Since LIBOR became a key benchmark in the 1980s, it has been the go-to interest rate which investors and banks have used in their agreements. But with the crucial benchmark set to expire at the end of 2021, banks and market participants must start preparing now to remove dependencies on LIBOR rates to avoid disruption when it ceases. Julie Barthes, Senior Director – Product and Technology at Finastra, writes
Although financial institutions have known about the impending change since 2015 and agreed on a transition timeline in 2017, they have only started receiving the required information needed to fully interpret the technical and regulatory requirements of the transition this year. Furthermore, alternative reference rates (ARR) have often been interpreted differently, with different countries and sectors moving at a different pace with regards to their transition plans. At the same time, the pandemic is adding to the uncertainty the industry is facing. All this means that financial institutions such as investment banks and investment managers need to be able to plan for different options and scenarios in case of further changes or delays.
For investment managers specifically the LIBOR transition presents several challenges. These include:
- Portfolio exposure:Investment managers often use LIBOR-based products in their portfolios, not just derivatives such as interest rate or inflation swaps, which are frequently used for hedging, but also many floating rate securities such as FRNs and ABS. These products will need to be based on alternative reference rates once LIBOR ends, and replacement of these products will drive significant changes in the valuation and risk profiles of investment portfolios.
- Changes to pricing and risk methodology:When the market switches to new reference rates, investment managers and institutional investors must update their systems to account for the new calculations. This results in changes in pricing methodology and risk management as LIBOR-based curves are often used for discounting and valuation. Market risk and capital requirement calculations also use LIBOR as the risk factor for VaR and stress test computations. These must also be switched to new reference rates by next year.
- Fee calculations:LIBOR is also used as a performance benchmark by many investment funds. Investment managers should adjust these benchmarks and fee structures to new rates and reach agreements with investors on their terms.
- Legal documentation and agreements: Fund documentation, master agreements, clearing agreements as well as confirmation messages must be updated, either with a standard protocol (ISDA), through regulatory recommendation or with bilateral discussions. New terms must be agreed by all the parties to minimize the impact on the bottom line.
- Technology: Current IT infrastructure must be updated to ensure that trading, position-keeping and product lifecycle management can respond to new ARR contracts. For example, the change of fixing time and a robust migration to new ARR, e.g. the new way of working.
Clearly, the move away from LIBOR will be complicated. Here’s four tips for smoothing the transition:
- Don’t delay
Good planning, networking with peers and keeping up to date with regulatory developments is critical. At recent forums and events, I’ve noticed a lack of urgency. In particular, the timescale for successful transition is often underestimated, and few see the bigger picture. A successful, cohesive transition can take several months and will affect a multitude of stakeholders.
- Adopt a joined-up, holistic approach
Many institutions underestimate the scale of the change and are approaching the transition on a piecemeal basis, department by department. But a successful transition requires collaboration across all functions, and this makes the scale of the challenge more apparent. For traders and portfolio managers the impact is mainly on the way investments are hedged and priced, and there’s a temptation for front office staff to think the transition simply involves a change to a benchmark. But for risk managers the impact is much greater. They need to be sure their pricing and risk calculations are correct and compliant with new regulations. Data management teams may think it’s just a question of saving and processing a new set of data, but unless consistent standards are in place from the sales teams through to back office accounting, and all systems are equipped to handle the new data, problems will arise. In short, it’s imperative that firms take a joined-up approach to the transition and that the IT team is also brought in early on in the process.
- Update your technology
LIBOR transition needs integrated, uniform, robust technology, enabling technical harmony across disparate financial solutions. Technology tools can help facilitate and automate the transition process and allow testing of different scenarios in advance to minimise the risk impact. Firms that also look at LIBOR transition as an opportunity to better automate processes – such as moving away from faxed contracts to digital contracts, will stand to benefit most.
- Get advice
Being able to call on an expert that can offer in-depth regulatory knowledge and guidance is essential. I’d recommend working with a technology vendor that can supply technical solutions and consultancy services, and services such as quantitative analysis on the impact of pricing changes. This will be particularly useful for smaller investment management firms that have limited IT and technical support bandwidth.
LIBOR’s discreditation in the aftermath of the 2008 banking crisis was always going to create some uncertainty. That’s why early preparation to adopt alternative reference rates is critical. Harmonised standards, clear and timely regulation and an integrated approach to technology will be vital in helping to ensure a smooth, simplified transition process. Above all, good planning, including putting contingencies in place for several potential scenarios is critical and should start immediately.