Our Insights

Farewell to IBOR

Preparations underway?

The transition away from interbank offered rates (IBORs)—which act as reference rates for hundreds of trillions of dollars of financial and commercial contracts including bonds, loans, derivatives, and asset-backed securities—is going to have a major impact on asset managers’ operating models.

Over the next few years, IBORs across markets globally will be displaced by alternative risk-free rates (RFRs) and risk-free-rates (RFRs). The end of 2021 will represent a significant pivot point in this new world following the Financial Conduct Authority’s (FCA) announcement that after this time it would no longer compel organizations to submit daily LIBOR rates.

The market adjusts to life without IBOR

In the United Kingdom, Sterling LIBOR is already making way for SONIA (Sterling Overnight Interbank Average), whereas in the US, USD LIBOR is set to transition to SOFR (Secured Overnight Financing Rate) by the end of 2021. Elsewhere, the EU Benchmark Regulation, in place since January 2018, has mandated financial institutions to move away from EUR LIBOR and EONIA (Euro Overnight Index Average) to €STR (Euro Short Term Rate). Even though IBORs have not yet disappeared, RFRs are being used more extensively across financial markets.

Key insight

  • Fund managers need to consider how the move to RFRs will affect returns, performance measurement, hedging strategies, as well as operational processes, and begin to prepare for the change

Assessing the impacts

While multinational banks have been preparing for IBOR reform for quite some time, there is now heightened awareness among asset managers.1 The potential impacts extend across a range of operational processes and require due consideration.

For example, readiness activities could include an assessment of IBOR exposures, and asset managers may want to avoid entering into any contracts tied to IBOR that mature after the end of 2021.2

LIBOR Dependencies3

90% 
of survey respondents use LIBOR as a benchmark in at least one fund or mandate

80%
of survey respondents use LIBOR for hedging

5% 
of funds by AUM use LIBOR, EURIBOR, or EONIA as a benchmark in their prospectus, including: 

     - 20% of alternative funds
     - 10% of money market funds

15%
of survey respondents have a critical dependency on LIBOR for accounting standards

The move to RFRs has the potential to affect expected cash flows for various investment products that previously referenced IBORs. Such changes could have an impact on fund returns, possibly even contributing to performance slippage and impacting performance measurement processes. In response to an Investment Association (IA) member survey, 90 percent of asset managers indicated they use LIBOR as a benchmark for at least one fund.3 LIBOR-based curves are regularly used as an interest rate benchmark in valuations, risk measurements, and pricing and asset allocation models.4

Portfolio hedging will also be affected by the roll-out of RFRs. 80 percent of respondents to the IA survey noted that they use LIBOR-linked derivatives for hedging purposes.5

“Firms will need to consider whether a change in a hedging instrument’s terms will lead to a cessation of the hedge relationship and assess any implications for designated cash flow hedges that hedge LIBOR cash flows beyond transition,” according to a Deloitte report.6

LIBOR is also occasionally incorporated into contracts between fund managers and their third-party service providers.7 Underlining LIBOR’s importance even further, the IA study found that 15 percent of asset managers had a “critical dependency” on LIBOR for accounting standards.8

Concerns are mounting that the adoption of RFRs for legacy IBOR contracts could be interpreted by some counterparties as being a substantial modification, leading to de-recognition of agreements under International Financial Reporting Standards rules.9

Not transitioning exposures to RFRs could result in managers being saddled with illiquid IBOR holdings.10

Asset managers begin the IBOR replacement process

In preparation, asset managers may want to consider reducing their exposures to IBOR assets and start integrating RFRs into their performance calculations and operational processes. While this is reasonably straightforward for new transactions, converting legacy contracts may be more challenging and require repapering. Language in legacy contracts, for example, may not address what firms should do when selecting replacement rates.11

Furthermore, there are language inconsistencies between derivatives and cash products, and occasionally between different cash products themselves.12 Industry groups such as the International Swaps and Derivatives Association (ISDA) and the Alternative Reference Rate Committee (ARRC) in the US are, however, developing fallback provisions for legacy transactions.13  

The next 12 months will be a critical period for asset managers’ IBOR planning. “The key to an effective transition will be a robust governance structure in management companies and across fund boards in order to oversee the coordinated design and implementation of IBOR transition efforts across portfolios. Governance should be under the control of the fund boards, and implementation must be led by asset managers,” according to a report by EY.14

Asset managers may wish to consider the following as part of their IBOR preparations15:

  • IBOR exposure assessment and contract inventory: understand exposures to LIBOR and other IBORs in your portfolio, including exposures to derivatives, loans, bonds and other financial contracts
  • Review of contractual terms: review and create an inventory ofcontracts referencing LIBOR or another IBOR
  • Contract renegotiation: prepare to re-negotiate impacted contracts, if necessary
  • IBOR exposure reduction considerations: consider reducing IBOR exposures by transitioning to RFR products
  • Infrastructure/systems changes: infrastructure adjustments, including technology and data systems may also be needed
  • Treasury process considerations: consider issues related to tax, accounting (including hedge accounting) and corporate treasury issues (funds transfer pricing) particularly if valuation changes are anticipated as a result of the transition from IBORs to RFRs

IBOR reform is a complex process, and its impact will be felt widely. While asset managers may face a number of challenges, transitioning to RFRs in good time will be vital.

You may also like

Sources

  1. EY (November 2018) Why asset managers need to prepare for LIBOR replacement
  2. Deloitte IBOR reform: A new era of benchmark rates
  3. Oliver Wyman (February 2019) LIBOR Transition Roadmap for investment managers
  4. Ibid.
  5. Ibid.
  6. Ibid. Deloitte
  7. Ibid. Oliver Wyman
  8. Ibid.
  9. Ibid. Deloitte
  10. Ibid. Oliver Wyman
  11. EY (August 1, 2019) How to address the legal and contractual challenges of IBOR transition
  12. Ibid.
  13. Ibid.
  14. Ibid. EY (November 2018)
  15. RBC Capital Markets (April 2, 2019) 6 priorities in developing an IBOR transition program