Moving Away From Interbank Overnight Rates (IBORS) to Better Rate Benchmarks
An Update and Frequently Asked Questions on the IBOR Transition
Cases of benchmark manipulation, such as LIBOR, have been occurring since 2012. Failures in, or doubts about, the accuracy and integrity of indices used as benchmarks can undermine market confidence, cause losses to consumers and investors, and distort the real economy. For these reasons, regulators around the world have decided to move away from IBOR-type rates, such as LIBOR and EURIBOR, to ensure the accuracy, robustness, and integrity of benchmarks and their determination process.
The pricing of a vast number of financial instruments and contracts depends on the accuracy and integrity of IBOR-type interest rate benchmarks such as LIBOR and EURIBOR. In 2019, U.S. dollar LIBOR underpinned contracts affecting banking institutions, asset managers, insurance companies and non-financial corporates, totalling approximately $350 trillion globally, on a gross notional basis. The financial industry also relies on these benchmarks for measuring the performance of investment funds, determining the asset allocation of a portfolio, computing performance fees, and underscoring the overall smooth functioning of markets.
The weak spot of LIBOR was that the panel of banks submitting rates was not asked to submit rates of actual inter-bank deposit market transactions, but rather their estimates of such transactions. This, together with the weak governance of the panel, allowed serious manipulations to take place. Global reforms on benchmark rates have focused on requiring panel banks to provide submissions based on actual transactions, to keep records of those transactions, and to publish their LIBOR submissions after a certain time. Criminal sanctions would be introduced specifically for the manipulation of benchmark interest rates. These reforms started in 2014 and introduced benchmark rates fully or partially based on actual transaction data, and the record-keeping requirements as well as criminal sanctions for manipulation were also introduced.
With the reform of benchmark rates largely concluded, authorities and practitioners shifted their focus to ensuring a smooth transition to the new rates from the current set of IBORs (the new benchmark rates are called the SOFR in the U.S., €STR in the EU, SONIA in the U.K. and TIBOR in Japan), for example by making sure financial institutions were actively preparing for the cessation of LIBOR. This global effort gathered pace when the Financial Conduct Authority, the U.K. regulator tasked with overseeing LIBOR, announced that it would stop requiring LIBOR submissions from banks by the end of 2021, effectively phasing out this benchmark rate.
Ensuring a Smooth Transition
Practitioners and authorities have been working to tackle the economic, legal, operational, and reputational risks implied with switching the reference rate in hundreds of thousands of contracts, issuing new contracts based on LIBOR, and updating risk management and IT procedures, to ensure a smooth transition.
In cases where banks continue to use LIBOR in newly issued contracts, their ability to function smoothly once LIBOR is discontinued will depend on clear fallback language that determines how the replacement of a discontinued rate would be handled. Updating existing contracts to include fallback language, or directly adjusting contracts to reference a new benchmark rate, may trigger a reassessment of the instrument under prevailing accounting standards. Any revaluation or reclassification of assets or liabilities that result from such a reassessment of contracts could have various impacts on the financial statements of banks. It could also trigger legal action from counterparties.
This also has implications for buy-side firms, as new reference rates will have different values from the discontinued ones, triggering revaluations and cash flow adjustments. Given the size of the exposure to LIBOR, even the difference of a few basis points between the discontinued rate and the replacement rate could have a substantial impact on the value of contracts. Internal valuation models will need to be recalibrated on replacement rates. Asset managers will also need to establish where LIBOR has been used and determine how to deal with the valuation changes in an orderly manner. “Re-papering” contracts to integrate replacement rates requires substantial administrative work for asset managers—investment management agreements, as well as other fund documentation, often reference LIBOR for benchmarking purposes.
Aside from contract changes, asset managers as well as banks will need to make adjustments to their risk management frameworks. Internal risk models make ample use of LIBOR; thus, once these are discontinued, models will have to adapt.
Hedging is another side of the risk management process that will be impacted. Several common hedging instruments such as swaps and forwards currently have the floating leg rate referencing LIBOR. With their discontinuation, questions around the availability and liquidity of alternative hedging instruments could arise, and hedging strategies may be impaired.
In order to have fully functional markets for instruments referencing the replacement rates, market liquidity and demand for such instruments must grow from their current, relatively low levels. In the U.S., this has been the focus of the Alternative Reference Rates Committee (ARRC), a group of private-market participants convened by the Federal Reserve Board and the New York Fed to help ensure a successful transition from US dollar LIBOR to SOFR.
In March 2021, the FCA agreed to extend the life of USD LIBOR (in most tenors) to June 2023. In response the United States Congress passed the Adjustable Interest Rate (LIBOR) Act (the “LIBOR Act”) which was signed into law by President Biden on March 15, 2022. The LIBOR Act applies to contracts governed by US law that lack clearly defined fallback provisions and offer these assets a process to transition to SOFR. This effectively allows for the automatic transition of so-called “tough legacy” contracts and also limits litigation rights for asset holders and by offering issuers safe harbor provisions for the transition to SOFR.
