By the end of June 2023, banks will no longer be required to publish rates used to calculate the U.S. Dollar London Interbank Offered Rate (LIBOR) for any tenor. All companies that trade derivatives or hold LIBOR-based securities will be affected. The volume of USD LIBOR legacy products is far greater than for other currencies already transitioned. This article highlights several industry-specific areas of focus for transition planning.
Asset managers and investment companies face special challenges because in addition to holding substantial investment portfolios, they have industry performance metrics, rankings, and compensation criteria that may be tied to a LIBOR metric. Planning considerations likely will be different for institutional versus retail customers. Asset managers rely on a range of external organizations, from custodians and administrators to pricing vendors, co-investors, and sub-advisors, which will need to be closely coordinated during the transition to new reference rates.
Inadequate or delayed transition plans carry several substantial risks. Clear and timely communication is required to address reputation risk for relationships with clients, regulators, custodians, and administrators. Firms can face commercial risk if they do not update investment strategies appropriately. Failure to coordinate third-party interactions and technology dependencies could result in operational risk. Accurate review and update of the full population of affected contracts can help avoid legal and regulatory risk.
Work Plan
- Mobilize a project team with dedicated resources to address transition.
- Inventory existing exposures. Track and group securities and contracts by existing fallback language and determine which terms need alteration. See Appendix A for a list of potential credit product securities.
- Includes Alternative Reference Rates Committee (ARRC)-recommended hardwired fallback language or other hardwired language that will fall back to the Secured Overnight Financing Rate or some other specific non-LIBOR rate
- Has a determining person who will select the replacement rate rather than a hardwired fallback. Ensure you understand who the determining person is for each contract; for example, it may be the issuer, calculation agent, or trustee. If the determining person has not disclosed their planned selection, follow up to determine if the party (a) agrees that they serve in this role under the terms of the contract, (b) intends to fulfill the responsibility of selecting a replacement rate, and (c) can communicate the nature of the replacement rate they expect to select and when they intend to formally select the replacement rate
- Has no fallback language, or fallback language that only refers to a previous LIBOR setting or a dealer poll (or surveys or inquiries for quotes or information) on interbank rates
- Assess contracts. USD LIBOR securities and contracts should be reviewed with legal counsel, including but not limited to the trigger events, fallback language, and legal jurisdiction the contract is governed under.
- Develop a strategy for new exposures. New contracts may be able to take advantage of fallback language that various industry groups are currently proposing. Consider when the investment manager should cease buying or offering LIBOR assets. Transition to new non-LIBOR products when there is sufficient liquidity. Test to help ensure all operations and systems can accommodate new products.
- Identify the businesses, functions, models, processes, and systems that use LIBOR. Determine needed changes to infrastructure, trading, pricing, and analytical systems, as well as risk and financial reporting systems with long lead times for remediation. This review should include third-party affiliates such as custodians, fund administrators, and market data providers.
- Develop internal and external communications. Engage with working groups and industry bodies as well as clients. Inform clients, directors, staff, suppliers, and other stakeholders about the transition, tailoring discrete messages for institutional and retail customers, and update these communications as the switch unfolds.
- Consider taxes. Asset managers should assess any tax implications and potential relief that could arise regarding hedging strategies.
- Evaluate benchmarks. Investment advisors may use LIBOR as a benchmark or target for funds that also may be linked to performance fees. The benchmarks will need to be transitioned in a way that is comparable to existing benchmarks to avoid the appearance of inflating measured performance. Asset managers will need to first identify all funds and mandates benchmarked to LIBOR and will need to work with the broader industry to align on new measures.
- Identify any potential conflicts of interest. Asset managers have fiduciary responsibilities to their investors. It will be important to identify and manage any potential or perceived conflicts of interest, such as interfund transactions or lending or fee arrangements between funds and managers.
SEC Statement
On December 7, 2021, the SEC issued a statement to remind investment professionals of their obligations when recommending LIBOR-based securities or investment strategies involving other LIBOR-linked investments such as interest rate swaps, municipal securities, or securitizations.
Investment advisers and funds should consider their obligations under the Investment Advisers Act of 1940 (Advisers Act) and Investment Company Act of 1940 related to LIBOR-linked securities. Investment advisers, including advisers to funds, have a fiduciary duty under the Advisers Act to act in their clients’ best interest, including duties of care and loyalty. Investment advisers should consider whether any advice on LIBOR-linked investments and applicable risks is consistent with their clients’ goals. Because the LIBOR cessation is likely to materially change the nature of certain investments, unless an adviser does not have an obligation to monitor, advisers should consider whether any LIBOR-linked investments they have recommended that clients purchase or continue to hold remain in the clients’ best interest. Investment advisers should consider whether those investments have robust fallback language. Where fallback language references an alternative rate, advisers should consider whether any economic differences arising from the use of an alternative rate could cause the investment to depart from their clients’ strategy or risk tolerance.
