The negotiation of bespoke fallback clauses as firms weave their way through the transition from Libor presents a huge task, despite work by regulators and industry bodies to ease the process, according to fintech vendors.
While most standard fallback clauses are defined by the International Swaps and Derivatives Association (Isda), and the Alternative Reference Rates Committee (ARRC) is attempting to define such clauses for cash products, a large volume of retail products rely on bespoke language. That means each agreement will need to be inspected and reconsidered.
“Most small or medium size firms who trade around a quarter of a million contracts would have maybe 100,000 retail contracts,” says Joy Mukherjee, associate director, Icertis. “Those fallback clauses are going to have to be negotiated.”
In some cases, one party to a transaction will be able to make unilateral decisions on certain clauses – which may complicate relations. However, in instances involving more than two parties, the situation becomes more onerous.
“In most cases in bilateral, trilateral or multiparty derivatives – without even going into the more exotic instances - this is going to be a tremendously difficult negotiation,” says Mukherjee.
From an operational perspective, vendors and market participants are growing increasingly wary of the need to manage existing credit agreements and understand the fallback language.
The ARRC – a group of market participants brought together by the US Federal Reserve Board and the New York Fed - has put forward two options for new agreements being entered into now using Libor with expectations that it will be disregarded in the future: an amendment approach sees an alternative rate being agreed between borrower and an administrative agent or a direct lender; and a hardwired approach in which a pre-determined “waterfall” of alternative rate options are applied. Each approach requires a substantial amount of work.
“Both approaches involve triggers, replacement reference rates and replacement benchmark spread adjustments,” says Christine Scaffidi, senior principal product manager, corporate and syndicated lending at Finastra. “It is key for FI operational teams to know which approach will be used for each existing credit agreement and have a plan for how to execute a transition.”
According to Scaffidi, market participants have been approaching vendors to look for help in the transition, with firms like Finastra advocating a test and evolve approach, rather than considering a “big bang” move to new rates. The firm is working closely with the ARRC, the Loan Syndications and Trading Association (LSTA) and the Bank of England’s sterling risk free reference rates working group to smooth the transition, but Scaffidi notes banks are still at varying degrees of readiness.
“Some are looking to be at the forefront, leading the way, while others are more comfortable taking a wait and see approach, expecting others to determine the path for them,” she says.
The list of tasks to prepare for the transition is arduous: from understanding the various alternative rates and how they may react to one another, to how base rates are calculated as well as how forward term rates shape, to calculating credit spread adjustments and being able to accommodate multiple currencies as Libor is phased out. But for many, the operational challenge of working in the fallback language is becoming critical.
For Mukherjee, finding what needs changed in a large volume of contracts and manipulating the changes are two separate processes that must be centrally managed, but market participants are still trying to find ways to execute what is a crucial part of the transition.
“There’s a rudimentary lack in terms of ‘what next’? Identifying all aspects of what is going to need changed is one part, but executing those changes is another,” he says.