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Industry Dialogue

The LIBOR Transition

The financial industry is no stranger to change. Over the years, regulatory and market reforms have prompted technology-enabled solutions and new ways of working. However, the upcoming end of the London Interbank Offered Rate (LIBOR) introduces an entirely new kind of change, presenting a unique set of challenges for market participants.

Since its inception in 1986, LIBOR has become thoroughly embedded in our capital markets, in valuations and analytical models across sectors and regions. The beginning of the end for LIBOR came in 2012, when a scandal demonstrated acute vulnerabilities in the rate-setting process. This first launched an effort to reform LIBOR and subsequently a global search for suitable alternative rates, which accelerated in 2017 with the United Kingdom Financial Conduct Authority (FCA) announcement that it would no longer compel panel banks to submit LIBOR quotes after 2021.

The financial industry is well accustomed to navigating regulator- led reforms, with hard effective dates and clear requirements that make it easier for market participants to plan. This LIBOR transition is markedly different. There is uncertainty around exactly how and when the rate will disappear and, more importantly, when liquidity in the market will shift. While regulators and industry associations are being proactive and offering guidance, ultimately it is up to market participants to arrive at a solution. In the United States, the Alternative Reference Rates Committee (ARRC) selected the Secured Overnight Financing Rate (SOFR) as the preferred alternative, but much work remains for an orderly transition.

To further advance this dialogue, we convened industry experts to discuss this major change. We sincerely thank our panelists for their perspectives and hope you find these insights helpful.

Brenda Lyons Executive Vice President,

Head of Product, State Street Global Services

FOREWORD

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Ann BattleAssistant General Counsel,

International Swaps and Derivatives Association

Samantha BrutlagAttorney-Adviser,

Division of Investment Management, Securities and Exchange Commission

Ornella CombaluzierManaging Director and Co-Head of Investment Risk Management,

State Street Global Advisors

REGULATORY AND INDUSTRY PERSPECTIVES

Our Panel

Joe BarryHead of Regulatory,

Industry, and Government Affairs, State Street

Moderator

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Industry Readiness

Joe Barry: Let’s start with an overall assessment of the asset management industry’s readiness for the LIBOR transition. Sam, what’s your perspective?

Sam Brutlag: We encourage market participants to start their preparations as soon as possible. SOFR is a live rate — it’s being published, it’s being used. There is work underway to create standard term versions of SOFR and to develop a credit spread to apply to products being converted from LIBOR to SOFR. Market participants need to be identifying, mitigating and disclosing any LIBOR-related issues.1

Joe Barry: Ann, you’ve worked a lot on the dealer side through ISDA. Could you give us that perspective?

Ann Battle: At ISDA, our members span from dealers to buy side, to even some end users and infrastructure providers. The industry as a whole is more prepared now than it was a year prior, so that shows the right momentum. It’s no secret that some of the bigger market participants are more prepared than smaller market participants. We see some smaller market participants grappling with

how they will apply a type of rate not traditionally used in non-derivatives and wanting solutions for those products before thinking about derivatives that hedge the products. It can have a bit of a paralyzing effect, because it’s hard to dedicate resources to a large transition plan. It’s even harder when you don’t have answers to all of your questions. The reality though is that some of these questions may never be answered. Firms need to work with the information they have now and with the 2021 deadline in mind.

Joe Barry: When you say, “may never be answered,” you mean by regulators?

Ann Battle: Yes, that’s right. I think the derivatives industry in particular is very accustomed to dealing with laws or regulations and determining how to implement them. But this LIBOR transition is different. It’s being driven by something that is going to happen in the market. Regulators are encouraging and pushing market participants to prepare for that event, as opposed to what we’ve seen with MiFID or Dodd-Frank where there are more answers to the questions as opposed

1 The Securities and Exchange Commission disclaims responsibility for any private publication or statement by any of its employees. Today’s comments express my views and do not necessarily reflect those of the Commission, Commissioners or other members of the staff.

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to the market needing to navigate it. In some ways, it’s being part of the solution. That’s really what needs to happen in the coming years.

Joe Barry: Ornella, what is your observation on readiness?

