While asset managers may wait for their counterparty banks to navigate them through the transition away from the London Inter-bank Offered Rate (Libor), the buy side cannot afford to be complacent as the rate gets phased out. But in some instances little preparation has been done.
“We’ve been talking to banks primarily but also some fund managers and even within the banks, very few have started doing anything other than their due diligence yet,” says Harry Edwards, partner at Herbert Smith Freehills. “No one that I’m aware of has actually started their outreach program to their clients for the very simple reason that it is not sufficiently certain yet what that language will look like.”
Some asset managers are waiting for direction from their bank, says Robert de Roeck, head of structured solutions at Aberdeen Standard Investments, and member of the Bank of England (BoE)’s working group on sterling risk free rates (RFRs).
“The regulators and central banks are leaning on [investment banks] a little bit to accelerate this evolution, and they should be. I personally am also leaning on banks to ensure that we participate in the discussions and help influence the shape of the new RFR ecosystems.”
Edwards supports that perspective, but says asset managers must be proactive.
“A lot of the conduct risk - at least in the traditional sense - will fall on the banks to ensure that the outreach program is designed with their regulatory obligations in mind,” he says.
“But one can easily see asset managers requiring a very careful and sensible program of their own to make sure that they are not solely reliant on banks to reach out to them and that they understand the effect on contracts and products which they hold on behalf of their customers.”
The UK’s Financial Conduct Authority (FCA) certainly believes the onus is on banks to usher clients to a non-Libor agenda.
“If you are a Libor borrower, you should be expecting your bank to contact you about the change ahead,” said the FCA’s chief executive Andrew Bailey, in a Libor transition briefing in July. “[B]anks should be discussing with you loan products that do not rely on Libor. If you are a bank lending Libor to corporate and retail customers, you should have plans to explain the forthcoming change to your customers and be explaining the potential risks of continuing with Libor,” he said.
De Roeck suggests that while larger asset managers may feel confident about the transition, smaller market participants will need help from their banks and others in the ecosystem.
“When you start drilling down to smaller clients and some of the smaller firms that may have exposure to Libor-referencing instruments, the same level of awareness may not be there. However, addressing this issue is a key focus of regulators, central banks, asset managers and investment banks, each of whom have a role to play in making sure everyone affected is made aware.”
One concern with the transition is the lack of a Sterling Overnight Index Average (Sonia) swaptions market, and the form in which the replacement swaption instruments may arrive on the scene, according to de Roeck.
“It’s all well and good to say, ‘we need to mitigate the risks and remove exposures to Sterling Libor swaptions.’ But what are we going to move into? Until there is clarity on the specifics of pricing and risk profiles of the new Sonia-based swaption replacement, it is very difficult to do anything,” he says.
But while the shift away from the traditional interest rate is occurring, a move by regulators to start engaging with the buy-side will be necessary in the coming months to ensure a complete transition, according to Edwards.
“The banks can identify the clients they need to reach out to and decide what they will reach out to them with. But, if the clients aren’t ready to engage, to understand what’s going on, and to take a view on what is being proposed to them so that they can conclude any amendments to the contracts as necessary, it is not going to get over the line in time,” he says.
For Agathi Pafili, senior regulatory adviser at the European Fund and Asset Management Association (Efama), and member of the European Central Bank (ECB)’s euro risk-free rate working group a key challenge for some asset managers lies in the publication of net asset value (NAV).
“What may be problematic is the publication time of the NAV being very close to that of the new risk-free rates. This can be problematic as it is not materially possible to delay publication of NAV. For the time being it seems difficult to understand and preempt what the right solution would be there,” says Pafili.
In February, the European Commission announced a two year extension for administrators of critical and non-critical non-EU benchmarks to comply with its Benchmark Regulation (BMR).
The two year extension has also added to the complexity firms face as they will now have to keep an eye on whether index providers are authorized under the rules, according to Gareth Parker, a consultant on benchmark and index regulatory affairs at Bovill.
“It is quite an astonishing situation in that the EU is now requiring EU index providers to be regulated from the end of this year, but they are actually now saying that all of the ones that they have no control over and don’t really know what is going on with them, rather than saying that they also want those guys to be ready they’ve actually given them an additional two years,” says Parker. “So, they are disadvantaging EU index providers against non-EU index providers which is not what I thought I would ever see a regulator do to his own market.”
Efama’s Pafili says the change in deadline was necessary as the previous one would have been “impossible” to meet.
“I can understand in theory the argument of lack of level playing field,” says Pafili. ”However, in practice Efama has been supportive of this decision for the extension of the transitional period for third country benchmarks and critical benchmarks, because what lies behind this decision was the need to face in an urgent way a key challenge. In the absence of equivalent non-EU regulatory frameworks and of well-established RFRs asking users to shift as of the end of this year to new RFRs or to quit third country benchmarks that are currently in use would have been a requirement practically impossible to meet.”
But the greater possibility of a no-deal Brexit could complicate things further as index providers prepare to comply with two sets of benchmark regulations with different timelines, according to Parker.
“If you are using any indices within the EU and the probably within the UK as well you are going to have to keep track of whether the administrators have got those authorizations yet because as the user of the indices you are not allowed to continue using them as a reference for calculating a performance, or you can’t use them for creating an ETF or all of the rest of these things. You cannot use them unless the administrator gets itself regulated under both of those regulations by the end of the transition,” says Parker.
On July 12, the US Securities Exchange Commission (SEC) said its staff was monitoring whether the lack of a dominant successor for the US dollar Libor replacement could “limit the effectiveness of all replacement benchmarks.”
For markets choosing to reference Sofr the lack of data continues to remain of concern, according to Matthew Horton, head of interest rates at ICE Futures Europe.
“One can proxy the Sofr rate by looking at other repo-based rates but therein lies the challenge,” says Horton. “Sofr is a new rate and being a secured rate, it has a different dynamic than an unsecured rate. This is the thing that people are trying to get comfortable with - the impact of having a secured rate and essentially no data set to look at how this has behaved previously.”
For Brian Dunton head of instrument engineering at Eagle Investment Systems, reliance on Isda’s protocol - which is to be announced later this year - will be necessary to ensure standardization of calculations.
“For a fintech company getting that compounding correct is essential and realizing that it is not only going to impact swaps and other derivatives, it is going to have a massive impact for bonds, all floating rate bonds, mortgage backed securities, syndicated loans, there is so much uncertainty about what happens to an existing loan that investors invested in given the certain conditions of that loan,” says Dunton.
“I haven’t seen [asset managers] doing anything yet, but they will soon as the number of even just bonds, floating rate notes starts to increase exponentially. I would say the major challenge facing them is adequately preparing for this due to the fact that many systems do not have the specific compounding calculation built in.”