On the basis of statements made by regulators so far, the market expects that panel banks will no longer be compelled to make submissions for the determination of the London Interbank Offered Rates (LIBOR) as of the end of 2021 and that LIBOR will cease to be published in its current form as a result. This gives rise to the questions what alternative interest rate benchmarks may be used instead of LIBOR rates in the derivatives market and how to proceed with regard to transactions referencing LIBOR rates that have a maturity beyond the end of LIBOR.

By Olivier Favre (Reference: CapLaw-2020-25)

1) End of LIBOR

The fate of the LIBOR benchmarks was sealed when Andrew Bailey, the chairman of the FCA at the time, stated in a speech on 27 July 2017 that “it would no longer be necessary for the FCA to persuade, or compel, banks to submit to LIBOR” by the end of 2021. Regulators have since then maintained the position that LIBOR should cease to exist at the end of 2021 and a transition to alternative risk-free rates should be completed by such date. Nevertheless, LIBOR benchmarks are still widely used for products traded today, in particular in the interest rate derivatives and loan markets and for floating rate notes.

LIBOR is currently administered by ICE Benchmark Administration Limited (IBA) and available in five currencies (USD, GBP, CHF, JPY and EUR) and seven maturities (overnight, one week, one month, two months, three months, six months, and twelve months), resulting in 35 values published on each London business day. The number of contributing LIBOR panel banks varies depending on the currencies: 16 panel banks are contributing as regards the USD- and GBP-LIBOR, 15 panel banks are contributing to the EUR-LIBOR, 12 panel banks contribute to the JPY-LIBOR and 11 panel banks contribute to the CHF-LIBOR.

On 1 April 2019, the IBA announced that it completed a transition to a new waterfall methodology, where the determinations by panel banks must be made, if possible, on the basis of real transactions. Despite these efforts, a large part of the determinations are still based on markets that are not active and LIBOR is to a large extent still dependent on expert judgment. In the view of the leading regulators, this is a fundamental flaw in the model, which is not sustainable and has no prospect of changing.

It is hard to predict what the end of LIBOR will look like. It is quite possible that there will be a phasing-out with individual panel banks withdrawing from the submission process at different times around the end of 2021. This raises the question at what point exactly LIBOR loses its representative effect and whether there should be a switch to alternative benchmarks even before the actual cessation of the publication of LIBOR by the IBA and, if so, how this should be reflected in the contracts.

In any event, the discontinuation of LIBOR rates will lead to a fragmentation in two dimensions: On the one hand, each currency will have its own solution for an alternative benchmark. On the other hand, the derivatives, loans and floating rate notes markets will probably not be fully aligned as regards the solutions for the adjustments to be applied with respect to the use of alternative risk-free rates (RFRs), e.g. with respect to the use of overnight rates instead of forward-looking term rates and the move from rates taking into account the credit risk of the interbank market to risk-free rates.

2) Risk-free Rates (RFRs)

a) Available RFRs

To meet the requirements that have been established by the Financial Stability Board (FSB), an alternative benchmark that may be used to replace LIBOR must not be based on a discretionary determination by an administrator or contributors to the benchmark, but it must be determined on the basis of a transaction-based methodology. Also, the rate must not be based on the interbank lending market, but it must be based on secured or unsecured transactions entered into in a wider market.

The national working groups in the relevant markets have identified the following RFRs that may be used as alternative to the IBOR rates: (i) in respect of CHF, instead of CHF-LIBOR: the Swiss Average Rate Overnight (SARON); (ii) in respect of USD, instead of USD-LIBOR: the Secured Overnight Financing Rate (SOFR); (iii) in respect of GBP, instead of GBP-LIBOR: the Sterling Overnight Index Average (SONIA); (iv) in respect of AUD, instead of BBSW: the Australia Overnight Cash Rate (AONIA); (v) in respect of JPY, instead of JPY-LIBOR, TIBOR and Euroyen-TIBOR: the Tokyo Overnight Average Rate (TONA); (vi) in respect of CAD, instead of CDOR: the Canadian Overnight Repo Rate Average (CORRA); (vii) in respect of HKD, instead of HIBOR: the HKD Overnight Index Average (HONIA); and (viii) in respect of EUR, instead of EUR-LIBOR and EURIBOR: the Euro Short Term Rate (€STR).

