The transition from LIBOR to alternative reference rates presents numerous challenges, particularly when it comes to renegotiating and operationalizing fallback language for both existing and new contracts. Although uncertainty remains among market participants and industry guidance continues to evolve, adopting a “wait-and-see” attitude before amending contracts is not considered wise. Financial institutions should consider acting now to develop a solution that supports the use of appropriate contract language in preparation for the permanent discontinuation of LIBOR.
This article looks at why financial institutions should consider acting now to develop a solution that supports the use of appropriate contract language in preparation for the permanent discontinuation of LIBOR.
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In the world of finance, there is one number that likely matters more than any other. It is the basis for tens of millions of contracts worth more than $350 trillion, ranging from derivatives to mortgages, bonds, and retail and commercial loans. It is considered the most important number in the world, but you can only find it in small print in contractual documents.
The number, of course, is LIBOR, and its anticipated end in 2021 is making a huge imprint on the financial services sector. Stanford professor Darrell Duffie expressed it this way, “The LIBOR transition is the largest financial engineering project the world has ever seen.” While many of the largest global banks have started planning early for the transition away from LIBOR to replacement benchmarks, many capital markets institutions are way behind. According to a recent survey by Debtwire of 100 investment banks, direct lenders, distressed debt investors, hedge funds, and business development companies, 46% of these institutions admit that they are not well prepared for the transition. As many as 39% are not even in the process of marshalling the required resources to address conversion issues, and 42% are not close to a concrete project plan.
It is important to know that the enormous scale of the global migration to alternative reference rates (ARRs) poses considerable challenges, including legal, operational, and financial risks. This means financial institutions will need to define their transition plans from the perspective of minimizing these risk exposures. Firms should focus on the following high-priority requirements:
- Renegotiating legal fallback terms.
- Operationalizing critical terms in legal agreements.
- Implementing and testing front, middle and back-office systems capabilities.
- Measuring and managing financial risk exposures.
To put it in the most basic terms, contracts must be changed, financial impacts must be quantified, and software systems must be updated.
Let’s look at this in more detail.
Since alternative reference rates will be used in global jurisdictions to replace LIBOR, current contracts that reference LIBOR—and that have a maturity beyond December 31, 2021—will need to be amended to reflect appropriate fallback language.
LIBOR Transition for New and Existing Contracts: Legal and Operational Challenges
Since ARRs will be used in global jurisdictions to replace LIBOR, current contracts that reference LIBOR—and that have a maturity beyond LIBOR’s discontinuation date of December 31, 2021—will need to be amended to reflect the appropriate fallback language, including revaluations. This language refers to the contractual provisions that lay out the process through which a replacement rate can be identified once LIBOR is not available. This represents a difficult and time-consuming legal challenge.
For example, existing LIBOR-based contracts include fallback language that will need to be identified and evaluated to determine the legal, operational and financial risk impacts on a firm. While the LIBOR language will be addressed in many derivatives contracts by new ISDA protocols, NextGen Strategic Advisors has observed that several of the large derivatives dealers expect that bilateral negotiations will be required for an estimated 20% of their counterparties. Also, the language in cash products (e.g., loans, bonds, securitizations) will need to be bilaterally renegotiated, if possible, and in all cases, will need to be captured and fed into operations, trading and valuation systems.
Furthermore, institutions will need to determine the appropriate locations in contracts where the updated language should be inserted. This complication is magnified by the challenges required to ensure that the LIBOR contracts are machine-readable. To the extent that contracts are still “in boxes” or stored in poor quality PDFs, an institution’s ability to execute the required changes and bilaterally renegotiate the contracts will be impeded.
The scale and complexity of such an effort, combined with the regulatory deadline, means that a manual approach to identifying and changing contracts, in the best-case scenario, will require significant resources, time and expense to execute.
Automation and Artificial Intelligence Can Accelerate Your LIBOR Transition
Most financial firms will significantly benefit from an automated AI solution designed to perform the review, analysis, updating and extracting of critical information in LIBOR-based contracts. Such a solution will enhance the renegotiation capability and operationalize contract information. Existing LIBOR contract language can be transformed into updated ARR replacement or internally defined language electronically, and key contact information can be extracted to support operations and risk management requirements. Assessment of valuation and risk impact can be performed in advance of finalizing the renegotiated contracts.
Here’s an overview of the core challenges that could be met by the right solution:
- Legal: digitalization, review, and revision of existing LIBOR contract language into updated ARR replacement language to support bilateral renegotiations.
- Operational: extraction of critical contract terms to update operations, finance, trading and risk systems with new contract terms and rates.
- Risk: measurement and management of financial risk exposures to minimize the P&L and risk impacts of the LIBOR transition.
While a few of the largest financial institutions may already host the technology know-how and can make the investment in building out their own AI infrastructure, most firms will be constrained by a lack of domain expertise and technology knowledge to manage this transition in-house. These firms will likely need to consider partnering with a service provider who has the AI software, digital accelerators and software expertise to deliver the necessary support.
The benefits of such a partnership can create significant and immediate value for a firm. Many firms typically address the LIBOR challenge separately in their legal, operations and risk management silos. However, a highly capable service provider can support addressing the LIBOR transition requirements across business functions.
The scale and complexity of this effort, combined with the regulatory deadline, means that a manual approach to identifying and changing contracts will require significant resources, time and expense to execute.