FINMA Guidance 08/2020: LIBOR replacement for derivatives

Philipp Rosenauer Partner Legal, PwC Switzerland 20 Oct 2020

The Swiss Financial Market Supervisory Authority FINMA recommends its supervised institutions affected by the replacement of LIBOR to sign the new Fallbacks Protocol published by the International Swaps and Derivatives Association (ISDA) as soon as possible.

It is expected that LIBOR will be discontinued by the end of 2021 and FINMA still considers the end of LIBOR as one of the principal operational risks facing its supervised institutions. The recommendations of FINMA Guidance 08/2020 are therefore addressed to those institutions that are affected by the discontinuation of LIBOR. 

A survey conducted by FINMA in June 2020 shows that the volume of contracts for over-the-counter (OTC) derivatives linked to LIBOR that extend beyond 2021 amounts to over CHF 11.5 trillion cumulated for all LIBOR currencies (CHF, EUR, GBP, JPY, USD). Thus, LIBOR-linked derivatives constitute the largest stock of legacy LIBOR-linked contracts to be replaced in Switzerland.  

These derivatives contracts must be migrated to other contracts based on alternative reference rates before or upon the discontinuation of LIBOR. If the OTC derivatives contracts are neither renegotiated with the counterparties nor adjusted, there is a serious risk of legal disputes with associated loss potential. Adjustments of the contracts should be made by including robust fallback clauses. In case of a discontinuation of LIBOR, such fallback clauses should set out clearly which alternative interest rates should be used and in what manner, and how exactly such a discontinuation will be identified. 

The ISDA IBOR fallback documents 

ISDA has announced the launch of its IBOR Fallbacks Protocol for existing LIBOR-based contracts (the "Protocol") and its IBOR Fallbacks Supplement for new LIBOR-based contracts (the "Supplement") on 23 October 2020. The Supplement and the amendments made by the Protocol will take effect on 25 January 2021. FINMA welcomes the launch of these adjustments to the ISDA Master Agreement.  

The Supplement will amend the 2006 ISDA Definitions to incorporate the new fallbacks. These changes will automatically apply to cleared and non-cleared derivatives referencing the 2006 ISDA Definitions that are executed on or after the date the Supplement comes into effect. The Protocol will enable market participants to choose to incorporate the revisions into their legacy non-cleared derivatives trades with counterparties that also opt to adhere to the Protocol (click here for more background information). 

According to ISDA, on 25 January 2021, "all new derivatives contracts that incorporate the 2006 ISDA Definitions and reference one of the covered IBORs will contain the new fallbacks. Derivatives contracts existing as of this date will incorporate the new fallbacks if both counterparties have adhered to the protocol or otherwise bilaterally agreed to include the new fallbacks in their contracts. The Protocol will remain open for adherence after this effective date."

Before the announced official launch of the fallback documents, it is already possible to agree to adhere to the adjustments (known as the “adherence in escrow” process). 

Supervised institutions should act as soon as possible

FINMA views the broad application of the new ISDA fallback documents as essential for a successful transition from LIBOR and therefore recommends its affected supervised institutions to sign the Protocol ideally before its launch (“adherence in escrow” process), and wherever possible before the date of its entry into force. 

Furthermore, FINMA stated that for any derivatives contracts that genuinely cannot be either migrated or amended (known as “tough legacy”), the affected supervised institutions should conduct a risk assessment for each contract or type of contract and should take specific measures to minimise the risks (specifically legal and valuation risks).

Next steps

According to FINMA, the next few months will be crucial for the necessary minimisation of the remaining risks in connection with the discontinuation of LIBOR. FINMA will therefore continue to closely monitor the development of the contract volume linked to LIBOR and will take institution-specific measures to mitigate the risks of inadequate preparation for the replacement of LIBOR where necessary. 

Contact us

Philipp Rosenauer

Philipp Rosenauer

Partner Legal, PwC Switzerland

Tel: +41 58 792 18 56