LIBOR TRANSITION: NO TIME TO LOSE
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LIBOR TRANSITION: NO TIME TO LOSE Despite the disruption caused by the COVID-19 pandemic, 2020 continues to be a key year for the transition from LIBOR to alternative risk-free rates. Markets and Securities Services In fact the increased market volatility as a result of the pandemic highlighted the weaknesses of LIBOR benchmarks, with the Bank of England Financial Stability Committee noting, in its Interim Financial Stability Report (FSR) published 7 May 2020, that in March 2020 both GBP and USD three-month LIBOR rates diverged from the alternative bank risk-free rates (RFRs), SONIA and SOFR, due to the lack of transaction-based submissions, reinforcing the Bank of England’s view of the importance of completing the transition to alternative rates. 1 So what should Asset Managers be doing and when do they need to do it by? Regulators have made it clear that the pandemic will not delay the transition away from LIBOR and that firms should still plan for the end of LIBOR post 2021. Asset Management Firms (AMs) broadly have two exposures to LIBOR: • Funds holding investments that reference LIBOR; and • Funds that reference LIBOR as a target or comparison benchmark, including for performance fees. Regulators have stated that AMs should work towards LIBOR ceasing after December 2021 and that they have a responsibility to facilitate and contribute to its orderly end. On 27 February 2020, in a letter to CEOs of AMs, the UK Financial Conduct Authority (FCA) stated that it expects asset managers to “take proactive steps now where appropriate and not wait for instructions from clients”. 2
Transcript of LIBOR TRANSITION: NO TIME TO LOSE
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LIBOR TRANSITION: NO TIME TO LOSE Despite the disruption caused by the COVID-19 pandemic, 2020 continues to be a key year for the transition from LIBOR to alternative risk-free rates.
Markets and Securities Services
In fact the increased market volatility as a result of the pandemic highlighted the weaknesses of LIBOR benchmarks, with the Bank of England Financial Stability Committee noting, in its Interim Financial Stability Report (FSR) published 7 May 2020, that in March 2020 both GBP and USD three-month LIBOR rates diverged from the alternative bank risk-free rates (RFRs), SONIA and SOFR, due to the lack of transaction-based submissions, reinforcing the Bank of England’s view of the importance of completing the transition to alternative rates.1
So what should Asset Managers be doing and when do they need to do it by?Regulators have made it clear that the pandemic will not delay the transition away from LIBOR and that firms should still plan for the end of LIBOR post 2021.
Asset Management Firms (AMs) broadly have two exposures to LIBOR:
• Funds holding investments that reference LIBOR; and
• Funds that reference LIBOR as a target or comparison benchmark, including for performance fees.
Regulators have stated that AMs should work towards LIBOR ceasing after December 2021 and that they have a responsibility to facilitate and contribute to its orderly end.
On 27 February 2020, in a letter to CEOs of AMs, the UK Financial Conduct Authority (FCA) stated that it expects asset managers to “take proactive steps now where appropriate and not wait for instructions from clients”.2
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AMs are users of swaps on behalf of clients, and so this target [2 March 2020 – the date market makers are encouraged to change the market convention for sterling interest rate swaps from LIBOR to SONIA] implies asset management fi rms should now consider switching from LIBOR swaps to SONIA swaps for new positions where possible.
AMs are signifi cant investors on behalf of clients in cash products (such as bonds, securitisations, structured products, loans). Therefore, [the Q3 2020 target for ceasing issuance of GBP LIBOR-based cash products maturing beyond 2021] suggests asset management fi rms should consider not making any new investments in GBP LIBOR-based cash products maturing beyond 2021 by end Q3 2020.
AMs also often operate funds and other products which have benchmarks or performance fees linked to LIBOR. So we think this target of end Q3 2020 is sensible for fi rms to consider when planning to cease launching new products with benchmarks or performance fees linked to LIBOR.
[The transition of legacy LIBOR products to signifi cantly reduce the stock of LIBOR referencing contracts by Q1 2021] is directly applicable to AMs that have LIBOR exposures or dependencies in the funds they operate, or the instruments they hold on behalf of clients. If your fi rm has LIBOR exposures or dependencies, but does not have a plan in place, you must act now.
