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 U.S. dollar LIBOR to SOFR. The European Central Bank, the Bank of England and the private market participant groups they chair are pushing in the same direction, but incentives to leave well-established rates and practices and embark in costly reorganizations may vary. A potential scenario that could arise at the end of 2021 is that LIBOR is discontinued and no liquid markets exist for all the currently available instruments referencing LIBOR.
It remains to be seen to what extent existing contracts for products referencing LIBOR adequately account for the possibility that LIBOR may be discontinued. While regulators and practitioners recognise that solid fallback language is needed to ensure that legal, regulatory and economic issues do not affect vast ranges of contracts in the balance sheet of financial institutions, the degree to which such fallback language is included in contracts, and to which counterparties are aware of it, is not clear.
Frequently Asked Questions:
What is Barings doing to prepare for the 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 identifies the work streams and resources needed to plan for, and execute ahead of, the transition. It is continually reviewed against market developments and enhanced as we move further through the planning stage and into delivery of the technical and operational stages.
Detailed impact analysis of the transition across Barings’ client base and business operations, combined with our strong integration with regulatory and industry working groups, will inform our view on when to transition specific instruments and portfolios. More detailed discussions are forecast to take place at the end of 2020 and into early 2021, linked to the market addressing questions such as the tax implications of transitioning certain asset classes, regulatory guidance on a suitable approach to so-called “tough legacy” assets and asset issuers triggering the transition of instruments.
Once the new term rate calculations are agreed in the market, Barings will propose replacement benchmarks for its products and engage with clients and distributers, before executing the agreed changes. These will include amending IMAs, notifying regulators and managing investor communications.
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.
- GBP: The Bank of England and the FCA have indicated that the new Sterling risk free rate will be SONIA (reformed Sterling Overnight Index Average), based on unsecured overnight Sterling transactions first established in 2007. There is currently a market for SONIA-linked Swaps and it is used as the alternative RFR for Sterling Overnight Index Swaps.
- EUR: The European Central Bank has indicated the new rate will be ESTER (European Short Term Rate) which started trading in October 2019. It is based on transaction data collected by the ECB on the daily unsecured money market trading from the 52 largest euro area banks.
As this transition is market-led, rather than regulatory-led, it is currently unknown if the proposed alternatives will be fully adopted by all markets in a jurisdiction, or if other competing replacement rates for specific asset classes may emerge. In any case, it will be the decision of each portfolio manager to suggest the most appropriate new benchmark for a fund or mandate.
Barings has engaged with a third party and is completing a deep-dive to analyze the potential alternative rates in the context of the contracts underlying the individual assets it holds, and to characterize the risks each contract describes.
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 has completed a review of the contracts underpinning every asset it holds on behalf of its clients, across major currencies, and has recorded the fallback position for each asset type. This review informs Barings’ investment teams’ view on how to transition specific instruments and portfolios. These discussions will be linked to the development of new, suitably liquid instruments and markets. The transition will include a balanced consideration of the existing fallback provisions for each instrument, industry progress in finding a transition-solution for existing instruments, and the development of suitably liquid alternatives.
In the event that fallback provisions are not present, the relevant investment teams will evaluate the appropriate steps on an asset-by-asset basis.
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.
What is Barings doing to manage the LIBOR exposure in impacted funds?
Barings is completing a review of the full set of contracts for impacted assets that it holds on behalf of our clients, in order to identify potential areas of focus. This review is scheduled to be completed by the end of Q2 2020.
The Alternative Reference Rates Committee (ARRC)1 released fallback language for asset classes including floating rate notes, syndicated loans, securitization and adjustable rate mortgages in 2019. Barings has since been applying this language to new asset contracts, aiming to actively reduce risk ahead of the transition.
A particular area of focus for Barings is on the development in the markets of a consistent approach to managing a potential mismatch between benchmarks referenced in the contract for a particular asset class, versus the benchmark used in the derivatives which hedge that exposure.
We expect the exposure of equity portfolios to LIBOR to be less than other asset classes. However, Barings is completing a review of the complete set of contracts for each equity asset it holds on behalf of clients.
1. ARRC is a group of private-market participants convened by the Federal Reserve Board and the New York Fed to help ensure a successful transition away from LIBOR.