For some of these RFRs, the market anticipates that existing benchmarks will continue to be published in a modified form. This is planned for Australia, Japan and Canada. In the EU, the EURIBOR will continue to exist, while the EUR-LIBOR and the Euro Overnight Index Average (EONIA) will cease.

The LIBOR rates are fixed at the beginning of the interest period and may then be applied to determine interest payments that become due and payable at the end of the interest period. However, the RFRs are – as opposed to LIBOR – overnight rates. As a result, if they shall be used in respect of a calculation period exceeding one day, the daily rates must be adjusted for the relevant term.

In respect of some RFRs, forward-looking term rates, which will be determined on the basis of derivatives transactions regarding such RFRs as underlyings, may be published in addition to the RFRs (e.g. for USD and GBP). The national working group expects that this will not be the case for Switzerland in the absence of a sufficiently liquid SARON futures market.

b) Compounding of RFRs

The standard term adjustment for the RFRs will be a compounding over the relevant calculation period. However, the compounded rates will only be known as of the end of the relevant calculation period, unless the relevant values will be taken from the previous calculation period.

In a base scenario, the calculation period runs for the same time as the interest period and the compounded RFR would only be available on the last day of such calculation period. This base scenario may not be suitable for cases, where the compounded RFR should be already determined as of a day prior to the last day of the interest period (e.g. for operational reasons, in order to make the relevant payments). 

If the compounded RFR must be available prior to the last day of the interest period, the calculation could be made by reference to a calculation period that runs differently than the interest period. For instance, it would be possible to start the calculation period at the same time as the interest period, but to end the calculation period a few days prior to the end of the interest period (this method is referred to as “lockout”). Alternatively, it would be possible to start the calculation period a few days prior to the start of the interest period and end it also a few days prior to the end of the interest period (this method is referred to as “lookback” or, in the terminology used by ISDA, “backward-shift”). With these methods, the compounded RFR would be known already prior to the end of the interest period.

3) Fallbacks for legacy transactions

a) Legacy transactions

As regards transactions referencing a LIBOR rate instead of an RFR and entered into with a term beyond the effective date of the LIBOR cessation (a legacy transaction), the question arises how such transaction can be transitioned during its respective term to an RFR. This may occur by agreeing to fallback clauses (either by including such clauses into the transaction documentation when it is entered into or by amending the transaction to that effect).

b) Derivatives documentation

OTC derivatives transactions are, as a matter of standard practice, documented under master agreements entered into for the trading relationship. The master agreements most frequently used in the market are those published by the International Swaps and Derivatives Association, Inc. (ISDA), which are available in a version of 2002 and a version of 1992 (the 2002 ISDA Master Agreement and the 1992 ISDA Master Agreement). ISDA Master Agreements are usually expressed, upon election of the parties, to be governed by English law or by the laws of the State of New York. 

In addition to ISDA Master Agreements, the derivatives market uses also other types of master agreements for local markets. In Switzerland, we have the Swiss Master Agreement published by the Swiss Bankers Association, which is governed by Swiss law and includes a choice of jurisdiction for Swiss courts. The Swiss Master Agreement was first published in 2003. It was published as an updated version in 2013.

c) Fallback clauses

A fallback clause must address three matters: firstly, it must include the triggers for the transition to the fallback rate. Secondly, the clause must specify the alternative RFRs that will apply upon a trigger event becoming effective. Thirdly, the fallback clause must specify the adjustments that shall apply with respect to the move to the relevant
fallbacks, including a term adjustment to address the differences in the term structure of the two rates (i.e. in respect of fallbacks to LIBOR, the move from a forward-looking term rate to an overnight rate) and a spread adjustment taking into account any differences with respect to credit risk (i.e. in respect of fallbacks to LIBOR, the move from a rate addressing interbank credit exposure to a rate based on secured transactions or transactions traded in a wider market).