Ornella Combaluzier: I agree with Ann that it’s all about balancing the unknown with what we do know at this time. Term rates are an example of how we must plan for uncertainties. The cash business will need to figure out how it’s going to function without those available. In terms of derivatives or bonds, we’re seeing some progress with issuers offering more SOFR-based bonds, in the United States specifically. But in terms of loans, that progress is very much lagging and we’re waiting to see what’s going to happen.

There is uncertainty around term rates for SOFR, as LIBOR had a credit component that you won’t have with SOFR, so it’s introducing another level of complexity. Within SSGA, even amidst all the uncertainties, we’re still planning for the transition through our governance structure, steering committees and working groups. We have very clear objectives and ownership for the

next steps. But again, you have to be prepared with back-up scenario planning to be able to address uncertainties.

Joe Barry: In the non-derivatives space, if I’ve seen any criticism of the ARRC process, it’s where industry participants hadn’t felt fully engaged, even though the ARRC eventually broadened their approach to include more small and mid-sized institutions. Is that a valid assessment?

Ann Battle: For background, I think it’s important to understand how it unfolded. When the ARRC was formed, the original plan contemplated that LIBOR would stay around, at least in the near term. In 2014, the Financial Stability Board found a large portion of derivatives that reference LIBOR and other IBORs actually don’t need to reference a term rate that accounts for bank credit spread.2 So the ARRC’s initial objective was to identify an alternative and develop for those derivatives a plan to promote liquidity in the alternative, but to keep certain derivatives that hedge financial instruments referenced to LIBOR. The people involved in selecting the rate were those who ultimately expected to use that alternative.

“Firms need to work with the information they have now and with the 2021 deadline in mind.”

Ann Battle, Assistant General Counsel, ISDA

2 Financial Stability Board, Final Report of the Market Participants Group on Reforming Interest Rate Benchmarks, July 22, 2014. https://www.fsb.org/2014/07/r_140722b/

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We at ISDA started working on fallbacks for LIBOR and other IBOR contracts in 2016, but had very little success bringing buy-side participants to the table. At the time, they had other priorities and again, no one expected that LIBOR would go away. That was all turned on its head in 2017 with Andrew Bailey’s speech. Immediately, the future of LIBOR became uncertain and everyone with financial instruments that were referenced to LIBOR needed to wake up to this issue. At ISDA, we saw after that 2017 announcement, the people who weren’t ready to engage with us in 2016 started calling. In implementing the fallbacks, we’re taking input from all market participants, including non- members. The ARRC has also done a lot of good work to bring everyone to the table as quickly as possible.

Joe Barry: It’s certainly an interesting history of the regulatory approach over the years. This transition was born out of a scandal that was a crisis at the time. There was no guarantee back then that LIBOR wouldn’t just disappear overnight. And then, what would we have done? It was very thoughtful work by the regulators and the industry to fix LIBOR, at least temporarily, and then over time carefully phase it out.

Identify, Manage, Disclose

Joe Barry: The SEC guidance in July signaled the importance of this issue. It’s very broad and sets pretty high expectations for the industry. Sam, could you explain a bit about it?

Sam Brutlag: It’s true the guidance is extensive, and we encourage you all to read it, because it’s hard to summarize and there’s a lot of information. Our main point was that market participants have to start thinking about this now and must allow enough time to prepare for a smooth transition. Our statement also offered questions that people should be thinking about and asking.

We’re encouraging fulsome disclosures that address investment funds’ actual holdings and impact from the LIBOR transition. We appreciate that drafting tailored disclosure is difficult, given that it’s a changing and developing process. We expect market participants to have procedures in place to update the disclosures as more information becomes available or as market changes happen.

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1. Do you have or are you or your customers exposed to any contracts extending past 2021 that reference LIBOR? For companies considering disclosure obligations and risk management policies, are these contracts, individually or in the aggregate, material?

2. For each contract identified, what effect will the discontinuation of LIBOR have on the operation of the contract?

3. For contracts with no fallback language in the event LIBOR is unavailable, or with fallback language that does not contemplate the expected permanent discontinuation of LIBOR, do you need to take actions to mitigate risk, such as proactive renegotiations with counterparties to address the contractual uncertainty?