For non-US law governed USD LIBOR products, the UK Financial Conduct Authority (“FCA”) announced in April 2023 that it would require publication of Synthetic LIBOR until September 30, 2024. Synthetic LIBOR will be equal to SOFR plus the applicable ISDA/ARRC credit spread adjustment. The publication of Synthetic LIBOR will allow non-US law governed USD LIBOR products that lack fallback provisions additional time to transition to a replacement rate.
With the successful completion of the GBP LIBOR transition, Barings is now focused on the USD LIBOR transition.
Frequently Asked Questions:
1. What is Barings doing to prepare for the USD LIBOR transition?
Barings’ large investment footprint, particularly in areas such as High Yield and Private Debt, in parallel to the work we are doing with industry bodies including the Loan Market Association and the Loan Syndications and Trading Association, means we are fully apprised of the impact the transition will have on both investments and portfolios. Investors can remain confident that we are well-positioned to prepare for an orderly transition.
Barings established a LIBOR Transition Steering Committee in Q4 2018, with the objective of monitoring market and regulatory developments, and assessing the impact of the change on our clients and our business operations. The Steering Committee is comprised of functional heads from across the business, including Investment, Operations, Distribution, Legal and Risk Management, and is overseen by Barings’ Head of Global Asset Services and the Executive Leadership Team.
In 2019, Barings developed a Transition Plan to identify, measure, monitor and manage all financial and non-financial risks of the transition from LIBOR to alternate rates. It identified the work streams and resources needed to plan for, and execute ahead of, the transition.
As a result, the Barings LIBOR Transition program created an inventory of the products, assets and technology systems Barings is responsible for, assessed the impact of LIBOR transition and put in place the technology and operational processes to transition them.
Barings’ objective was to transition all LIBOR benchmarked products to new rates by the end of 2021, and it accomplished this for all but five portfolios, where the underlying client preferred to transition at a later date.
2. Is there an expected alternate rate in the market? How is Barings analyzing and assessing the impact of alternative rates?
Alternative Risk-Free Rates (RFRs) to LIBOR have been proposed by the central banks and regulators in each of the key geographical areas. These are:
- USD: The Alternative Reference Rates Committee (ARRC) has indicated that the new USD risk free rate will be SOFR (Secured Overnight Finance Rate), a rate based on overnight Treasury Repo rates. Trading in SOFR Futures and un-cleared Overnight Index Swaps referencing SOFR began at the end of 2018.
3. Do Barings’ funds hold any assets which don’t have documented fallback provisions?
In recent years it has become standard practice in debt documents to have some fallback language addressing the potential to transition to a replacement rate in the event that LIBOR is no longer used. Even prior to the introduction of specific language covering this topic, most credit agreements would contain language around the switch to a base or prime rate if LIBOR was unavailable for any reason.
Barings engaged PWC to review the strength of each asset’s contractual fallback language and agreed a transition risk rating for that asset. Barings has risk rated loans on-boarded subsequently, excepting assets originated in 2019 or later, as these assets generally had good fallbacks in place already. The focus in late 2021 was to ensure that GBP LIBOR assets had good fallback language, so their eventual transition would create as little uncertainty as possible and to minimize the risk that any GBP LIBOR asset could inadvertently fall back to a fixed rate.
Following the introduction of the Safe Harbor legislation, the Barings assessed fallback risk rating effectively became redundant and as a result it was determined that Barings will not capture it anymore.
Instead, this indicates that the directive action Barings could take regarding the USD LIBOR book could be to influence the transition timing in some instances, concentrating on timely outreach to Issuers and ensuring any refinancing includes strong fallback language.
4. For loans, who will lead the process to amend the contract of existing investments where a fallback provision is not included?
The Agent and the Borrower will typically lead the process, as generally the fallback provisions require both the Agent and Borrower to agree on a replacement rate. In some cases, Lenders may be required, or have a right, to object.
5. What is Barings doing to manage the LIBOR exposure in impacted funds?
For public assets there is little to no action to take on individual assets. The knowledge of a change in rate in advance of actual transition would be material non-public information that the public teams would not have access to. For public assets we are generally “takers” of a transition.
For private assets, our deal teams who are responsible for the underwriting and monitoring of the assets are tracking the SOFR and LIBOR status. Where Barings is the agent, we are working with the Borrowers to transition to SOFR as amendments come up. We believe there are a limited number of assets where Barings is the agent and we don’t have ARRC hardwired transition language (meaning if there is no active amendment before June 30th, we naturally roll to SOFR on the next interest rate contract request). The Deal teams are targeting the Barings agented deals that don’t have hardwired language to work through the amendments. For deals where Barings is not the Agent, we will need to wait for the Borrowers and Agent to work through the plan, but the same fact set exists here where many of those assets have ARRC hardwired transition language.