Read the article and learn about:
- The implications of the (L)IBOR reform and its specific challenges for buy-side firms
- The economic risks facing buy-side firms in connection with the transition of IBORs
- Recommended actions for buy-side firms
From the end of 2021, most Interbank Offered Rates (IBORs) will be phased out by regulators and replaced by new alternative reference rates (ARR). This has significant consequences for most investment management firms, with many implications only just emerging. Understanding the impact for each firm and taking the right actions will require a structured and cross-organizational analysis and change process under appropriate executive ownership, which addresses some essential questions. This article takes a closer look at the changes, implications, and recommended actions for firms impacted.
For more than 40 years, Interbank Offered Rates (IBORs), especially LIBOR as well as EURIBOR, have set the benchmark rate for lending on an unsecured basis, underpinning the worldwide trade in financial products from bonds and loans to derivatives and mortgage-backed securities.
However, a series of scandals has sealed the fate of the once dominant IBOR benchmark, including a group of banks being accused of manipulating their IBOR submissions during the financial crisis. To address the shortcomings of IBORs, IOSCO published the Principles for Financial Benchmarks1 in July 2013 to address conflicts of interest, etc. In September 2013, G20 leaders endorsed these principles as global standard.
Multiple regulatory-driven actions have followed, for instance the European Benchmark regulation2, which recognizes major interest rate benchmarks (such as LIBOR, EURIBOR, EONIA, …) as critical benchmarks3 and requires these to be robust, reliable, resilient, and always possible to calculate, without compromising their integrity.
Integrity especially has become important, illustrated by the three-month US dollar LIBOR, the most heavily referenced IBOR benchmark. It is supported by less than $1 billion in transactions per day and has seen a sharp decrease in number of participants within the IBOR panels, diluting IBOR’s relevance and resilience.
Given these facts, regulators and market participants agree that financial products need to transition to new alternative (ARR) / risk free (RFR) reference rates based upon real transactions. Working groups have been set up globally to determine these new rates and guide the market on the transition path (see Appendix 1).
Geographical differences in the transition
Both the UK and US plan to phase out LIBOR and transition to a new benchmark by the end of 2021. In the EU, the situation has evolved differently. The European regulators had an aggressive plan for the transition, but has recently allowed all critical benchmarks two more years to become compliant. This “safety net” for EURIBOR4 was given due to uncertainty around whether the new hybrid methodology will be sufficiently robust and ready in time5. Uncertainty also exists given the fact that another bank stepped down from the EURIBOR panel recently6.
What does the reform mean for buy-side firms?
As the reform affects all instrument classes, the market impact will be substantial. Directly impacted instruments are those that refer directly to one of the affected interest rate benchmarks and will need to change in terms but also in respect of their contractual foundation (e.g. derivatives, floating rate notes, and loans). Indirectly impacted instruments are those using interest rate benchmarks for FX forward calculations or discounting.
As FRN and derivatives are the most impacted instrument classes, next to loans, all buy-side firms will be impacted within their investment portfolios. The impact can be classified into four main areas:
1. Portfolio valuation and benchmarks
Many fixed income funds are benchmarked against (L)IBOR rates or include (L)IBOR rates against which not only performance but also management fees are measured. Any change to the benchmarks can potentially affect the fee incomes.