Investment management market prepares for LIBOR wind-down
Regulators warn about potential risk exposures and ask the market to implement alternative reference rates now
Regulatory changes in benchmark interest rates can have a significant impact on investment managers. The discontinuation of the London Interbank Offered Rate (LIBOR), slated for the end of 2021, is no different. LIBOR plays an important role in financial markets, acting as a reference rate for cash products and derivative contracts held by a wide array of market participants.
It also is extensively embedded throughout a range of contracts, processes, systems and models across industries and market segments. Regulators around the globe are actively seeking to prevent market disruptions expected from the withdrawal of LIBOR.
Major global banks rely on LIBOR, which mandates the rates they lend to one another in the international interbank market for short-term loans. Subject to oversight by the UK Financial Conduct Authority (FCA), LIBOR represents the average interest rate for unsecured financing for a given future period in a specific currency. LIBOR is determined based on data reported by panel banks to Intercontinental Exchange (ICE) Benchmark Administration (IBA), the LIBOR administrator. LIBOR is published by the IBA each business day for seven maturities (i.e., for overnight or up to 12-month borrowings) in five currencies, such that there are 35 LIBOR rates published each business day.
The replacement of LIBOR
More than 40 years in operation, LIBOR’s impact has dominated the market, and its end will be far-reaching. LIBOR is currently used to price about US$370 trillion of financial contracts daily. It also serves as a critical benchmark rate of performance measurement for investment securities and as a proxy rate for wholesale funding.
Regulators are encouraging market participants to urgently implement alternative reference rates and are highlighting potential risk exposures to firms, their shareholders and customers. They also stress the time-sensitive nature of the changeover. They point out that while many issues related to alternative reference rates have yet to be decided, firms should not delay until all open questions have been answered, as it likely could prove to be too late to complete the very complex and challenging transition requirements.
LIBOR impacts on investment management
LIBOR is used extensively by investment managers for several key reasons:
- They hold LIBOR-based products in their portfolios. Most use LIBOR-based derivatives for hedging. They also hold LIBOR-linked securitizations, loans and floating rate notes (FRNs).
- They use LIBOR as a performance benchmark for their funds.
- They use LIBOR for valuation models, pricing and risk models. They also use it in calculations, systems models, administration and operational processes.
The discontinuation of LIBOR may affect the liquidity, value and functioning of certain investments, including bank loans, floating rate debt, LIBOR-linked derivatives and certain asset-backed securities. The degree of impact is influenced by both the types and terms of the investments. For instance, interest rates may have to be renegotiated, or an investment might become less liquid, or its value may change if the contract lacks fallback language or is insufficient to address the discontinuation of LIBOR.
Investment managers face several key LIBOR transition risks. Leading considerations include:
- Liquidity of investments
- Ensuring customer value is not lost
- Ensuring benchmarks are transitioned without giving the appearance of inflated performance
- Liquidity-risk classification of investments
- Investor disclosure requirements
- Impact on investment recommendations
- Economic risk of poor handling when transitioning customer portfolio to LIBOR
- Education of front-office staff, including investment advisors and relationship managers, on the impact of LIBOR transition
- Impact on prospectuses
- Conduct and legal risk with customers and counterparties
- Impact on investment environment
Key areas that investment managers should address in transition include these:
In the past, the industry coped with regulatory-driven change by throwing people at the problem.
- Managing and amending existing contracts that extend beyond the end of 2021
- Designing new contracts
- Remediating policies, procedures, systems, processes and training to support an effective and timely transition
- Providing adequate communication and disclosures to customers, investors and shareholders on the potential risks
DXC Technology has been building and piloting methodologies, tools and models to assist firms addressing their LIBOR transition requirements. Our overriding observation is that the impacts are significantly more extensive and complex than expected by many customers. Implementing potentially large-scale product, transaction, technology and process remediation also presents considerable execution risk. Other complications include repapering legacy contracts, managing trigger events and third-party dependencies. Economic, finance, legal and regulatory considerations further compound transition risk.
Issues for existing contracts
It is expected that firms will have identified existing LIBOR contracts that extend beyond 2021. Legacy contracts will need to be analyzed and assessed to determine potential issues and strategies to resolve them. Most of these contracts are unlikely to have provided for the permanent discontinuation of LIBOR; this will give rise to potential disputes, misaligned expectations or ambiguity over the interpretation of these contracts. There may be situations, for example, where a floating-rate obligation may become a fixed-rate obligation. The potential business, regulatory, financial, legal and reputational costs could be considerable.
