With benchmark reform underway, many asset managers are only now beginning to consider the extensive planning and preparations required to support a transition away from the London Inter-bank Offered Rate benchmark (LIBOR) to Risk Free Rates (RFRs).
Craig Bisson,Partner at Simmons & Simmons, explores three big ways the buy side will be impacted by benchmark reform, and how asset managers and insurance firms can start preparing their legal documents, operations and businesses for this change ahead. This article is based on a recent podcast interview.
Products and Fallbacks
The first area of impact is around products. Asset managers will already be holding LIBOR-based products in their portfolios—for example, syndicated-loans, securitisation positions, floating-rate notes (FRNs) or, as is the case with many pension schemes, long-dated interest rate swaps (IRS).
Some of these contracts will have terms within them that deal with what happens if LIBOR becomes unavailable for a period (so-called “fallbacks”). But these provisions are generally only designed for short-term interruptions in the rate, and do not envisage a complete cessation of the type we are now led to expect for LIBOR.
Furthermore, these fallbacks are often operationally unfeasible, for example using a dealer poll – meaning that a party or agent would have to go out and poll different banks for every single contract, potentially on a daily basis. The fallbacks could also create a value shift or otherwise result in an outcome which is not economically equivalent, for example fixing to the last published rate. There are also issues around consent. Looking at cash securities, for example, a change in the rate would typically require the unanimous consent from noteholders. Can that really be achieved?
Industry bodies, including the International Swaps & Derivatives Association (ISDA) the Securities Industry and Financial Markets Association(SIFMA) and the Loan Market Association(LMA) have recognised the challenges and are starting to draw up replacement fallback language. But of course, there is a real fear of inconsistency or basis risk between different fallbacks for different asset classes.
The regulators have been clear that they expect both the buy-side and the sell-side to act now to get a handle on their exposures, noting for asset managers their fiduciary duties to clients and the risk of a liquidity drying up in LIBOR referencing trades as the 2022 deadline approaches.
Use of LIBOR in Funds and Products
The move away from LIBOR will have an impact on an asset manager’s use of LIBOR in their funds and products. Now that the industry has the expectation that LIBOR will cease to exist, risk warnings are being included in offering documents within the capital markets space but currently are far less common in investment fund prospectuses. I think that is something that should probably change.
LIBOR references in prospectuses and other legal documents should be updated before the rate is withdrawn at the end of 2021.
When switching to RFRs and applying a spread, asset managers will need to be careful to avoid artificially inflated performance within the fund which might for example lead to a greater amount of remuneration, or fees paid to the manager.
Communications around the benchmark and changes to the benchmark need to be very carefully managed with investors and it is important that the switch to a new benchmark does not trigger higher performance fees to the manager than it would otherwise have been entitled to.
Communications around the benchmark and changes to the benchmark need to be very carefully managed with investors and it is very important that the switch to a new benchmark does not trigger higher performance fees to the manager.
Business Impact Including Changes to Operations and Systems
There is a business impact to the buy side too. Asset managers use LIBOR as an input into all sorts of internal calculations, systems and models. LIBOR is included in valuation curves for discounting and asset valuation, as well as for stress testing purposes.
Additionally, the custodians holding fund assets will likely employ LIBOR-based models for valuation purposes and risk assessment. It is also worth noting that in certain areas the use of LIBOR is mandated by regulation (such as under the EU’s Solvency II Directive for liability discounting purposes). This would have to change and is something regulators are aware of.
The systems that are currently in place, including financial systems, models used, front-office technology and contracts with services providers, will all need to be assessed and updated in accordance with benchmark reform preparations.
Dear CEO Letter Marks the Start for Many. Where to Begin?
The “Dear CEO” letter issued by the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) late in 2018 was a marker in time for companies to start considerations and deliberations around LIBOR, which means time is ticking for firms to make preparations in time.
Specifically, firms really need to be able to quantify their LIBOR exposures within their portfolios and at fund level. At Simmons & Simmons, we are already working with a number of clients to help them assess and determine their LIBOR exposure and their current position on fallbacks.
At the portfolio level, investors can in due course expect to receive correspondence from banks and brokers requesting fallbacks or a change in the interest basis. And of course, managers should be following industry developments around fallbacks.
Asset managers will want to identify any mismatches between the trade and the asset that it hedges—for example, a cash product hedged with a derivative. Is there a basis risk introduced in light of those fallbacks? That must be analysed carefully.
At the fund level, firms will want to review the constitutional documents of the funds for LIBOR references, looking at things like default interest or as a performance measure or other benchmark. Does the investment objective of the fund reference LIBOR?
An important area of change, albeit not a legal one, is around operational and administrative processes. Firms will need to analyse where in their systems and models the firm is currently using those rates.
Some questions to ask include: “Are there any contractual restrictions that are imposed on me that I’ve already agreed to, that are going to prohibit me from switching the rate? What consents do I need from my contracting counterparties? Or from my fund investors? What are my fiduciary duties?”
In summary, asset managers and funds should be reviewing their exposure, analysing where it sits within their portfolios and funds, and working out what the existing fallback arrangements are. Legal disputes—of which I suspect there will be some as a result of the transition—are far more likely where there is no fallback, or where the fallback is uncertain or unfeasible in practice.
Tying up those significant changes to the new world, in time ahead of the transition deadline, will be key. Communication with investors around this change will also be important.
What are the Timings?
Asset managers about to enter into another 25-year LIBOR referencing interest rate swap perhaps need to be thinking about whether or not that is, in this current environment, the right trade (which it may still be given eg. the relative lack of liquidity in RFRs) and perhaps taking steps to ensure they can justify the position – taking into account possible future liquidity issues in the LIBOR market. An awareness of the fallback methodology will also be relevant here.
The PRA and the FCA have made it clear that firms should not expect a change of course on this from regulators.
Industry players—and asset managers in particular—need to get involved with the benchmark reform process early. Simmons & Simmons can help firms rise to the challenge, including in terms of scoping, exposure analysis, fallback assessment, risk warnings and client communications.
Additional resources:
More info on benchmark reform: http://www.elexica.com/en/resources/microsite/benchmarks-regulation
