On July 13, 2020 the Bank of England (BoE) published its ‘Libor: Entering the Endgame’ speech by Governor, Andrew Bailey, where the importance of transitioning off the London InterBank Offer Rate (LIBOR) was again emphasised.
This follows from the FCA letter sent earlier in the year to asset managers noting the regulator’s expectations for preparations for LIBOR transition due to take place in December 2021. Buyside firms are already identifying operational and technology challenges to the inevitable move away from LIBOR to calculated risk free rates (RFRs). The major challenges are being felt in performance and risk calcs, liquidity, and operational risk.
In this piece we take a look at the challenges the transition could present to the buyside, regulatory considerations and how flexible architecture could present a solution to mitigating some of these challenges.
The LIBOR transition presents risk to all areas of the buyside across client portfolios, operational risk, conduct risk and legal risk. Regulators have pointed out a number of preparatory considerations:
- Replacement: Any reference to LIBOR in benchmarks or performance fees and any funding arrangements based on LIBOR should have a robust plan for transition or be in the process of being transitioned. Where this is not possible firms should have an understanding of the fallback provisions enhancing them as required. Trade documentation and master agreements in particular can contain terms that explain what would happen if LIBOR became unavailable; these are often referred to as ‘fallbacks’.
- Liquidity in LIBOR will gradually dry up, so asset managers should consider their fiduciary duty to clients and the enhanced holding risk around cut-over to new rates. Evidencing the timing and rationale for transition (and recording this ex-post) will be crucial given the likely volatility of spreads over time.
- Communication and Disclosures of the risk of cessation of LIBOR should be included in products being sold which have a LIBOR reference (such as in prospectuses or other documentation). Importantly brokers and the sell-side should also be communicating the risks around continued LIBOR use.
- Conduct Risk: Regulators have been clear on the conduct risks around transition. This includes moving the fund and client exposure to the new reference products and managing the liquidity, switching and re-hedging process in a fair and transparent manner, with appropriate disclosures and audit trail. For example, there is potential that switching to a new reference rate could give rise to confusion around performance. Equally, the buy side should be mindful of triggering performance-based fees that are unjustified.
- Documentation may all contain references to LIBOR including marketing materials, fund documentation, investor master agreements, and prospectuses among others. For standardised contracts, such as those covered under International Swaps Derivatives Association (ISDA), market participants may rely on replacement language delivered via the ISDA protocols but for other non-standard contracts there may be a need to bilaterally negotiate the fall-back provisions with clients and counterparties.
- System upgrades and operational changes: We have observed that some technologies struggle to easily process the significantly increased calculations that arise from the overnight interest (OIS) fixings and curve build. Additionally, many systems are incapable of maintaining dual fixing indices per currency, and still others cannot recalculate positions dated prior to cutover or simulate the expected volatility in liquidity and spreads. Upgrading systems now to be able to handle the level of computation and to control and analyse across indices will be key to ensuring a smooth transition.
Mitigating risk with flexible architecture
Funds should look to flexible architecture to mitigate LIBOR transition risk and enhance their audit capability. When selecting any system, look for a solution that can help with:
- Controlling the cutover to RFRs, rather than relying on counterparties/the sell side. Firms want market data connectivity, models, and the analytics ruleset to allow them to run all investment data sources concurrently and compare the risk and P&L on any given date with any given inputs.
- Simulation: Analytics to create what-if scenarios and simulations that model the liquidity and price volatility around cutover and its impact on portfolios.
- Audit capability: A bi-temporal and immutable data store ensures valuations and risk results can always be recreated, even if subsequent data has overwritten positions and market inputs. Bi-temporality is a way of storing information, where each piece of data is captured with two datetime values: One for when you know it, and one for when it is valid.
- Control: The ability to partition and entitle investment data enables all sources to be elegantly partitioned and controlled for access and to prevent misreporting.
- Curve switching and the ability to run valuation and risk reconciliation with different models and curve builds. Asset managers can build a smooth curve with daily discounting and review pricing anomalies in the current book versus the prior book based on the existing curve. All corrections are fully tracked and immutably stored.
- Full cashflow projection for OTCs, cash management across the fund structure, and bi-temporal reconciliation between any collection of trades (as cash flow breaks are likely to increase until forwards are in-line and settlement processes improve).
- Compare to the benchmark: Asset managers need a system that enables the creation of a reference portfolio and full look-through and strategy capability to track performance against a benchmark.
Asset Managers cannot afford to be passive in the process given the short timeframes involved in cutover. We have built LUSID – an open API and event driven data store – to be the backbone of fund architecture. Its extensible data model, transaction mapping and holdings features combine to make onboarding dynamic, exceptionally rapid and complete. With the ability to partition and reconcile bi-temporally, tracking and rectifying anomalies is simple.
Contact us to discuss how LUSID can help chart an active and potentially profitable route through transition.