What does the end of LIBOR mean for investment managers?
In July 2017, the UK’s FCA (Financial Conduct Authority) announced that the interest rate benchmark LIBOR would be phased out by the end of 2021. Since the FCA announcement, regulators and market participants have worked on plans to transition to new alternative reference rates before the deadline.
This transition presents several challenges for investment managers:
Portfolio exposure. Most investment managers have LIBOR-based products in their portfolios: not just derivatives such as interest rate or inflation swaps, which are frequently used for hedging, but also many floating rate cash securities including FRNs and ABS. What happens to these contracts when LIBOR ends? Right now, the options are to negotiate with brokers to transition LIBOR-based contracts to alternative rates – or to passively rely on fallback methodology. Because the terms of contracts will be changed, exposures on these products could trigger huge changes to the value and risk of portfolios. LIBOR-based products in investment portfolios therefore need careful monitoring.
Changes to pricing and risk methodology. When investment managers switch to new reference rate products, investors will have to update their systems to cope with new calculations. This also leads to changes in pricing methodology and risk management. LIBOR-based curves are commonly used for discounting and valuation. Sometimes the LIBOR curve is required by the regulator: EIOPA (European Insurance and Occupational Pensions Authority) sets the yield curve to discount the insurance liability based on LIBOR. The new directives should be given to the insurance asset managers before 2021. Market risk calculations too, generally use LIBOR as the risk factor for VaR and stress test computations. These, together with risk scenario computations, should be switched to new reference rates.
Fee calculations. LIBOR is also used as a performance benchmark by a large set of investment funds, which sometimes impacts performance fee calculations. Investment managers should transition these benchmarks and fee structures to new rates and agree with investors on the substitution.
Third-party agreements. Other third parties for the investment manager – custodian, fund administrator, broker, may also use LIBOR as an input to the service they provide. These terms should be reviewed and agreed by all the parties to minimize the economic impact.
Operations and IT. Updated systems and processes are required to ensure that the trading, position keeping and product lifecycle management can be handled correctly with the new market conventions.
So for investment managers, there is a lot of work to do to ensure a seamless transition to the post-LIBOR world. However, good planning and active preparation will help to mitigate the economic, operational, regulatory and legal risks.
To find out more about how we can help you prepare for the LIBOR transition, please visit finastra.com/life-after-libor or for more information on Fusion Invest, our investment management solution, click here.