4. What alternative reference rate (for example, SOFR) might replace LIBOR in existing contracts? Are there fundamental differences between LIBOR and the alternative

reference rate — such as the extent of or absence of counterparty credit risk — that could impact the profitability or costs associated with the identified contracts? Does the alternative reference rate need to be adjusted (by the addition of a spread, for example) to maintain the anticipated economic terms of existing contracts?

5. For derivative contracts referencing LIBOR that are utilized to hedge floating-rate investments or obligations, what effect will the discontinuation of LIBOR have on the effectiveness of the company’s hedging strategy?

6. Does use of an alternative reference rate introduce new risks that need to be addressed? For example, if you have relied on LIBOR in pricing assets as a natural hedge against increases in costs of capital or funding, will the new rate behave similarly? If not, what actions should be taken to mitigate this new risk?

SEC STAFF STATEMENT ON LIBOR TRANSITION: QUESTIONS FOR MARKET PARTICIPANTS TO CONSIDER3

3 Securities and Exchange Commission, Staff Statement on LIBOR Transition, July 12, 2019. https://www.sec.gov/news/public-statement/libor-transition

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Ornella Combaluzier: I’d like to add to that. We’ve talked about how larger, more sophisticated clients are probably more prepared. As an organization, we must have those conversations with our clients at all levels to make sure they understand the risks underlying the different products they are exposed to. From an economic standpoint, there will be discussions around the revaluation of certain positions, such as derivatives contracts, for example, and the impact on the P&L. Regulators aren’t going to provide specific guidance there, so we need to have a clear communication strategy targeting all clients.

Joe Barry: True, and there are different nuances to consider in an institutional context versus retail. On the disclosure side, it occurs to me there’s a little tension there. You have to disclose the risks to the fund, but at the same time managers are being pushed to mitigate them. How do you look at that issue?

Sam Brutlag: I think there are two categories: new contracts, and existing contracts or products. For the existing ones, the big risks would be where there is no fallback language and the contract relies on LIBOR. In that

case, think about renegotiating those contracts and choosing an alternative rate that will be published beyond 2021. For new contracts, we’re encouraging people not to use LIBOR. If it has to be used, we encourage them to include really effective fallback language.

Ann Battle: On this point, it’s important to recognize the difference in fallback language across different types of products, such as derivatives, loans and floating rate notes. Derivatives, both cleared and non-cleared, almost universally use the rate options published in ISDA’s standard definitions, so in the confirmation to document the transaction, you would reference the name of the rate option in the definitions. For a loan or a different type of financial instrument where you have to define the floating rate, you typically see a longhand description of the rate.

It’s a good thing for the derivatives market that we have a centralized, standard set of definitions that can be updated to include more robust fallbacks. The current fallback for derivatives did not contemplate a permanent cessation of any benchmark. That’s why we’ve been working to implement fallbacks to actual rates.

“We must have conversations with clients at all levels to make sure they understand the risks underlying the different products they are exposed to.”

Ornella Combaluzier, Co-Head of Investment Risk Management, State Street Global Advisors

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The challenge though is that LIBOR replacement rates are inherently different from LIBOR. They are better and more robust in the long term. However, they’re overnight rates. They don’t have a term structure, and they’re risk-free or nearly risk-free rates and they don’t incorporate bank credit risk or other premia as LIBOR does. Since the beginning of 2017, we’ve been working on how you would adjust those risk-free rates to allow the counterparties to continue the contract in a way that’s as close as possible to their original intentions, and in a way that’s as fair as possible to all market participants.

We consulted on fallback adjustments for LIBOR in multiple currencies and a few other IBORs, and we recently completed a supplemental consultation that covers these adjustments for USD LIBOR. We expect to update our definitions to include these more robust fallbacks by the end of 2019 with an effective date of early 2020. Central counterparties who incorporate our definitions have confirmed that they expect to apply the fallbacks to new and legacy cleared derivatives as well. Counterparties who have legacy exposure to LIBOR in non-cleared

derivatives will affirmatively need to agree with each other that these swap contracts will include the fallbacks.

We’ve published protocols in recent years to help the industry address issues like the move to the euro, and more recent regulatory developments. In this case, we will publish a protocol through which market participants can agree that their legacy LIBOR portfolio will contain updated fallbacks. If market participants adhere to that protocol, there won’t be any changes to the reference rates when the amendments take effect, but the counterparties will have agreed to use the better fallback rates.

