition will affect how payments are made and received by your organization, making the accounting department an important voice in transition activities. Additionally, transitioning away from the LIBOR in a hedging instrument may result in the de-recognition of a hedging relationship, which will affect how your accounting team develops and reviews financial statements.
  • Other stakeholders as needed
    • No two organizations are alike, and the LIBOR transition is a far-ranging event; take stock of your business processes and consider which departments may be impacted.

2. Define a clear transition strategy

Having gathered your contracts, identified high-risk contracts and built your transition team, it’s time to start planning your transition strategy.

Develop a strategy document that comprehensively describes your planned transition activities, including tactics to minimize your organization’s risks, costs and delays. This should take into account a few key concerns.

What ARRs must be used?

There are a variety of alternative risk-free rates that have emerged as potential replacements for the LIBOR. Nearly all have the advantage of being based on actual transactions, making them more accurate, reliable and less manipulatable than LIBOR.

Which ARR you use will depend on your primary currency denomination. The following table lists five major ARRs and their key characteristics.

ARR Working Group Administrator Key Features
Secured Overnight Financing Rate (SOFR) Alternative Reference Rates Committee (ARRC; US) Federal Reserve Bank of New York
  • Secured
  • Transaction-based
  • Based on overnight repo market
Reformed Sterling Overnight Index Average (SONIA) Working Group on Sterling Risk-Free Reference Rates (UK) Bank of England
  • Unsecured
  • Transaction-based
  • Based on overnight wholesale deposits
Euro Short-Term Rate (ESTR) Working Group on Risk-Free Reference Rates for the Euro Area

(Eurozone)

European Central Bank
  • Unsecured
  • Transaction-based
  • Based on overnight wholesale deposits
Swiss Average Rate Overnight (SARON) The National Working Group on CHF Rates (Switzerland) SIX Swiss Exchange
  • Secured
  • Partially transaction-based (built from transactions and quotes on the SIX platform)
  • Based on interbank overnight repo market
Tokyo Overnight Average Rate (TONAR) Study Group on Risk-Free Reference Rates (Japan) Bank of Japan
  • Unsecured
  • Transaction-based
  • Based on overnight call rate market

As the markets grow more volatile due to COVID-19 and a possible recession, general counsels should monitor the corresponding volatility of their relevant ARR as well as the LIBOR. This will give you a sense for how suitable your rate is for replacing LIBOR and how your contracts will perform during times of economic stress.

A note about yield curves and term rates

The various working groups are in the process of developing term ARRs. However, since many of these ARRs are relatively new, their underlying markets are not sufficiently liquid to build a robust term rate. The majority of working groups have promised to release an official term rate for their ARRs before the end of 2021.

Develop model fallback language

Evaluate your organization’s contracts and begin building model fallback language to incorporate into contracts referencing LIBOR that mature past 2021. These will be your primary targets, but it’s equally important to incorporate robust fallback language in new contracts that already reference an ARR. After all, there’s no guarantee that there won’t be future disruptions to your replacement rate, or even another transition.

Both the ARRC and the International Swaps and Derivatives Association (ISDA) have developed guidelines for robust fallback language. For derivatives, the ISDA should be consulted, while cash products should be based off of the relevant working group’s guidelines. In order to be robust, however, your model fallback language should take into account three elements at minimum:

  • Successor rates, spread adjustments and trigger events
  • Consistency of terms and conditions across asset classes
  • The feasibility of implementation and fairness towards counterparties

Identify contracts with problematic language

Based on the model language you’ve developed, look through your contracts to see which contain weak fallback language (or none at all!) that don’t meet the standards you’ve set.

Develop a playbook for counterparty communication

Counterparties will have questions about how the LIBOR transition affects them; it’s important to develop a unified communication strategy to get your organization on the same page. Your communication strategy should address questions about the new rates as well as concerns over whether the transition will have a negative impact. Be proactive and transparent when communicating with counterparties, especially those you identified as being at risk of paying more or receiving less due to the transition.

Stay tuned for part three of our series, where we will go into detail on what tools will be helpful during the LIBOR transition.