The much-discussed LIBOR end date of 31 December 2021, for all currency-tenor pairs except five USD tenors, is rapidly approaching. This year, the focus of IBOR transition programmes within asset management firms has moved from an exposure identification and contract collation phase to an execution phase, with the need to make real decisions across investments, product governance, risk management and front-to-back operations.
In this article EY’s Ken Phillips and Samuel Botha explore some issues that firms are noting as they plan for transition and offer a market perspective addressing them.
LIBOR rates, with the exception of five USD LIBOR tenors, will cease to exist post-2021. Financial products and other contracts that currently reference LIBOR will need to transition to reference different interest rates. Alternative reference rates (ARRs) have been established for most major currencies. For example, for Sterling the ARR is the reformed SONIA (Sterling Overnight Index Average), for US Dollar the ARR is a new rate called SOFR (Secured Overnight Financing Rate) and for Euro the ARR is €STR (Euro Short Term Rate). The new interest rate on financial products, post-transition, could be one of these ARRs or – depending on the type of contract- it could be a fixed rate or another variable rate. Repapering the entire book of LIBOR business, to remove the LIBOR dependency, is a significant operational, logistical and legal challenge for many firms, but it also brings about a myriad of risks that need to be addressed. In this article, we explore some of these transition risks for asset managers and offer a perspective on how they might be managed.
The foundation of all LIBOR transition programmes is a robust and repeatable process that can identify all LIBOR exposures as they evolve over time. This is a fundamental requirement of all programmes to ensure that all exposures are monitored and transitioned with appropriate oversight within the required timeframes and to inform reporting across financial accounting and regulatory disclosures by both asset managers and their clients such as insurers.
It is also worth noting that LIBOR exposures could be wider than financial instruments such as loans and derivatives. Some firms have noted exposures in lease contracts and rental agreements. In addition, in the asset management arena, LIBOR can be a critical feature in fee arrangements, acting as a benchmark.
Most asset managers had completed an initial IBOR transition impact assessment in 2020, however setting up a repeatable process to track exposures as they continuously evolve across asset classes, responsible investment teams, and client portfolios or funds has proved challenging and a highly manual and time-consuming process.
When a product is transitioning from a LIBOR rate to a replacement rate, there may be optionality as to what rate the product transitions to. Furthermore, timing the transition while systematically considering market liquidity across available options, transaction costs and the overall impact to client portfolios is key to avoiding client detriment due to transition. Identifying an economically equivalent replacement to forward-looking term IBORs using backward-looking ARRs (e.g. compounded in arrears conventions applied to overnight RFRs) is not straightforward, especially in relation to fund and portfolio benchmarks and requires appropriate analysis and approval by relevant fund boards.
New products may change the investment risk profile of a fund and may require enhancements to risk management systems across market risk, credit risk and liquidity risk. For example, a security that falls back from LIBOR to an ARR plus a credit adjustment spread (“CAS”) may not necessarily have similar pricing and liquidity characteristics as a similar ARR-based issuance by the same issuer that directly references ARRs.
Before transition, firms should ensure that they have reviewed their investment risk management processes in the context of transition-related risks and verified that systems can monitor risks appropriately.
Interest calculated using RFRs (overnight rates) is a considerably more complex calculation than using LIBOR rates. Interest rates are overnight rates and therefore change each day, meaning that interest needs to be compounded. This increase in complexity has required firms to invest significantly in their system infrastructure to ensure that new data can be sourced correctly, rounding errors avoided and that interest on new products is reflected correctly across the systems landscape.
For asset managers, this means ensuring that the front office order management systems and risk management systems can deal with the new ARR-based products. This was a priority last year to enable firms to be able to press the switch to transition when they choose to do so as liquidity shifts.
The increased complexity of most new products and the risk that current IT system estates cannot accommodate them are also relevant across the entire supply chain. Firms need to ensure that any outsourced providers of services also have systems capable of administering the new products.