Joe Barry: Sam, some have raised the possibility that SOFR might not be suitable for everything, and there may be alternative rates developed. How does this SEC view this?

Sam Brutlag: We’re closely monitoring the development of alternative rates. At the moment, SOFR is recommended by the ARRC and it’s been published by the Fed since April 2018. We’ve seen growth in bond issuance referencing SOFR and futures are traded in it, so it has seen a lot of momentum.

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Standard-term versions of SOFR and a spread to apply to the products being converted from LIBOR to SOFR will also allow it to be used more widely in the industry.

Joe Barry: The development of term products requires a certain amount of critical mass in the market. Would the industry benefit from more regulatory guidance here, given questions around the suitability of SOFR for some products?

Sam Brutlag: It’s true, there has been some pushback. There are other benchmarks for certain cash products and other non-derivative financial instruments, but these have seen limited traction in the market.4 SOFR right now is the highlight. Private parties are free to choose the rate they think works best for a particular contract or product. But, it’s important for market participants to be smart about choosing a rate and understanding how that rate can impact their business. A fragmented market could heighten liquidity risks.

Joe Barry: What’s the approach of the SEC’s investment management division in terms of monitoring the industry’s response?

Sam Brutlag: Well, one goal of our statement was to inform all types of investors — individual and institutional — that this is happening. Second, we want to encourage fulsome disclosures. Our Office of Investor Education and Advocacy welcomes questions. We also want to hear from all of you on ways we could be helping and staying engaged on this topic.

From an investment management perspective, we review prospectuses and make sure the disclosures are adequate. We’re emphasizing this tailored disclosure point because a generic paragraph in a prospectus really doesn’t help.

Joe Barry: Ornella, any comments about the process at SSGA so far and what you’ve been focused on?

Ornella Combaluzier: 2019 is a year of internal planning, identifying our exposure to LIBOR and having specific targets on conversions. In the derivatives space, we’re actively looking at converting our swap instruments to the new SOFR rates.

The timing of when you switch — do you wait until liquidity builds up or do it now — is a little tricky.

4 Bank Yield Index, Ameribor (an index based on lending rates between regional banks and some industrial companies).

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But our message is: understand your LIBOR exposure, have targets for conversion, and discuss other dependencies (systems and contracts) with your teams internally. We’re proactively raising this with our clients. Depending on the nature of the client, they might have different questions for us.

Proactive Engagement Is Critical

Joe Barry: What kinds of clients have been most engaged to date on LIBOR-related issues?

Ornella Combaluzier: The larger pension plans and ones with more exposure to alternatives have been asking more questions. We have clients with real estate, private debt, hedge fund exposures, etc., with LIBOR-based benchmarks and valuation.

Joe Barry: Who seems to be getting the message the clearest now?

Ann Battle: The biggest players in the derivatives market are most prepared. Large insurance companies are definitely very aware, as are large asset managers. I think your typical hedge funds are looking at this, but maybe not to the same degree. For corporates, I think it’s really difficult at this time.

In the United Kingdom, you don’t quite have that hurdle because SONIA was determined to be the most appropriate alternative and is currently used in the OIS market for GBP. SOFR is based on the most liquid rate in the world — the US repo market — and so therefore the ARRC identified SOFR as the best alternative. But I don’t think we can ignore the fact that it creates a much bigger hurdle for people, particularly in Treasury departments, to trade the rate.

Joe Barry: I’ve seen some — mostly from smaller banks — say, “We don’t even deal with the repo market. This has nothing to do with mortgages, so why are we using this rate?”

Ann Battle: We do hear these concerns from regional banks, and I sympathize with them. There’s no certainty at this time but I would expect that for them to risk manage, that rate would develop. But that rate would likely be outside of the standard work that’s going on with SOFR for the broader derivatives market.

Joe Barry: Besides having investment funds make accurate disclosures, anything else you want regulated firms in the industry to do?

“Understand your LIBOR exposure, have targets for conversion, and discuss other dependencies such as systems and contracts with your teams internally.”

Ornella Combaluzier, Co-Head of Investment Risk Management, SSGA

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Sam Brutlag: We’d like them to read our statement, which outlines the issues we’d like everyone to consider. We also want feedback. We want it to be a conversation.

