Acronyms can mean different things, so we better start with the meaning of LIBOR.
LIBOR stands for London Interbank Offered Rate and is a benchmark interest rate of lending operations in the international market of major global banks. This key benchmark indicates borrowing costs between banks and is accepted worldwide.
LIBOR is calculated daily by the Intercontinental Exchange (ICE) for five currencies: the US Dollar (USD), the Euro (EUR), the British Pound (GBP), the Japanese Yen (JPY), and the Swiss Franc (CHF). That was the easy part. It is also calculated for seven tenors:
- Overnight/Spot Next
- One Week
- One Month
- Two Months
- Three Months
- Six Months
- 12 Months
So every business day (according to London), 35 individual rates are calculated for each currency and tenor combination.
But the most important thing you need to know about LIBOR is that it will be discontinued soon.
As you might imagine, LIBOR is mentioned in millions of contracts, so it’s not an overstatement to say that every financial institution in the global financial system uses it. And now that the system is going to be ceased, LIBOR replacement will impact everyone.
LIBOR has been around for decades, however, 2008 was the year that set off its decay. The rate worsened the financial crisis of the year, and some scandals around the manipulations by the rate-setting banks followed.
One thing led to another, and eventually, LIBOR is planned to be ceased by the end of 2021.
When will LIBOR be discontinued?
Let’s take a look at the LIBOR transition timeline. The UK Financial Conduct Authority (FCA) made an announcement on March 5, 2021, that stated the following:
- All CHF and EUR LIBOR settings, the 1 Week and 2 Months USD LIBOR settings, and the Overnight/Spot Next, 1 Week, 2 Months and 12 Months GBP and JPY LIBOR settings will cease immediately after December 31, 2021.
- The Overnight and 12-Months US dollar LIBOR settings will cease immediately after June 30, 2023.
As you can see, the LIBOR transition dates are quite close. But with LIBOR out of the picture, there’s a question we all need an answer to.
What’s going to be used instead of LIBOR?
Alternative Reference Rates (ARRs) will replace LIBOR starting January 1, 2021. Here’s the list of the LIBOR alternative reference rates available at the moment:
- Secured Overnight Financing Rate (SOFR), issued by the Fed Reserve Bank of New York (in USD)
- Reformed Sterling Overnight Index Average (SONIA), published by the Bank of England (in GDP)
- Euro Short-Term Rate (ESTR), published by European Central Bank (in EUR)
- Swiss Average Rate Overnight (SARON), published by SIX Swiss Exchange (in CHF)
- Tokyo Overnight Average Rate (TONAR), published by the Bank of Japan (in JPY)
We do have to mention that SOFR will not replace LIBOR completely till 2023. A special committee helps to ensure a smooth transition from the USD LIBOR to a robust alternative reference rate. This committee is called The Alternative Reference Rates Committee (ARRC), and it consists of private-market participants convened by the Federal Reserve Board and the Federal Reserve Bank of New York.
Does LIBOR differ from Alternative Reference Rates?
Definitely. Let’s take SOFR, for example. LIBOR is a future-oriented rate, whereas SOFR is not. LIBOR represents the capital cost of the bank, while SOFR merely measures the rates that are suitable for secured financing in short-term operations.
What can be done with contracts?
We’ve already established that millions of contracts all over the world will be impacted by the LIBOR discontinuation. And each of them will need to be amended to reflect the new rates.
With the overwhelming amount of amendments looming, the question arises: how to phase out LIBOR smoothly?
The best piece of advice we can give you is to stop referencing LIBOR in your new contracts. It’s also a good idea to add fallback language to the existing contracts and start referencing an alternative reference rate.
What is fallback language?
Simply put, fallback language is a guide that helps to identify the replacement rate, also called benchmark replacement. Fallback language consists of three components, namely:
- Fallback trigger event
- Benchmark replacement
- Benchmark replacement adjustment
When you draft a new contract that references a rate different from LIBOR, it should still include strong fallback language. You need to take this precaution because ARRs are not flawless and could someday face the same issues LIBOR has today. So, draft every contract with flexibility in mind.
You can use some of the following options to update your contracts:
- Rewrite the contracts altogether
- Make amendments to the existing contracts
- Count on present fallback language
- Count on hardwiring regulations
Your organization will be exposed to certain risks if you have contracts referencing LIBOR after it’s discontinued. So start the transition from LIBOR in your organization as soon as possible.
How to transition from LIBOR?
The process will take some planning, time, and effort, so be prepared: it’s a marathon, not a sprint. Here’s our example strategy of gradually transitioning from LIBOR:
- Create a team responsible for the transition. The precise size and composition will depend on your organization’s size and type, but we’ll give you some pointers. First, make a senior manager responsible for the project. Second, include the legal project and compliance team members into the team together with technology team members and other stakeholders. And don’t forget to assign precise transition tasks.
- Prepare a straightforward transition strategy.
- Draft a transition document that will define the transition steps and help you minimize risks or mistakes along the way.
- Collect all the contracts you need to amend in one place.
- Estimate your document management resources.
But we’re not finished with the tips’?here’s the most important yet.
How technology makes the transition from LIBOR easier
The right technology solution can help your organization switch from LIBOR more effectively than you’d do it manually. For instance, software can quickly check thousands of contracts and extract the LIBOR-related entities for your legal team. And instead of spending time tracking down mentions of LIBOR, they will focus on the remediation tasks.
A robust document workflow automation system powered by Contract Lifecycle Management (CLM), such as AXDRAFT, will also help make the transition from LIBOR easier. So if you were on the fence about investing in a document automation software, now would be a perfect time.
Here are some more tools to help you switch from LIBOR swimmingly.
With automated workflows, you can group and check contracts based on their type, expiration date, risks, value, or other criteria you need. A tool like this will help you send these contracts to the stakeholders for review automatically.
Automated data export
An automated data export tool will help you gather the metadata you need on reference rate type, important contract dates, type of fallback language, document term length, and more. The data is automatically taken out of contracts.
Automated document assembly
Such a tool can let you use pre-established fallback language by automatically drafting it into contracts.
With automated document creation software, you will be able to reference alternative ACCRs and triggers with fallback language. It can also help you draft contract amendments automatically based on legacy information. And if that’s not enough, you can import data from documents or spreadsheets into new contracts and generate documents in batches.
Optical Character Recognition (OCR) tools can read texts and categorize risks according to fallback clauses. What’s more, top automated document management and assembly providers often partner with OCR experts to provide their clients with the best contract lifecycle management solution for managing a successful LIBOR transition.
Contract management tools for audit and compliance
A truly productive contract analysis process will involve machine learning (ML). A contract management software using it can help you classify document risks effectively based on the extracted data. And when you automatically draft new documents, this tool will categorize them based on the type and content.
At the end of 2021, banks will no longer be able to reference LIBOR, so it’s best to start the transition from this benchmark as soon as possible.
Switching from LIBOR smoothly and quickly will help your organization minimize business risks, avoid operational issues, financial and tax implications, as well as contract remediation challenges, and more. So don’t hesitate to use technologies to help you with this process. After all, software is faster and more attentive than any person on your team.