In addition fi rms should not expect or base their transition plans on future regulatory relief or guidance or on legislative solutions.
The letter further makes reference to 2020 targets published by the FCA, Bank of England and the Working Group on
Sterling Risk-Free Reference Rates (RFRWG), on 16th January 2020, which identifi ed where they see AMs need to act on LIBOR exposure, setting targets for when these actions should commence or be completed:
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Although the RFRWG subsequently amended the target dates for lenders, the FCA has not indicated that it will amend its expectations of AMs.
With reference to the two exposures AMs have to LIBOR, they need to consider the following:
Investments that reference LIBORAs stated in the 2020 targets, AMs should be in the process of replacing investments that reference LIBOR where possible. New investments should not be based on LIBOR if they mature beyond 2021 and existing investments that extend beyond Q4 2021 should be reviewed to see if the reference rate can be replaced or the investment closed-out and replaced with non-LIBOR equivalents.
For derivatives that extend beyond the end of 2021 and reference LIBOR, International Swaps and Derivatives Association (ISDA) is actively looking at fall-back provisions to ensure continuity in the market in the event that LIBOR rates cease to be produced while products are still referencing them. At the time of writing it is anticipated that the Supplement and Protocol will be published during July 2020.
Funds that reference LIBORAs stated in the 2020 targets, AMs that operate funds that reference LIBOR should be looking at replacements. Where
a benchmark is included in a fund’s’ investment objectives, the firm should consider whether the replacement requires investor agreement, for example if the new benchmark differs significantly from the existing one, or whether a notification period will suffice. Firms will also need to consider whether local requirements mean that the home state regulator of the fund needs to approve the change of benchmark prior to implementation.
However, the structure of RFRs is different from LIBOR in that they are overnight rates and do not, as proposed, have term structures. This difference will generally mean that longer-term products, such as UCITS and AIFs, need the applicable overnight rate for each day to be aggregated, i.e. as a compounded or simple average to provide the right data to calculate performance fees or show whether a fund has met its objective. A feature of averaging an RFR rate is that any idiosyncratic, day-to-day fluctuations in market rates are smoothed out, so that the rate reflects movements in interest rates over a given period. Therefore, in general, compounded and averaged RFRs can be less volatile than forward looking LIBOR benchmarks.
Whereas LIBOR term rates are forward looking, average or compounded RFRs look back over the relevant period and are calculated using actual overnight rates. As a result, AMs could adopt backward looking average or compounded RFRs that better reflect the recommended holding period of a fund.
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LIBOR replacements:
1 Interim Financial Stability report at www.bankofengland.co.uk2 Asset management firms: prepare now for the end of LIBOR at www.fca.org.uk3 Further statement from the RFRWG on the impact of Coronavirus on the
timeline for firms’ LIBOR transition plans at www.bankofengland.co.uk4 Transition to sterling risk-free rates from LIBOR at www.bankofengland.co.uk5 Impact of the coronavirus on firms’ LIBOR transition plans at www.fca.org.uk
Although some regulators paused their active monitoring of the transition to enable focus on business critical activity, for example, the PRA and FCA suspended transition data reporting at the end of Q1, and cancelled some Q1 firm meetings, in light of the FSR they have decided to resume full supervisory engagement on LIBOR from 1 June 2020, including data reporting at the end of Q2.4
The message is clear, as stated by the FCA, firms cannot rely on LIBOR being published after the end of 2021.5 As a result AMs should be actively engaged in removing LIBOR related products and references from their funds.
Currency
RFR SONIA (Reformed Sterling Overnight Index Average)
SOFR (Secured Overnight Financing Rate)
€STR (Euro Short-Term Rate)
ARON (Swiss Average Rate Overnight)
TONAR (Tokyo Overnight Average rate)
Administrator Bank of England Federal Reserve Bank of NY
European Central Bank
SIX Swiss Exchange
Bank of Japan
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