Joe Barry: That seems reasonable.Ann, do you see any major unanswered questions?

Ann Battle: I wouldn’t say that there’s any million dollar, unanswered question for the industry that the regulators can answer. Of course, more clarity on when and how LIBOR might disappear would help all of us. But I also recognize that’s not one regulators can really answer at this time.

Joe Barry: Ornella, your thoughts?

Ornella Combaluzier: Organizations need to have a transition plan in place with clearly defined objectives and ownership. From a technical standpoint, the other challenge we’ll have is around cross-currency swaps, where rates are going to be specific to each country, which will introduce basis risks. So that’s another area we’re going to be looking at. Overall, the goal is to be prepared and to have these conversations internally and with our clients.

Joe Barry: Excellent advice from everyone. Thank you all for your perspectives.

Talinn DemirjianManaging Director,

Enterprise Risk Management, State Street

Jason GranetManaging Director,

Head of LIBOR Transition, Goldman Sachs

Ephraim HirschfeldSenior Product Manager,

Charles River Development

Nitish IdnaniPrincipal, Risk and Financial

Advisory, Deloitte

OPERATIONAL AND RISK PERSPECTIVES

Our Panel

Joe AcerSenior Vice President,

Global Process Delivery, State Street

Moderator

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Liquidity and the End of LIBOR

Joe Acer: Let’s start with the question that the prior panel did not have time to fully address, about whether it would be better to have a hard close of 2021, to have certainty on when LIBOR is going away?

Jason Granet: John Williams, the president of the New York Fed and co-chair of the Financial Stability Board (FSB), titled his speech, “901 Days.”5 Fed officials are very particular about the words they choose, which signals their level of commitment. For me though, the date that truly matters is when liquidity switches and people follow. If you look at speeches from Andrew Bailey6 and Edwin Schooling Latter,7 I believe global conviction is unbelievably high. Once fallback mechanisms are in place and documentation is complete, I think regulators may turn the volume up on providing more clarity.

At this stage, I think there are two things squarely in pen. First, the FSB Official Sector Steering Group (OSSG) has said that overnight SOFR is going to be the fallback for derivatives markets. And second, FASB has approved SOFR for hedge accounting. These are two firm things that I believe are indicative of the direction of travel.

Ephraim Hirschfeld: Jason is spot on here about liquidity. From a pragmatic standpoint, the general purpose of getting into these contracts is either trying to lessen rate exposure or increase it. So if we move into a world where liquidity dries up in LIBOR, suddenly these contracts are no longer serving that purpose. I think your point is very well taken that once liquidity goes away, that’s when people will move.

5 “901 Days,” Remarks by John C. Williams, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the Securities Industry and Financial Markets Association (SIFMA), New York City, July 15, 2019. https://www.bis.org/review/r190716a.htm

6 “LIBOR: Preparing for the End,” speech by Andrew Bailey, Chief Executive of the United Kingdom Financial Conduct Authority, at the Securities Industry and Financial Markets Association’s (SIFMA) LIBOR Transition Briefing, July 15, 2019. https://www.fca.org.uk/news/speeches/libor-preparing-end

7 “LIBOR Transition and Contractual Fallbacks,” Speech by Edwin Schooling Latter, Director of Markets and Wholesale Policy at the FCA, delivered at the International Swaps and Derivatives Association (ISDA) Annual Legal Forum, January 28, 2019. https://www.fca.org.uk/news/speeches/libor-transition-and-contractual- fallbacks

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Jason Granet: As a market practitioner, I always wanted to have the ability to see into the future. In a way, we can do that now by looking across the pond at what’s happening in the SONIA market. In the United Kingdom, they’re a bit ahead of us in terms of calculation methodologies, the way in which the market is adapting, what pension funds are doing and how things are being modeled. The SONIA- fication of that market is deep into the late innings, whereas SOFR here in the United States might be in the early innings. We have an advantage of being able to see a little bit into the future on this one, and that’s not an advantage you get in a lot of other market situations.

Nitish Idnani: One additional comment, just going back to the original question, is it a hard deadline, is it a soft deadline? From what I see with market participants and their transition programs, I think everyone is working toward that December 31, 2021 date. Just practically, from what firms are doing, that is the date that everyone is marching toward.

