Financial Services Ireland

IBOR: how to remain ‘future-flexible’ under a changing frame of reference

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IBOR: how to remain ‘future-flexible’ under a changing frame of reference

The wealth and asset management industry will benefit from adopting a future-flexible strategy in response to the transition from interbank offered rates (IBORs) to new alternative reference rates (ARRs) for investment products.

We’re rapidly heading toward a new era where trillions of dollars of financial products will be benchmarked to a new form of reference rate. The phasing out of IBORs will have a huge impact on the entire wealth and asset management industry – from from wealth managers to private banks, asset managers and pension funds to asset service providers, universal banks and corporate investors.

Many asset managers apply hedging strategies using LIBOR-referencing interest rate derivatives. Many also invest in bonds or other securities in which interest payments reference an IBOR. The migration away from IBORs will affect how asset managers benchmark their mandates, manage assets in their portfolios, calculate fund net asset value (NAV), manage risks and communicate with clients. Thriving in this new environment will require Wealth & Asset Management firms to adopt strategies that remain flexible in their outlook ‘future-flexible’ so that they can make the most of new opportunities that the switch to ARRs will create for the sector, while also avoiding wasted effort on dead-end projects.

IBOR to ARR – turning compliance into opportunity. The migration away from IBORs will affect how asset managers benchmark their mandates, manage assets in their portfolios, calculate fund net asset value, manage risks and communicate with clients. Can you turn this into a reputational advantage? Enhance your product strategies? Or, use it as an opportunity to simplify your operating model? – Paul Traynor, Advisory Lead, Wealth & Asset Management

Three core opportunities

IBOR migration creates opportunities for the Wealth & Asset Management industry that can be classified into three core categories – starting with fiduciary responsibilities:

Future flexibility is essential

Given these opportunities, why is it important for Wealth & Asset Management firms to focus on a strategy that is future-flexible? Because there is still so much uncertainty not only around IBOR transition itself, but also about the future shape of the market and the response of various players within it.

What we know for certain is that things are going to change, in fact, they already have. ARRs are being developed, such as SOFR in the US, SARON in Switzerland, and SONIA in the UK or €STR in the EU. But unlike the response to the global financial crisis of 2008, there is a comparative lack of international regulatory coordination when it comes to pacing. There is no consensus on whether ARRs should be secured, unsecured or some form of hybrid (e.g., spread applied to a secured rate). Similarly, there is no cross-jurisdictional harmony on the timeframes for when the transition from the old to the new rates should be completed.

Given this environment, Wealth & Asset Management firms need to stay future-flexible so that they can accommodate different approaches in different markets. They need to build and maintain systems, processes and models that can adjust to a range of developments and uncertain timeframes. Firms need to avoid undertaking ‘throw-away work’ – efforts that become redundant or wasted in a fast-changing landscape. For example, staking everything on an ARR that fails to generate sufficient liquidity would be unwise.

Firms are, of course, affected by the response of vendor solutions providers such as market data providers and application providers. If data feed providers fail to prepare for IBOR transition in time – if they can’t provide swap curves or data in the right formats and at an affordable price – Wealth & Asset Management firms will feel the knock-on impact. Therefore, maintaining flexibility in order to adopt and plug in the best solutions is important, as is staying tuned to the promise of innovative solutions in the algo trading and artificial intelligence spaces too.

Encouraging disruption

It’s also worth highlighting that IBOR transition could encourage developments in disruptive technologies, cloud computing and artificial intelligence to help with valuations or enable more flow-driven or algorithmic trading. This could shake up the market in new ways, even beyond the basic IBOR transition impact. We have already seen some larger and mid-tier entities acquiring vendor packages. We estimate that upwards of 10%-15% of the larger asset managers and asset servicers are considering providing solutions in the IBOR space, as well as adjusting their own investment and hedging models.

Another good reason for maintaining flexibility is the buy-side’s dependency on the sell-side’s response. Banks are assessing the impact of IBOR transition on their own cash and derivative products and services, but they too face significant time pressures in terms of providing the liquidity the buy-side needs.

At the other end of the value chain, pension funds, corporates and other clients must also respond to the IBOR challenge – clarifying their own needs and preferences. This is another good reason why Wealth & Asset Management firms need to be proactive in holding conversations with clients.

They need to help clients understand the scale of the transition, and the importance of both agreeing new contract terms in good time and embracing new products.

Transition challenge

As should already be clear, the scale of work triggered by IBOR transition is significant. Some firms believe that most IBOR transition costs for the Wealth & Asset Management sector could arise from reprioritisations within the business – actions taken to avoid the major costs that would otherwise be incurred. Others hint at the significant costs of installing new fall-back provisions, modes of disclosure or securing client consents.

For example, in order to address the problem of legacy contracts referencing IBORs after 2021, firms will need to put substantial effort into repapering contracts. They will also need to invest in new systems to revalue instruments and manage risks, and take account of potential accounting and tax repercussions. Such actions combined could well result in program structures similar to those incurred by MiFID II compliance – or in some cases, possibly even exceeding them.

Overall, Wealth & Asset Management firms will need some ten different work streams to address all necessary issues. These would cover:

Addressing and coordinating all these business, operational and regulatory issues will inevitably prove a complex and time-consuming challenge.

Many firms have been slow to get started with IBOR transition activities. For example, only around 35% of the leading asset managers have identified the senior management and governance structures they need. The figure is likely to be far lower for wealth managers, pension funds and corporate entities.

The asset managers who are the most advanced by way of preparation at this juncture tend to be US headquartered or bank and insurance captives, and liability-driven investing (LDI) firms employing OTC derivatives, inflation swaps, cross-currency swaps and floating rate note (FRN) money markets – all of which are impacted by IBOR transition. Larger wealth managers, which could also feel the impact through structured products, packaged loans, complex products and securitisations, are also starting to perform their impact analysis. However, small and medium-sized firms and wealth managers have tended to focus on other competing priorities with closer deadlines.

Moving forward

Those firms that are yet to prioritise IBOR will need to do so over the next few months. IBOR transition has major repercussions for the Wealth & Asset Management sector – and organisations should act now to absorb those repercussions.

If they haven’t done so already, firms need to assess what impact the transition to ARRs is likely to have on their business and plan their response accordingly. They need to consider the impact on the broader ecosystem, communicating with banks, issuers, financial market infrastructures and enabling vendors.

Whatever response they settle on, it needs to be one that’s future-flexible – and that allows them to make the most of all the opportunities available to them. By doing so, firms should eventually find themselves counting the benefits, rather than the cost of the IBOR transition.

So, there’s much for firms to ponder – and act on – if they’re to ensure their transition to ARRs is a smooth one.

This article was initially published on EY.com based on the work of:

  • Dr Anthony Kirby Head of Regulatory Intelligence
    akirby1@uk.ey.com

Paul Traynor

Partner and Advisory Lead, Wealth & Asset Management
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