Survey Highlights Need for Users to Rewrite Libor-Based Contracts

A survey conducted by JCRA, an independent financial risk management consultancy, and law firm Travers Smith, has found that a large majority of firms with exposure to Libor are yet to start making preparations for its discontinuation. 

The benchmark is set to be withdrawn in 2021, but the firms say that most of those surveyed have not started negotiating replacement language in their contracts that reference the outgoing benchmark.

The survey focused on derivatives users and covered over 100 firms, including investment funds, asset managers, property developers, social housing associations, infrastructure developers, corporates and banks. It found that 83 per cent of firms are yet to start making changes to their contracts, with 15 per cent in the early stages of this process and only two per cent having completed the project.

“The numbers tell their own story,” suggests Joshua Roberts, JCRA’s lead adviser on benchmark reform. “There is going to be a huge amount of renegotiation of contracts in the next few years, and we are concerned that many firms may leave this to the last minute. This will create a significant issue of capacity as there is only a finite number of legal advisers with the expertise necessary to renegotiate these contracts.”

Jonathan Gilmour, head of the derivatives & structured products group at Travers Smith, adds, “Market participants will want to ensure that they have robust mechanics in their documentation to deal with Libor discontinuation. They will need to work with their legal and commercial advisers to understand the options that are available to them when amending their contractual arrangements. ISDA and the LMA have proposed wording to deal with benchmark fallbacks in the derivatives and loan markets respectively.

“When negotiating amendments with their counterparties, one of the key points to be considered, particularly by buy-side institutions, is whether they are comfortable with the risk of being bound by fallbacks and pricing adjustments determined by the calculation agent – who will typically be their sell-side counterparty – or by a regulatory authority,” he adds.

The survey also found that nine per cent of firms were not aware whether their contracts would be affected by the discontinuation of Libor. “We would advise firms that do not know whether they have contracts referencing Libor to conduct a comprehensive review to identify their exposure to benchmark reform,” says Roberts. “Even among sophisticated firms, there seems to be a degree of uncertainty over exactly where these exposures lie.”

The poll also found that 75 per cent of firms polled have contracts that both reference Libor and have a life span beyond 2021. Across the whole market, the volume-weighted proportion of interest rate derivatives referencing Libor that go beyond that date is estimated at around 40 per cent. “Many in this group will be referring to loans, rather than interest-rate derivatives,” says Roberts. “While we would expect a large proportion of these to be refinanced naturally before Libor is discontinued, this does not solve the wider problem: what alternative rate will they use when they are refinanced? Will it still be Libor or will we have a market for Sonia-linked lending?”

Gilmour adds, “Firms will also want to consider amending their contractual arrangements to deal with a potential mismatch between the loan and derivatives markets’ approach to Libor’s replacement benchmark. As part of this process, they might want to discuss the implications of a switch to one of the more likely new benchmark rates with their legal and commercial hedging advisers, by working with them to run the numbers, consider the potential impact on individual trading relationships and comparing notes on how the market is evolving.”

The replacement of Libor continues to vex minds in the financial markets industry thanks mainly to concerns that certain Ibors will suffer from a lack of liquidity in the underlying markets. ISDA recently published a white paper outlining the preferred fallback mechanisms according to a survey of market participants and will incorporate the findings into its Standard Definitions of Derivatives documentation.

After that is settled, the industry may then start to look harder at the required renegotiations of a “significant number” of contracts according to Roberts, who adds, “Crucially, firms should do this in a way that avoids or at least minimises, value transfer. Firms should look to benchmark the economic aspects of the renegotiation to minimise risk and ensure they fully understand any value transfer that is occurring.”

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Colin Lambert

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