Talinn Demirjian: To add to that from a risk management perspective, I do think everyone believes they still have all these months. The concern though

is that if the liquidity switches earlier, it may create some challenges for firms that thought they had until that specific date to prepare.

Jason Granet: Last fall, the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) sent a ‘Dear CEO’ letter8 to the major financial firms and insurance companies. I was at the Bank of England when we received the feedback, and they made it very clear that anyone with a base case that is not the end of 2021 or earlier will need to rethink their strategy. No matter what your business is in the United Kingdom, you have to make sure you’re keeping an eye on what’s going on there.

Ephraim Hirschfeld: I think the SONIA-fication point is interesting in the sense that it touches on guidance from a regulatory standpoint. In the United States, I would like to see some input from the IRS on the tax implications of unwinding. Falling back has the advantage of not realizing any gains or losses, but that could trickle down into decision-making in terms of falling back versus unwinding. Going into new contracts might offer a much cleaner workflow than renegotiating bilateral agreements.

“From a risk management perspective, the concern is that if liquidity switches earlier, it may create challenges for firms that thought they had until a specific date to prepare.”

Talinn Demirjian, Enterprise Risk Management, State Street

8 “Firms’ preparations for transition from LIBOR to risk-free rates,” letter from Bank of England Prudential Regulation Authority and UK Financial Conduct Authority, September 19, 2018. https://www.fca.org.uk/

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Jason Granet: In April 2019, the ARRC sent a letter to the IRS9 seeking clarification on tax issues. I think regulators are eager to get this done. I would expect messaging and clarification from the IRS soon. Regulators want feedback and are interested in having a conversation.

The Operational and Risk

Management Impact

Joe Acer: Nitish, can you talk about operational impacts and what managers should be thinking about as they build and mature their LIBOR programs?

Nitish Idnani: Absolutely. You really have to think about what is fundamental to the business. I would classify it in three broad buckets: what is core to the business, the operational impact and your clients’ expectations.

When it comes to the business, you have to look at what securities go in the portfolio. For holdings that reference LIBOR, you’ll want to think about what happens to their liquidity and valuation impact; the benchmarks tied to LIBOR and fund performance assessed against LIBOR that also come into play.

When it comes to the functional and operational impact, fallback language and adjusting fallback language in contracts will be a big part of it. Tax will also be key. Then there’s the broader system impact. Fund managers rely on a lot of third parties, such as custodians and fund administrators, who will need to be prepared. Transition programs really need to assess their readiness. The other piece of this is communication with customers. What are their expectations? What kind of updates do they want to receive? So that’s broadly where a transition program and its workstreams should focus.

Jason Granet: Participation is key here, and involvement varies by functional role. Someone in a corporate position might say they’re not working on the LIBOR transition issue at all. But ask a portfolio manager, and they might say they’re spending a lot of time looking at their holdings to manage exposure. There are many questions yet to be answered and may never be answered. Pricing becomes ambiguous when we don’t have answers to questions. The more market participants involved in this process, the better.

9 “Re: U.S. Federal Income Tax Issues Relating to the Transition from IBORs to RFRs,” letter from the Alternative Reference Rates Committee, April 8, 2019. https://www.newyorkfed.org/medialibraryMicrosites/ arrc/files/2019/ARRC-Tax-Whitepaper-April2019.pdf

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Joe Acer: Talinn, given your involvement in LIBOR and risk management, can you talk about some of the key thematic risks that firms face in their transition programs and how they should be thinking about addressing them?

Talinn Demirjian: We think about risk management from two perspectives. There’s the risk management with a small ‘r’ and the one with a large ‘R.’ I don’t want to give short shrift to the small ‘r,’ so I’ll just mention that the key areas are really operational risk and model risk, thinking about valuations, how to model new instruments, hedge accounting and tax implications. On the large ‘R,’ the first thematic issue is the lack of a legal and regulatory mandate — whether it’s a firm date or a soft date, when liquidity switches and so forth. There is nothing really from the ‘outside’ pushing firms to hit certain milestones at a certain pace. And the varying rates of the pace of the transition create a lot of downstream implications. The second factor is that exposures to LIBOR-linked instruments continue to grow. I think that’s a real challenge. From the perspective of liquidity, it really is sort of a waterfall

process. We need to create enough liquidity in the swaps and futures markets for risk-free rates, so that we can get a term risk-free benchmark built. And then until we have a term benchmark, how do we offer loans in that space? Until we can offer loans in that space, how do we get critical mass in terms of demand for those loans? I think a lot of people are under the impression we have a long time to sort this out. But that’s really not the case.