ISDA intends to implement the relevant fallback clauses in a supplement to the 2006 ISDA Definitions, which are the relevant ISDA definitions applicable to interest rate benchmarks, and in a “Protocol” (ISDA Fallbacks Protocol) for inclusion of the fallbacks into transactions already in place at the time of the publication of the supplement to the 2006 ISDA Definitions.

d) Trigger events

In the fallback language to be prepared by ISDA, the triggers are expected to include the following events:

i) a public statement or publication by or on behalf of the relevant administrator of the relevant IBOR announcing that it has ceased or will cease to provide the relevant IBOR permanently or indefinitely, provided that there is no successor that will continue to provide the relevant IBOR; and

ii) a public statement or publication by the regulatory supervisor for the administrator of the IBOR, the central bank for the currency of the relevant IBOR, an insolvency official with jurisdiction over the administrator of the IBOR, a resolution authority with jurisdiction over the administrator of the IBOR or a court or an entity with similar insolvency or resolution authority over the administrator of the IBOR, which states that the administrator of the IBOR has ceased or will cease to provide the IBOR permanently or indefinitely, provided that there is no successor that will continue to provide the relevant IBOR; and

iii) a relevant LIBOR rate ceasing to be representative, as a result of panel banks ceasing to make submissions, prior to the date a trigger pursuant to i) or ii) above becomes effective (pre-cessation trigger).

For i) and ii), the effective date of such events may be at a later point in time than the occurrence of the relevant event. For instance, if the administrator of a relevant IBOR announces much in advance that it will cease to publish the relevant IBOR at a certain date in the future, the event would have occurred as of such announcement, but the fallbacks will only apply on the future date when the publication of the IBOR will cease.

As regards iii), the occurrence of such a pre-cessation trigger event will need to be defined in an objective way that allows a uniform application, e.g. on the basis of a decision by a regulator that the LIBOR has lost its representativeness.

e) Definition of RFRs

As regards the identification of alternative RFRs, the 2006 ISDA Definitions and the ISDA Fallbacks Protocol will include provisions mapping the relevant IBORs to an alternative RFR. Moreover, these provisions will also include secondary fallbacks for the event of a cessation of a primary fallback.

f) Term adjustment

As regards the term adjustment, ISDA consulted with the derivatives market participants as regards the approach to be taken to address the differences in the tenors between IBORs and the overnight RFRs. The result of these consultations showed a preference of the derivatives market for a “compounded setting in arrears” rate to be determined in respect of each IBOR tenor and a “lookback/backward-shift” of the calculation period by two banking days for the determination of the term adjusted overnight RFR. It is the intention that the 2006 ISDA Definitions and the ISDA Fallbacks Protocol will include such term adjustments for the RFRs. Therefore, as of the first interest period after the relevant trigger event becoming effective, the calculation would be made on the basis of a calculation period determined with such “lookback/backward-shift” method.

g) Spread adjustment

To address the differences in the credit and liquidity risk and further factors, such as fluctuations in supply and demand between the relevant IBORs and the RFRs, a spread is added to the relevant value (spread adjustment).

ISDA also sought the views of the derivatives market participants as regards the methodology to be applied for such spread adjustment. The outcome was a preference for the calculation of a historical median over a five-year lookback period as opposed to a calculation on the basis of a mean, which would be calculated over a longer look-back period, subject to the trimming of outliers.

On the basis of the consultations, it is the preference of the market to set the spread adjustment at the time the fallbacks will be applied without providing for a gradual phase-in over a transition period. It is the intention that the 2006 ISDA Definitions and the ISDA Fallbacks Protocol will include such spread adjustment to be set for each LIBOR tenor. Such adjustment will be determined as of the date the relevant trigger event for the fallback will be effective.

h) Publication of adjusted RFRs

It is ISDA’s intention that Bloomberg shall publish on behalf of ISDA the term- and spread-adjusted RFRs in the relevant tenors. For each such tenor, Bloomberg shall publish three values: the term-adjusted RFR, the relevant spread and an “all-in” rate as the aggregate of the term-adjusted RFR and the spread.

i) Implementation for ISDA documentation

– Fallbacks as part of supplement to 2006 Definitions:

The fallback clauses will be included in a supplement to the 2006 ISDA Definitions. As a result, as of the go-live date of such supplement, any derivatives transactions documented in a confirmation referring to the 2006 ISDA Definitions will include such fallbacks specified in the supplement to the 2006 ISDA Definitions.

– ISDA Fallbacks Protocol:

As regards the inclusion of fallbacks into transactions already in place at the time the supplement to the 2006 ISDA Definitions goes live and with a term beyond the LIBOR cessation, the parties may adhere to the ISDA Fallbacks Protocol.

As regards the scope of such ISDA Fallbacks Protocol, ISDA currently intends to cover not only transactions entered into under ISDA Master Agreements or by reference to the 2006 ISDA Definitions, but to apply a broader scope, covering also some transactions entered into under non-ISDA documentations (including those entered into under Swiss Master Agreements), provided that they include any cashflows that are determined by reference to a relevant IBOR. ISDA intends to include an annex to the ISDA Fallbacks Protocol with the relevant non-ISDA Documentation to be covered by the protocol.

