The London Interbank Offered Rate (“LIBOR”) is an interest-rate average calculated from estimates submitted by the leading banks in London, used in lending between banks on the London interbank market. Over time, LIBOR has been used as a reference for setting the interest rate on other loans and a myriad of other financial products. Following the uncovering of manipulation of this rate, the role of LIBOR in setting interest rates in the financial market has been called into question.
In July 2017, the UK Financial Conduct Authority (“FCA”) announced that from the end of 2021 it would no longer require banks to submit quotes in order to obtain interest rates to form LIBOR. Therefore, market participants should not rely on LIBOR being available after this date. As a consequence, the FCA expects firms to be taking appropriate steps to ensure they can transition to alternative risk-free reference rates (“RFRs”) before the announced deadline of the end of 2021.
Because of the systemic importance of LIBOR in the swaps market, the International Swaps and Derivatives Association (“ISDA”) has been involved in finding effective solutions for the derivatives market to move away from LIBOR in an orderly manner. A particularly interesting aspect of the discussion is the preparation of so called “pre-cessation triggers” .
A “cessation trigger” is a contractual fallback in the LIBOR wording, which triggers a switch to the fallback (RFR plus margin) when the publication of LIBOR will be discontinued in 2021.
Conversely, a “pre-cessation trigger” is a contractual fallback in the LIBOR wording, which triggers a switch to the fallback (RFR plus margin), before LIBOR ceases to be published. Such a circumstance can happen when LIBOR eventually ceases to be “representative”: this might be a consequence of the fact that when a deemed significant number of banks stops submitting the rates for calculating it, the FCA will issue a statement of “non-representativeness” before 2021.
The FCA’s wider discussion on such pre-cessation trigger is noteworthy, in particular for its comments and concerns in relation to these contractual fallbacks. The co-Chairs of the Financial Stability Board’s Official Sector Steering Group (the “FSB”), Andrew Bailey, have written to ISDA requesting that it includes a “pre-cessation trigger” alongside the cessation trigger in its standard language in derivatives contracts, via either definitions for new contracts or in a single protocol (without embedded optionality) for outstanding contracts. The FSB also advises against “opt-in” or “opt-out” alternatives as this would present additional complexity and risk management challenges, but notes that parties could still agree to bilaterally amend the pre-cessation and cessation triggers.
Further, the FSB’s letter notes that, while the two largest central counterparties (“CCPs“) intend to move cleared derivatives contracts away from LIBOR in the event of a “non-representative” determination by the FCA, no similar trigger exists for uncleared contracts. This could cause a discrepancy in rates between cleared and uncleared contracts, with potential market fragmentation ramifications. The pre-cessation trigger would cause a LIBOR-based contract to fall back to an alternative reference rate in the event that the FCA, as the regulator of LIBOR, deemed that LIBOR was no longer representative.
ISDA has therefore consulted derivatives market participants on a number of aspects of the proposed fallback provisions in its documentation, including whether or not to include a pre-cessation trigger, and reported that the majority of respondents supported the move, but that there were differing views on how it should be implemented.
ISDA has not published any pre-cessation trigger language so far, and the FSB has urged it to take further steps, if necessary, to do so.
ISDA’S APPROACH TO THE TRANSITION AWAY FROM LIBOR
The derivatives market operates by way of the ISDA Master Agreement (whether the 1992 or 2002 form) and by the usage of industrywide mechanics for adoption of amendments. With respect to LIBOR transition, ISDA addresses or is seeking to address the issues in the following ways:
- Proposed Changes to the 2006 ISDA Definitions: ISDA proposes to include new fallbacks from LIBOR to the RFRs and adjustments required as a result of the differences between LIBOR and RFRs. The 2006 ISDA Definitions will be the mechanism by which these fallbacks and adjustment provisions will be included in new derivatives transactions;
- Protocol: ISDA will publish a protocol to allow participants to include the fallbacks and adjustments mentioned above in legacy derivatives (entered into prior to publication of the amended 2006 ISDA Definitions); and
- Existing ISDA Position: The existing fallback in the ISDA documentation provides that, if LIBOR is not available, the Calculation Agent must calculate a replacement rate by using an arithmetic mean of quotations (the deed poll method). This requires the Calculation Agent to obtain at least two quotations from specific reference banks or “major banks in London.” However, this fallback option is limited in that such reference banks may not be prepared to provide these quotations. It is arguable, given the volume of legacy trades on the books of banks and financial institutions, that there could be a considerable amount of legacy trades that are not amended because parties have not adhered to the relevant ISDA protocol or agreed to the RFR by way of a bilateral agreement. In such circumstances, parties will need to rely on the deed poll method, which is silent on what happens if the required quotations cannot be obtained or provided by the reference banks or major banks (as applicable). In that scenario, it may be left to the courts to determine the solution.
