What has happened?

The London Interbank Offer Rate (LIBOR) is the interest rate that participating banks offer to other banks for loans on the London market. It is the most widely used benchmark for short term interest rates globally. [1]

LIBOR is scheduled to be phased out by 2022. A suggested replacement rate is the Sterling Overnight Interbank Average Rate (SONIA) which measures the rate paid by banks on overnight funds. SONIA is calculated as a trimmed mean [2] of rates paid on overnight unsecured wholesale funds.

What does this mean?

LIBOR may be used as a reference rate applicable to payment obligations in some commercial contracts such as late payment clauses in commercial contracts. These contracts typically include “fall-back provisions” which are specific contractual terms to fall back on when LIBOR is unavailable. Also known as “Fallback language”, this refers to the contractual provisions that lay out the process through which a replacement rate can be identified. When LIBOR is no longer in use, robust fallback language will be required in financial contracts to enable a smooth LIBOR transition.

Furthermore, with a few alternative reference rates like SONIA being suggested to replace LIBOR, provisions need to be prepared to allow for greater flexibility for parties to agree on their own reference rate. [3]

What should be done?

Banks will need to compare the values, trends, co-integration, and distribution features between LIBOR and alternative reference rates to identify the most viable replacement for LIBOR. [4]

Firms will need to consider other key contractual features that may impact the LIBOR transition. This includes maturity date, the firm’s role in the contract, benchmark use, amendment and consent provision, governing law and jurisdiction, and force majeure provisions.

Banks and financial institutions should identify all contracts that use LIBOR as a reference rate and modify express “fallback language”. To do this, they could use AI-based model libraries, optical character recognition, and computer vision techniques to extract contextual information from digital documents. Natural language processing (NLP) technologies can be used to screen contracts and pinpoint language variations, identify contracts that have been impacted, and predict exposure in dollar value. [5]

In the UK, SONIA has been selected as the alternative benchmark that will replace Libor. However, transitioning to SONIA will present its own challenges.

Furthermore, they should leverage on robotic process automation (RPA) solutions to embed robust fallback provisions and mechanisms. This will enhance contractual robustness and reduce manual interventions. The banks could use automated modelling techniques built via machine learning (ML) algorithms and deep neural networks to adjust the Risk-Free Rates for pricing the instruments. [6]

However, banks should keep up to date with the positions of regulatory bodies on the use of AI-led decisions, latest developments, and industry practices. [7] This is so that they will be able to properly justify AI decisions without incurring penalties from misuse of AI in financial decision-making. [8]

Law firms should consider the example of Norton Rose Fulbright which has introduced a multidisciplinary LIBOR team that comprises lawyers from various practice areas to deliver services on a transition away from LIBOR. [9] Being able to pre-empt and prepare clients for a smooth LIBOR transition will significantly differentiate a firm from the others. Therefore, firms should focus on using the right technology for the right task throughout the sorting, due diligence, and amendment phases of a project. This will speed up and de-risk large-scale contract reviews and amendments. Having a close understanding of in-house teams’ project delivery challenges and priorities means they can offer different solutions to suit different needs.

Written by Nickolaus Ng

Assessing Firms:

#MorganStanley #JPMorganChase #UBS #RBS #DeutscheBank #Ashurst #NortonRoseFullbright #Allen&Overy

Footnotes:

[1] Collins Dictionary of Business, (3rd ed.. 2005)

[2] A trimmed mean removes a small designated percentage of the largest and smallest values before calculating the average.

[3] A reference rate is an interest rate benchmark used to set other interest rates.

[4] Sanjukta Dhar, ‘The End of the Road for LIBOR: Handling the Impact on the Financial World’ (2019) TATA Consultancy Services White Paper

[5] ibid

[6] ibid. Note that risk-free rates refers to the interest an investor would expect from an absolutely risk-free investment over a specified period of time.

[7] Ashurst, ‘The End of LIBOR - Regulatory Challenges’ (Ashurst Legal Updates, 2020) <https://www.ashurst.com/en/news-and-insights/legal-updates/the-end-of-libor-regulatory-challenges/>

[8] ibid

[9] Norton Rose Fullbright, ‘Norton Rose Fulbright wins three IBOR transition mandates in three weeks’ (Norton Rose Fullbright Press Releases, May 2020) <https://www.nortonrosefulbright.com/en/news/53c363f0/norton-rose-fulbright-wins-three-ibor-transition-mandates-in-three-weeks>

Disclaimer: This article (and any information accessed through links in this article) is provided for information purposes only and does not constitute legal advice.