Also, it is ISDA’s intention that the ISDA Fallbacks Protocol will amend collateral documentations by incorporating the relevant fallback clauses also for the purposes of the calculation of interest payments.

– Bilateral agreement:

As an alternative to adhering to the ISDA Fallbacks Protocol, the parties may enter into a bilateral agreement for the purposes of including the relevant fallback clauses into such pre-existing transactions.

j) Implementation for Swiss documentation

– ISDA Fallbacks Protocol:

The ISDA Fallbacks Protocol may also apply in respect of transactions entered into under a Swiss Master Agreement published by the Swiss Bankers Association, to the extent that such Swiss Master Agreements will be included by ISDA in the list of protocol covered non-ISDA documentation.

However, the ISDA Fallbacks Protocol will only incorporate fallbacks into pre-existing transactions. For transactions entered into after the go-live of the protocol, the parties will have to include a reference to fallbacks into the relevant transaction documentation (e.g. by way of incorporating the 2006 ISDA Definitions or by entering into a Swiss IBOR Appendix).

– Swiss IBOR Appendix:

The Swiss Bankers Association intends to publish a Swiss IBOR Appendix that may be entered into as a bilateral agreement by parties to (i) a Swiss Master Agreement for OTC Derivative Instruments published by the Swiss Bankers Association (including (a) the 2003 version, (b) the 2013 version for use in connection with certain ISDA Definitions and (c) the 2013 non-ISDA version not for use in connection with any ISDA Definitions), (ii) a Swiss Master Agreement for Repo Transactions published by the Swiss Bankers Association (bilateral 1999 version, multilateral 1999 version) and (iii) a Swiss Master Agreement for Securities Lending and Borrowing prepared by the Swiss Bankers Association (2011 version). The Swiss IBOR Appendix will include into such Swiss law governed master agreements the same fallbacks as those specified in the ISDA Fallbacks Protocol published by ISDA. Therefore, for the Swiss law governed agreements mentioned above, entering into the Swiss IBOR Appendix as a bilateral agreement will be an alternative to adhering to the ISDA Fallbacks Protocol by both parties.

As opposed to the ISDA Fallbacks Protocol, the Swiss IBOR Appendix will not only incorporate fallbacks into pre-existing transactions, but also achieve this result for transactions entered into after the date of signing of the Swiss IBOR Appendix. 

In addition to including such fallbacks, it is intended that the Swiss IBOR Appendix will include clauses specifying how RFRs are compounded, where the parties do not agree differently in the relevant transactions.

Moreover, the Swiss IBOR Appendix shall include the relevant fallbacks for the transition from EONIA to €STR as the relevant fallback rate when EONIA cessation is scheduled to occur at the end of 2021.

4) Litigation risk in the absence of fallbacks

Parties to OTC derivatives transactions are exposed to a litigation risk when LIBOR ceases to be published in the event they failed to incorporate fallbacks into legacy transactions (as set out under 3 above) and there are no statutory provision under the governing law of the contract providing for the application of fallback clauses by operation of law.

A party that could enter into a new transaction on better terms compared to the pre-existing transaction may hold off its consent to the amendment and argue that the obligations have become impossible to fulfil and have therefore been frustrated.

This argument could be disputed by the other party with the argument that the LIBOR cessation is a change in circumstances that should be classified as requiring the application of fallback clauses. Under a Swiss law governed agreement, an adjustment of the terms of the contract by a court could be requested under the doctrine of the “clausula rebus sic stantibus”, which applies under general principles of Swiss contract law, or on the basis that the contract was incomplete in the absence of fallbacks and should be supplemented accordingly. However, a Swiss court may not adjust or supplement the terms of the contract if a transaction was entered into at a time when the market was already on notice about the potential LIBOR cessation at the end of 2021. It would be up to the court to determine at what point in time exactly the parties would be deemed to be “on notice” of the LIBOR cessation.

To achieve a predictable outcome of the transition of legacy transactions, the parties will therefore have to adhere to the ISDA Fallbacks Protocol or agree to the inclusion of fallback clauses into the documentation in advance of the LIBOR cessation.

Olivier Favre (olivier.favre@swlegal.ch)