Come the end of 2021, LIBOR (London Interbank Offered Rate), the leading benchmark used to calculate interest on $350 trillion + of financial products, will be replaced with an alternative risk-free rate known as SONIA (Sterling Overnight Interbank Average) in the UK. Other markets are also following suit by transitioning away from LIBOR including the US (shifting to Secured Overnight Financing Rate); Japan (Tokyo Overnight Average Rate), the European Union (Euro-Short Term Rate) and Switzerland (Swiss Average Rate Overnight). This changeover to risk free rates will impact any investor transacting in debt instruments such as bonds, securitisations, corporate loans and syndicated loans. It will also affect financial institutions trading derivatives. As a result, the LIBOR reforms will be felt extensively across the financial services industry, including at fund managers.
Digesting the impact on investments
LIBOR reform will have a dramatic impact on asset managers’ investments and hedging activities. As a number of financial instruments use LIBOR as a reference rate, the transition to risk free rates could have a material impact on asset managers’ performance and risk management. Over the last 12-18 months, asset managers have been going through their portfolios and carefully identifying any underlying exposures they may have which are tied to LIBOR. As nobody ever imagined LIBOR would become redundant, many organisations have been busily repapering their legacy derivative and bond contracts. The derivatives industry has made excellent progress on developing fallback language for new and legacy contracts. In January 2021, the International Swaps and Derivatives Association (ISDA) language on IBOR fallbacks went live. This will apply as the standard arrangement in all new ISDA interest rate derivatives referencing LIBOR, and will take effect in all outstanding covered ISDA contracts where both counterparties to the transaction have signed the ISDA protocol. This means the contracts will convert from LIBOR to a fallback rate based on a chosen risk-free rate.
In the case of repapering legacy bonds, the situation is more complicated for asset managers. According to the International Capital Market Association (ICMA), the value of outstanding legacy bonds referencing LIBOR - which are due to mature beyond 2021 – totals $864 billion. Of this, 80% are denominated in USD and 9% in GBP Sterling. So why is it so difficult to repaper bonds? Under English common law, amendments to interest rate terms on bond contracts requires consent from at least 75% of the holders of the outstanding principal amount of the bonds. This is a high threshold, so revising legacy contracts will take time. Additionally, unlike a derivative transaction where there are two counterparties to a trade, bonds have multiple subscribers meaning it will be harder to reach consensus. However, repapering is something fund managers need to be prioritising.
Get ready for risk-free rates
Regulators, including the UK Financial Conduct Authority (FCA) have made it clear that they expect asset managers to be using the new rates by the end of this calendar year, despite all of the disruption being caused by COVID-19. Repapering of legacy contracts will be vital in ensuring compliance with this new regulatory requirement.
Further on March 3rd, 2021, the Securities and Exchange Commission’s Division of Examinations announced its 2021 examination priorities, indicating the Division will continue to engage with registrants thorough examinations to assess their understanding of any exposure to LIBOR, their preparations for the expected discontinuation of LIBOR and the transition to an alternative reference rate, in connection with registrants’ own financial matters and those of their clients and customers.
With the reality settling in that LIBOR reforms will have an extensive impact across the financial services industry; fund managers need to be prepared. Portfolio BI is here to help.