ISDA CONSULTS ON “PRE-CESSATION TRIGGERS”
After its first consultation closed with mixed results, ISDA issued a second consultation on implementing pre-cessation fallbacks for derivatives in response to a request from FSB. In the new consultation, ISDA asked respondents whether expected amendments to the 2006 ISDA Definitions should contain triggers for benchmark change based on a “non-representativeness” pre-cessation trigger. Per the consultation, the spread adjustment would then be calculated as of the relevant “non-representativeness” announcement date (or permanent cessation, if earlier), but fallbacks would be implemented based on a permanent cessation or a statement by the FCA that LIBOR is “non representative.”
Despite the outcome of the first consultation, ISDA CEO Scott O’Malia believes that the second consultation will generate a better response due to several recent developments, such as:
- clarification from the FCA and the ICE Benchmark Administration on the “reasonable period” during which LIBOR would continue to be published following the occurrence of a related Pre-Cessation Trigger; and
- a recent consultation launched by LCH Limited regarding amendments to its rulebook to implement pre- cessation Triggers.
The pre-cessation consultation gives market participants the opportunity to comment on the approach ISDA should take with regard to LIBOR transition, including a pre-cessation trigger. ISDA asks whether pre-cessation fallbacks should be included alongside permanent cessation fallbacks both in the amended 2006 ISDA Definitions (for new contracts) and in a single protocol (for legacy contracts), with no optionality (i.e. no option to choose not to include pre-cessation triggers).
For derivatives contracts entered into after the date of the 2006 ISDA Definitions are amended, these new fallbacks and triggers will automatically apply. Legacy transactions will need to be amended using an ISDA protocol. It was expected that the ISDA LIBOR Fallbacks Protocol would be published early this year, but in light of the re-consultation (and the extended deadline), as well as the coronavirus disease (COVID-19) dislocation, a protocol may well not be available until late 2020.
For the consultation to be deemed representative:
- at least 70 market participants (excluding professional services firms or trade associations) must submit responses, and at least 35 percent must be from participants other than bank/broker-dealers and infrastructure providers;
- at least 65 percent of respondents have to affirm that the Definitions Supplement and Protocol should include both permanent and pre-cessation trigger events, of which at least 35 percent must be respondents other than bank/broker-dealers and infrastructure providers; and
- respondents rejecting the inclusion of both permanent and pre-cessation trigger events, and also indicating that they would be unavoidably harmed by or unable to use a Definitions Supplement and Protocol including both types of trigger events, “do not represent a significant portion of” a particular market segment (e.g. responding corporations).
If the criteria are not met, ISDA intends to publish a Definitions Supplement and Protocol that implement permanent cessation triggers only, unless both parties to a contract opt in to the inclusion of pre-cessation triggers. In such a case, the pre-cessation trigger would apply under the Protocol only if each of the adhering counterparties to a covered contract has made the same election.
Comments on the second consultation were due by March 25, 2020. However, despite the initial intention not to extend this deadline, recent circumstances have pushed ISDA to move this deadline to April 1, 2020.
The extension by ISDA of the consultation deadline should not be taken as an indication that LIBOR cessation will be postponed. As it currently stands, LIBOR panel banks will not be required to provide submissions to the FCA after the end of 2021, and whether LIBOR ends at the end of 2021 is dependent on whether those banks continue making submissions.
All market participants affected by the discontinuation of LIBOR in the derivatives market should review and respond to this important consultation. ISDA’s presentation of the consultation is available: here. ISDA’s consultation paper is available: here.
Financial institution should engage in a wholesale review of its legacy derivative positions in order to gauge any potential dispute or litigation risks, and make a concerted effort to identify those contracts which are most at risk of challenge on or before the 2021 cutoff date.
For more information, and any guidance or advice on LIBOR discontinuation and how it affects your derivatives documentation, Cleveland & Co External in-house counsel, your specialist outsourced legal team, are here to help.
 For an overview on the FCA’s position of LIBOR discontinuation and pre-cessation triggers, please see our previous article: FCA issues guidance on discontinuation; ISDA discusses pre-cessation triggers.