Joe Acer: Ephraim, you have a unique vantage point on LIBOR from Charles River Development. Tell us, what type of valuation or analytical challenges will these upcoming changes create?

Ephraim Hirschfeld: The biggest thematic issue for us is the lack of availability of term rates. I was on a call the other day and we were looking at analytics provided by the biggest data provider in the world. There was a SOFR floater that matured in about three years that was basically behaving like a fixed-rate bond. So, we got the provider on the phone and they said, “Yes, we do publish a SOFR curve but we have no idea how to estimate forward rates on it, so it’s getting a fixed-rate duration.” And it’s not just liquidity in

“As managers build and mature their LIBOR programs, they really have to think about what’s fundamental to the business. I would classify it in three broad buckets: what is core to the business, the operational impact and clients’ expectations.”

Nitish Idnani, Risk and Financial Advisory, Deloitte

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the primary market. There’s also the cross-currency component to it. The central clearing parties are looking to start moving from an effective Fed Funds rate environment to a SOFR-discounting environment. That requires a liquid basis swap market between Fed Funds and SOFR which doesn’t actually exist today. A lot of the mark-to-markets and price alignment interests can be quite challenging to compute in this type of world.

Another interesting thing is the intricately woven ecosystem of models we have across the industry. As an example, we use LIBOR-based swaptions for calibrating interest rate models. This is important because it is the underpinning for building interest rate trees for pricing callable bonds, which don’t have to have any LIBOR provisions whatsoever. It’s the basis for Monte Carlo simulations for estimating prepayments on mortgage-backed securities. Overall, I think the markets have come up with some good conventions for SOFR in the sense that trading and settlements are well understood. But I think valuation models are quite complex and all the ripple effects have not been quite figured out yet across the industry.

The Asset Manager Perspective

Joe Acer: Let’s shift a little to the market perspective. Jason, I know in running Goldman’s overall LIBOR program, you’re engaging the buy side, sell side and regulators. Can you touch on some of the things you’re seeing that you think are impactful for asset managers?

Jason Granet: All market participants are thinking about the term rates and their preparedness. Firms need to make infrastructure changes and other commitments, but are waiting for a term rate because they don’t want to spend technology, time and money if they potentially have to rewind and do something else. What I would say is that the compounded rate is here to stay; ISDA is going in that direction in the derivatives world. So it will not be wasted computation time to figure out how to do those calculations.

One thing I would put on the ‘good hygiene’ list is that some of the largest asset managers are no longer buying instruments without gold-plated fallback language. Engagement and educating the market has been another important factor. And the last thing I’ll say, just being very US-centric here, is for everyone to test the rate you’ve chosen.

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Do it in inconsequential size, relative to the economic realities of your organization; drop a little blue or red dye on it, let it go through your pipes. You will track where it goes; you will see weird things spit out; something might break along the way. This is why you do it on a small scale at first. You learn a lot about what you need to do, and it will allow you to have the conversations with your tax, accounting, controllers, infrastructure, models and risk systems or whomever else. I do believe that liquidity will shift one day. Asset managers must be prepared — that’s a big theme that’s come up in my conversations.

Nitish Idnani: I agree with Jason. Not everybody has to be leading, but doing some of those things — dropping the colored dye and seeing where the breaks happen and what you need to deal with — will be key. I think it’s management’s responsibility to be aware and assessing what this means to each organization and where some of those pressure points could be.

Jason Granet: That’s right. It’s everyone’s responsibility.

Nitish Idnani: This has been a very big topic in one-on-one discussions. This transition is coming and we could

argue that the building blocks are falling into place. Not everything is there yet, and I completely recognize the term-rate question and the liquidity question. But there is absolutely work to be done to think about what this means and getting prepared.

