LIBOR - How to Approach the Rate of Change
Since the rigging scandal in 2008 the London Inter-bank Offered Rate (LIBOR) has been the target of criticism from the press, regulators and financial sector alike. The criticism centres around the apparent ease in corrupting the benchmark and the lack of underlying transactions supporting the published rates.
What is LIBOR?
LIBOR is a widely used benchmark for short-term interest rates, providing a forward-looking average rate at which LIBOR panel banks could obtain wholesale, unsecured funding and is reported across five currencies and seven maturity dates. Used globally, LIBOR is often referenced in derivative, bond and loan documentation, and crucially for investment managers, is often used as a benchmark to measure investment performance.
What is Happening?
Historically there had been little oversight over the production of the LIBOR rate, however since the Financial Conduct Authority (FCA) began regulating the index in 2013 significant improvements have been made. The administrators of LIBOR, ICE Benchmark Administration (IBA) have made enhancements to the governance, submission and calculation methodology to avoid a repeat of the LIBOR scandal in 2008.
In 2017 the FCA announced that they will no longer compel banks to submit LIBOR estimates by the end of 2021. The IBA has stated their ambition to continue to publish LIBOR in some form after this date but there is a consensus that all users of LIBOR should plan for the cessation of LIBOR by the end of 2021. The FCA has stated that they wish investment managers to treat the transition from LIBOR as a regulatory imperative, and the supervisory arm of the FCA will be taking measures to ensure that appropriate plans are in place for the cessation of LIBOR.
Simultaneously, the future of Euro Interbank Offered Rate (EURIBOR) and the Euro OverNight Index Average (EONIA) is looking uncertain and expected to be discontinued by the end of 2021. These rates are currently not considered compliant under the European Union's Benchmark Regulation, so users of these rates should monitor closely.
What are the alternatives?
Central banks around the world have been leading efforts to agree on an alternative risk-free rates (ARR) based on real transaction data. In the UK the Risk-Free Rate Working Group has proposed a reformed Sterling Overnight Index Average (SONIA) as the alternative benchmark. SONIA is now administered by the Bank of England and is calculated based on wholesale overnight unsecured transactions.
Comparison of the Alternative Risk-free Rates proposed globally
As the table above shows, the proposed ARRs are fractured in their calculation methodology, basis and publishing time; however, they all follow the ambition to provide an empirical reference rate. As the lending term is literally overnight, even the unsecured transactions are considered to be nearly risk-free.
How do they differ?
The key difference between LIBOR and the proposed alternatives is that LIBOR is forward-looking and over multiple maturity dates - the panel banks submit the rates that the bank could obtain today for a loan that matures at set points in the future. These characteristics of LIBOR mean that it serves as an indicator of both bank credit risk and longer-term interest rate outlook.
What is in a rate? LIBOR consists of three factors, where ARRs more purely reflect the risk-free lending rate.
Various approaches have been proposed to create forward-looking risk-free rates based on the newly agreed ARRs and how best to incorporate credit risk alongside the ARRs where needed. These discussions will continue, and we fully expect the proposals will mature and the industry will settle on conventions for incorporating forward-looking and credit risk principles.
What should Investment Managers do to prepare?
Investment managers should approach this as a project and appoint a high-profile sponsor who can effect change throughout the whole organisation. SMEs should be involved from across the firm. Due to the scale of LIBOR's usage, it is worth spending time and effort in educating the wider organisation on the upcoming changes.
A critical first step for the project that should begin now, if it has not already, is to establish the organisation's total exposure to LIBOR. LIBOR use within most investment managers can generally be broken down by three themes.
Various instruments use LIBOR to determine either interest payments or the value of the instrument itself.
For shorter dated securities, as the end of 2021 approaches, liquidity and availability of LIBOR based instruments are expected to dwindle. Investment managers should carefully monitor market activity and invest appropriately, not least because the FCA has made clear that they will be treating a failure to do so as a failure in an investment manager's fiduciary duty to their clients.
Longer dated securities should have a contractual fallback identified, however, these are potentially not economically equivalent or operationally feasible. As progress in this area will be made primarily via industry consultation and collective agreement, investment managers should ensure that they are represented in the appropriate industry bodies.
It is common for investment managers to reference LIBOR in a fund's benchmark. Substituting LIBOR with an ARR will need some consideration as to whether a spread should be applied to avoid an untoward shift in reported relative performance.
Operationally, there will be a lead time in changing the fund's prospectus or client's Investment Management Agreement. If compounding a daily rate, care must be taken to ensure that the new benchmark is calculated correctly.
Investment managers should not hesitate to plan for the cessation of LIBOR and selecting an alternative benchmark. There is understanding from regulators and clients alike that as discussions evolve on ARRs more options will be made available, and the industry will begin to settle on some preferred rates that may not even be available yet.
3. Operational and legal
In addition to the above, LIBOR is commonly used throughout investment managers from front-to-back. Common examples include as a penalty for late payment (in both client and vendor contracts), in front-office and investment risk models, and in finance for discounting and hedge accounting.
As is clear from above, a transition from LIBOR will affect nearly the entire organisation. To ensure full coverage, SMEs should be involved from the functions affected. A sample collection of SMEs that will contribute to a successful transition project include:
- Front Office: The front office will naturally be impacted the most by investments, and may not feel the need for project involvement, however, in order to demonstrate to regulators that the transition is being managed appropriately, buy-in is crucial. Engaging proactively with the front office is vital to ensuring the smooth transition from LIBOR.
- Legal Services: For each use of LIBOR that is identified an assessment should be conducted as to whether an update to legal documentation may be required. It is important to engage with legal services proactively, as capacity may need to be carefully managed.
- IT: There may be various reports and systems with LIBOR hard-coded in (e.g. to value or discount cash instruments within the system) that IT may be best placed to identify. In addition, most uses that other departments identify will need IT involvement to assess the impact and enact any changes.
- Investment Risk: As the industry progresses with the transition from LIBOR, investment risk should be involved in monitoring liquidity and modelling potential stresses to LIBOR based instruments. This will be at least partially covered through their business-as-usual practice, however, they should be an integral part of the transition plan for LIBOR based investments.
- Product / Account Management: The project should proactively engage with product and account management to ensure that there is appropriate messaging to and feedback from clients. These functions will be best placed to provide insight as to the suitability of new benchmarks and to assess the impact in changing client and fund documentation.There may be various reports and systems with LIBOR hard-coded in (e.g. to value or discount cash instruments within the system) that IT may be best placed to identify. In addition, most uses that other departments identify will need IT involvement to assess the impact and enact any changes.
- Performance: : All usage of LIBOR as a benchmark can be identified by the performance department. Performance can provide valuable input into assessment of scale and impact of operational impact of a change to benchmarks, including any fixed income attribution and use as a risk-free rate to calculate performance statistics.
- Finance: The scale of impact for financial reporting and analysis should be assessed by finance and should be supported by the project.
- Investment Operations: As investments and benchmarks evolve, investment operations should be consulted and kept updated as there will be various impacts on their administrative functions.
For every use of LIBOR that is identified, a plan should be drawn up and implemented as soon as practicable. Due to the uncertainties in some areas, it is natural that many initial plans will simply involve monitoring the market, and investment managers should be prepared to adapt their plans as new information arises.
How ISC can help
Our experience enables us to articulate journeys from current to best-practice future states. Our consultants understand the full life-cycle of each investment transaction made by our clients. We understand how people, processes and technology interact and frame our projects in these terms. If you would like to discuss how best to prepare for the next phase in LIBOR's lifecycle, or if you would like further information please get in touch via firstname.lastname@example.org.