Registered investment companies and business development companies should consider their disclosure obligations related to LIBOR. These funds are required to disclose their principal risks in their prospectuses. These risks will depend on the fund’s investment objective(s), holdings, investment strategies, and structure. Private fund advisers also must state all material facts necessary to make the statements made to any investor or prospective investor in the fund not misleading. If a fund invests a significant portion of its assets in LIBOR-linked investments, it should disclose any principal risks related to the potential cessation of LIBOR, as well as the anticipated impact and expected impact timing on those investments, including volatility, value, and liquidity.
Valuations using LIBOR as an input are likely to be affected in a variety of ways by the transition to an alternative reference rate. Advisers, funds, and fund boards should be aware of any valuation risk and effects on valuation inputs and assumptions associated with LIBOR transition.
Funds and advisers should monitor and manage any transition conflicts of interest, including disclosure and other legal obligations relating to performance fees. Some advisers and funds charge clients or investors a performance fee that is subject to a hurdle rate, which is the minimum return necessary for the adviser to start collecting the performance fee. Many hurdle rates are tied to a benchmark rate, such as LIBOR, or to an index that may contain LIBOR-linked securities. Advisers and funds should consider clearly disclosing how the benchmark rate will transition to a different one in advance of the LIBOR transition, including if the transition to a new rate could make it easier to earn a performance fee.
Investment advisers and funds should be aware of LIBOR transition-related operational complexities that may require market participants (including investment advisers, funds, and their key service providers) to make significant changes to their operational processes and IT systems, which could take a significant amount of time to complete. Advance coordination with other market participants on methods and timing to communicate changes to the terms of each LIBOR-linked investment held will be critical to successfully navigate the transition.
Conclusion
The transition away from LIBOR will be complicated and likely will require significant hours to implement correctly for companies with a large volume of contracts. By taking steps to identify and mitigate risks early, institutions will be better prepared to address potential risks that may arise from the LIBOR transition.
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Appendix A
| Credit Products That Reference Interest Rate Benchmarks | ||
|---|---|---|
| Credit Products | ||
| Loans |
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| Structured Products |
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| Short-Term Money Markets |
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| Bond Other |
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Appendix B – ARRC Legacy Playbook
| Anticipated Status of Different Broad Categories of USD LIBOR Contracts After June 30, 20231 | |||
|---|---|---|---|
| Trigger Events/Governing Law: | |||
| Fallback Type: | Precessation Trigger Included | No Precessation Trigger, Contract Under U.S. Law | No Precessation Trigger, Contract Under Foreign Law |
| Hardwired fallback to ARRC recommended or other specific rate | Contract will move to ARRC recommended or other specified hardwired replacement after June 30, 2023 | Contract may reference synthetic LIBOR, if published, until LIBOR ceases publication, then move to the hardwired replacement rate | Contract likely to reference synthetic LIBOR, if published, until LIBOR ceases publication, then to move to the specified replacement rate |
| Fallback to be selected by a Determining Person | Contract will move to rate selected by Determining Person after June 30, 2023 or to the Fed selected replacement if the Determining Person does not choose any replacement | Contract will move to Fed selected replacement after June 30, 2023 if Determining Person chooses it or does not choose any replacement, but may remain on synthetic LIBOR, if published, otherwise, until LIBOR ceases publication and then move to the rate selected by the Determining Person | Contract likely to reference synthetic LIBOR, if published, until LIBOR ceases publication, then to move to rate selected by Determining Person |
| No fallback, or only references to dealer polls or previously published LIBOR values | Contract will move to Fed selected replacement after June 30, 2023 | Contract will move to Fed selected replacement after June 30, 2023 | Contract likely to reference synthetic LIBOR, if published, until LIBOR ceases publication, then may convert to fixed rate (if a previous LIBOR value is referenced) or may be subject to legal uncertainty |
Source: “LIBOR Legacy Playbook,” newyorkfed.org, July 11, 2022
- 1Specific outcomes will depend on the precise details of any given contract and the laws it is under; market participants should consult with their legal advisors to understand the exact nature of each contract they are a party to.