We recommend the use of technology to provide an overall enterprise-wide status of the overall transformation program, which will be complex, as it is made up of many focused workstreams across horizontal functions such as legal or risk management and in portfolio management or customer-aligned business units.
In the past, the industry coped with regulatory-driven change by throwing people at the problem. There is an opportunity to leverage technology advancements to benefit from augmented intelligence, machine learning and process automation to accelerate high-volume administrative tasks in contract repapering and code analytics, and to accelerate platform changes and commensurate testing. Risk-model scenario testing may benefit from burst-compute capacity available in the cloud, be that public or private, depending on data requirements.
Key areas for consideration include:
- Materiality of contracts individually or collectively
- Disclosure requirements
- Adequacy of risk management policies
- Future operability of contract
- Need to renegotiate contract due to inadequate or lack of fallback language
- Level of income or profit at risk due to disputes, contract renegotiation or fundamental valuation differences between LIBOR and the new alternative reference rate
- Risks associated with the use of an alternative reference rate where LIBOR, for example, is currently used in pricing assets as a hedge against increases in the costs of capital or funding
- Impact on hedging strategy — for example, derivative contracts referencing LIBOR that are used to hedge floating-rate investments or obligations
Issues for new contracts
Firms will have to determine whether new contracts should reference the alternative reference rates rather than reference LIBOR. If these new contracts reference LIBOR, they will need to incorporate fallback language that addresses its discontinuation to avoid the issues associated with legacy contracts as mentioned previously.
Standard fallback language is being developed by various organizations, including the Alternative Reference Rates Committee (ARRC) and the International Swaps and Derivatives Association (ISDA), which will provide firms with useful guidance.
Steps for remediation
Managing the operational execution risks associated with LIBOR transition is one of the most significant issues for investment managers. Firms will need to undertake a comprehensive impact assessment of the discontinuation of LIBOR on systems, processes, models and calculations.
Firms with significant LIBOR footprints will likely have to implement changes to a wide range of proprietary and third-party platforms. Robust historical data sets for alternative reference rates will have to be sourced and integrated into valuation, trading and risk-management systems. Middleware and reference data management will be affected. Investment managers may have to ensure that their IT systems are able to incorporate new instruments and rates with features that differ from LIBOR.
Lead times for changes and testing to legacy platforms that were not architected to support different reference rates could extend out 12 months or more, depending on other priority projects. Understanding change dependencies and the timing of each change will be critical to achieving a cost-effective transition. Thousands of data points need to be considered in the LIBOR transition.
Communications and disclosure requirements
Regulators require disclosure of timely, comprehensive and accurate information about risks and events that a reasonable investor would consider important to an investment decision. The discontinuation of LIBOR is likely to require disclosure of risk factors, management’s discussion and analysis, board risk oversight and any impacts on financial performance. Investor communications will be critical, and their scope will have to include anticipated impacts, progress on risk identification and mitigation.
Customer outreach and education on the upcoming transition cannot start early enough. The regulators have already pointed out that customers cannot be disadvantaged because of this program and that the uncertainty of future industry dynamics will not be an excuse for any mis-selling or ill-advised situations.
LIBOR will officially expire at the end of 2021, but market participants should already be planning to phase it out. Regulators recommend paying close attention to decisions being made regarding LIBOR because the replacement chosen will have an impact on existing and new contracts, processes, systems and models across industries and market segments. The time is now to start considering alternative reference rates to head off market disruptions and any potential risk exposure.
About the authors
Jon Gudelis is a digital solutions director in DXC Technology’s Banking and Capital Markets business in London. He has over 25 years of experience in bank technology and operations managing transformational change. He has championed fraud mitigation in payments, information life-cycle management for General Data Protection Regulation (GDPR) compliance and now, remediation services for LIBOR transition.
Ray Nulty is chief executive officer at Stratagem Partners, a specialist international financial services advisory firm focusing on strategy, risk and public policy. He previously held global responsibility for the financial services practices at a number of major consulting firms. Ray has chaired reviews of key industry developments and policy proposals on behalf of governments, regulators and industry associations.