Talinn Demirjian: To that point, one of our questions for this discussion was, “What is the risk management response to these risk themes?” And universally, it is about proactivity and pushing things forward without waiting for the market. In almost all cases, that is going to be the solution to these problems — figuring it out early, proactively moving to whatever is next and not being a market follower. There are too many ripple effects, as Ephraim referenced, to be able to cope with them if you wait until you get closer to the deadline.

I’d also like to go back to one point Jason made about gold-plated fallback language. There is some concern from an operational risk perspective that we rely too much on fallback language. On whatever the date may be that market liquidity switches, we will actually have a big transition that firms may not be prepared for operationally, in terms of the number of contracts that could be in play.

“Test the rate you’ve chosen. Drop a little blue or red dye on it and let it go through your pipes. You will learn a lot about what you need to do.”

Jason Granet, Head of LIBOR Transition, Goldman Sachs

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Jason Granet: One thing that is good is that a lot of derivatives have moved into the cleared space and so the clearinghouses have been very clear (pun intended) about their path. In reference to protocols, I think one of the big challenges will be tracking who has signed and who hasn’t. Participating in the consultations ISDA puts out is also critical so that market participants won’t have to scramble to learn everything at the end.

Risk Assessments and the

Technology Factor

Joe Acer: Let’s talk about the governance process around trading new rates. Can you elaborate on what firms should consider there?

Jason Granet: Sure, I can speak to Goldman’s process. Typically when you want to trade any new product or instrument at a regulated organization, you need to show a governance process where you check that what you’re doing works. We have committees that look at this across the business, and for us it’s a one-time requirement to put a new instrument, like SOFR futures for example, through that process.

Talinn Demirjian: It’s the same for State Street. We have committees that look at all of the implications of a new product, a new instrument. And for us it would be a one-time requirement, as long as there are not significant material differences between what the first process looked at and what the next item is. There are a lot of implications around any new business and an extensive governance process around it.

Jason Granet: Quite frankly, this process can be very helpful in other ways. As part of our due diligence, when someone wants to trade a new structured equity product, we’ll ask them if it involves LIBOR. If the answer is yes, my team gets a call and we examine it in depth. We’ve found that it serves as a kind of filter in the organization, helping to catch things you might otherwise never think are connected to LIBOR. It’s also excellent for firm-wide communications to emphasize that LIBOR is important. I really encourage people to think through what processes they have in their organization to consider adding this step, because it can be very helpful in education and catching things.

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Joe Acer: From a systems perspective, what are the greatest concerns for the LIBOR transition? And is there any technology that can help ease it?

Ephraim Hirschfeld: One of the things we’ve found in onboarding clients is that some people have hard-coded data interfaces and others have soft coded. Charles River’s soft-coded native data interface with providers of market data makes amalgamating data, such as SOFR, SONIA, TONAR, etc., into the product a matter of including more translations rather than coding or bringing the data in. We’ve dealt with some software internally, even billing software, that is hard coded so data doesn’t flow in, which is a challenge. So that’s one way our tech stack is helping. Another way is cloud-type solutions where you can push convention changes. Your basis swaps show up the next day and you can have the logic sitting there. What technology providers can’t help with is some of the tougher decisions, which is unwinding versus fallbacks or any type of position changes.

Nitish Idnani: The question we’ve heard loud and clear — even going back to 15 months ago — is how can technology

help with individual workstreams? Just understanding across all products what type of fallback language exists in current contracts and being able to digitize what exists. Then you read through, using natural language processing or other technologies, what’s in those contracts. For certain products that might require bilateral negotiation, being able to automate that process or at least a technology platform that makes it efficient are things clients are very interested in. Business decisions still need to be made, but the execution can certainly be facilitated with technology.

Ephraim Hirschfeld: From a broader ecosystem view, just tighter integration with third-party applications and sources is important. Looking at the State Street front-to-back platform as a case study, having the ability to integrate the fund accounting systems where the actual book of record might be recognized in the fallbacks and having that flow through to your actual performance and risk management systems, and your analytical systems, is essential.

Joe Acer: Thanks to everyone for your insights.

“From a broader ecosystem view, tighter integration with third-party applications and sources that flow through to performance, risk management and analytical systems is essential.”

Ephraim Hirschfeld, Senior Product Manager, Charles River Development

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