The key challenges here include dealing with a variety of conventions for interest calculations and compounding across asset classes, understanding the impact of relevant trigger events (such as the ISDA protocol and ISDA fallbacks supplement as counterparties adhere or rescind adherence, the FCA announcement about LIBOR cessation on 5th March 20201, re-couponing exercises by LCH and EUREX transitioning IBOR legs of existing contracts to ARRs) and how data flows, hand-offs and exceptions are handled in a timely manner across the front-to-back systems landscape through to fund-accounting and custody services.
Amending the interest rates on financial assets and liabilities, including derivatives, can have valuation impacts, accounting consequences including derecognition, impacts on the continuity of hedge accounting relationships, tax impacts related to cash compensation and increased disclosure requirements in financial statements requiring detailed exposure data. Valuation differences can arise on transition due to changes to cash flows, changes to the discount rate or both. Furthermore, economic differences between IBORs and RFRs due to credit risk premiums baked into IBORs can lead to the use of a credit adjustment spread for the transition to be considered economically equivalent.
Firms should ensure that they assess valuation and accounting risks to funds and client portfolios early in the process and take actions to mitigate it. Funds holding assets referencing LIBOR are also exposed to valuation risks, which would increase closer to the cessation date as trading volumes and the demand for such products diminish. This is particularly acute in the case of certain types of contracts that are difficult to transition (“tough legacy”). Various legislative approaches have been proposed to define and deal with tough legacy, and this is an evolving area to watch closely. In cases where transition depends on third parties and the asset class is also illiquid (such as infrastructure deals), there may be a significant challenge to effect orderly transition in a timely manner.
The Central Bank of Ireland expects “the Board of each fund management company … to ensure that appropriate preparations for the impact of the benchmark reforms are in place for each fund it manages”.
Transitioning assets and liabilities to different interest rates across funds may give rise to a number of instances where there is an actual or apparent conflict of interest. Entities should have a robust process to identify and mitigate or manage conflicts arising from IBOR transition, while evidencing fair treatment of clients.
For asset managers, this relates to changes to contractual agreements such as Investment Management agreements for funds and with clients, that identify a benchmark for performance measurement and in some cases performance fees.
For example, a lower replacement rate could result in a lower benchmark for performance measurement, and potentially a lower hurdle for calculating any performance fees due to the investment manager. In dual-rate environments, this is challenging as the representativeness of the replacement rate needs to be considered alongside liquidity. Asset management firms must have robust processes in place to satisfy themselves and fund boards that there has been no material transfer of value in the transition process.
Furthermore, demonstrating that managers have fulfilled their fiduciary obligation to their clients may require a more detailed process for IBOR transition. For example, where there are transition options on existing positions within funds and client portfolios (for example, where there is a choice as to what interest rate to transition to), firms should have a clear and transparent process for selecting an option for all positions held. Decisions could consider a variety of factors from liquidity, pricing, transaction costs (e.g. break fees or dealing costs), valuation risks associated with legacy positions, and firm-wide transition strategies or principles for a consistent approach to transition (based on the firm’s board-approved transition plan and related controls e.g. pre-trade controls and defaults).
Client communications are also a critical mitigant of conduct risk. Communications with clients need to be clear, unbiased and timely for investors to review where any action may be required.
There is a clear regulatory expectation of robust governance within firms of their transition, headed by an appropriate senior executive. For example, for FCA-regulated firms, there is an expectation that a Board-approved transition plan governs firm-wide activities with clear Senior Manager (SMF) accountability and oversight. The Central Bank of Ireland expects “the Board of each fund management company … to ensure that appropriate preparations for the impact of the benchmark reforms are in place for each fund it manages”. Firms should ensure that the transition programme structure, governance and leadership meet applicable regulatory expectations across the jurisdictions that they operate in.
While the transition away from LIBOR and other IBORs is an industry event, there is a strong regulatory impetus for orderly cessation with appropriate governance for fair treatment of clients through the transition. Regulators expect that by now firms would have a final view of their LIBOR exposures and a detailed plan to execute transition of products, holdings and contracts across currencies and asset classes with robust governance to mitigate conduct risk and conflicts of interest. To the extent that some firms are not at this point yet, this should be immediately and urgently addressed.
Firms should also reassess the extent to which their board-approved transition plans periodically address the issues discussed here, and enhance their plans as market conditions evolve.
Don’t hesitate to reach out if you have a question.