The countdown for the expected end of the London Interbank Offered Rate (LIBOR) benchmark as of the end of 2021 is reaching the two year mark. However, LIBOR benchmarks are still widely used in derivatives transactions, floating rate notes (FRNs), loan agreements and mortgage agreements. The topic of an orderly transition from LIBOR to alternative risk-free rates (RFRs) has recently been identified by the Swiss Financial Market Supervisory Authority (FINMA) as one of the key risks in the market (see FINMA Risk Monitor 2019). Importantly, the transition may have to be completed even earlier should the relevant LIBOR rates no longer be viewed as representative because panel banks cease to contribute to LIBOR prior to the cessation.

1. Trading RFRs

Already today, market participants may use alternative RFRs (e.g. SARON instead of CHF LIBOR, SONIA instead of GBP LIBOR, SOFR instead of USD LIBOR and €STR instead of EUR LIBOR). For instance,

• in the derivatives market, the 2006 ISDA Definitions provide for definitions how to calculate such alternative RFRs, which are overnight rates, on a compounded basis; and
• in the Swiss FRN market, the Swiss National Working Group (NWG) has provided template language for SARON FRNs.

In the loan market, it is yet to be determined whether market participants will use alternative RFRs as compounded overnight rates or whether it will be the preference to use, to the extent available, forward-looking term rates that will yet have to be developed (which is expected in the US for SOFR and in the UK for SONIA, but not in Switzerland for SARON).

2. Need for Fallbacks

For contracts with a term running longer than the availability of LIBOR rates (i.e. presumably beyond 2021), besides valuation risks and risks relating to the operational readiness for a transition to RFRs, a key risk lies with the need to amend such legacy contracts for the purposes of including the appropriate fallback language that is needed to address the transition from the LIBOR benchmarks to the alternative RFRs.

Such fallbacks should (1) define the triggers for the switch to the fallbacks, (2) identify the alternative RFRs used as fallback, (3) specify how overnight RFRs are compounded throughout the calculation period and (4) specify what spread adjustment is applied for the switch from the LIBOR rate to the alternative RFR.

The consequences of a failure to amend the relevant contracts in time prior to the discontinuation of the LIBOR rates would be severe. There is a clear risk that many such agreements would result in litigation between the parties. FINMA published guidance to increase the awareness of the issue among financial institutions under its supervision (see FINMA Guidance 03/2018). FINMA also announced that it will continue to assess whether the institutions with the largest exposures to LIBOR benchmarks adequately identify, limit and monitor the risks resulting from the LIBOR cessation.

3. Fallbacks for Derivatives

In the derivatives market, ISDA will publish an amendment to the 2006 ISDA Definitions that includes fallbacks. Any new transactions referencing the amended 2006 ISDA Definitions after their publication will automatically include the relevant fallbacks. For transactions referencing the 2006 ISDA Definitions, which are already outstanding at the time of the publication of the amended 2006 ISDA Definitions, it is intended that a protocol will allow an amendment of all such legacy transactions outstanding between two parties adhering to the protocol without the need to enter into bilateral amendment agreements.

For transactions documented under Swiss Master Agreements for OTC derivatives transactions, the Swiss Bankers Association will publish an Annex that will replicate the fallbacks included in the amended 2006 ISDA Definitions. Such Annex can then be applied by a bilateral agreement between the parties.

4. Fallbacks for FRNs

For FRNs referencing a LIBOR rate with a term exceeding the end of LIBOR, the parties are advised to include fallbacks by reference to alternative RFRs. Otherwise, there will be no certainty of an orderly transition.

5. Fallbacks for Loans

In the loan market, Screen Rate Replacement Clauses provide for the intention of the parties to apply - in the absence of a replacement benchmark formally designated by the administrator of the screen rate, a competent authority or a competent working group - a fallback that will be generally accepted in the lending market. It remains to be seen whether these clauses will be supplemented with more specific fallbacks.

6. Conclusion

The transition from LIBOR rates to alternative RFRs is gaining momentum. Given the complexity of the exercise and the need to enter into bilateral agreements with counterparties in many cases, the market participants are well advised to factor in sufficient time to ensure readiness prior to the deadline. The topic is a top priority for the Swiss regulator.