Closing the Door on LIBOR – The Future of Benchmarks

As the phase out of LIBOR nears, and regulators across the globe work to enhance regulatory standards for benchmarks and frame suitable replacements, these activities have large impact on the investment operations of asset managers. Here’s what managers need to know:

The London Inter-Bank-Offered rate (LIBOR) touches all of our lives. From student loans to credit cards, from mortgages to financial derivatives, the number underpins an estimated level of $350 trillion worth of financial contracts on a gross notional basis. It’s no wonder it has often been referred to by traders as “the most important number in the world.” As such, the impact of the phase out of this benchmark has wide implications.

Asset managers who refer to LIBOR or any other benchmark in their portfolios need to start thinking about how the phasing out of LIBOR and the introduction of the EU’s Benchmarks Regulation will affect their business. In November, the Financial Conduct Authority (FCA) and the Bank of England announced their latest plans to work towards replacing the LIBOR benchmark with the Sterling Overnight Index Average (SONIA).

The Working Group on Sterling Risk-Free Rates was given an extended mandate, which the FCA said would “catalyze a broad-based transition to SONIA over the next four years across sterling bond, loan, and derivative markets.” By the end of 2021, SONIA will be the primary sterling rate interest rate benchmark, replacing LIBOR. Regulators no longer deem LIBOR suitable after historic issues with manipulation of rates. The quest for transparency by global regulators is well known and the FCA and Bank of England’s work on LIBOR is being replicated globally. The general consensus on base rates is that banks ought to set rates based on actual trading rather than subjective estimates based on data that only the rate setters are privy to. The European Central Bank’s inaugural meeting to assess a replacement rate for LIBOR for the eurozone took place on March 13 and was the start of a critical policy debate that will continue throughout 2018.

Conducting a Portfolio Review

The industry hopes the transition away from LIBOR will be a methodical one, but it would be prudent for asset managers to start reviewing their portfolios now to identify any current references to LIBOR, far in advance of the implementation date.

In particular, managers should consider the contractual implications of removing these references once LIBOR is obsolete, and consider what to replace them with. They should also note the business implications of the uncertainty where they rely on the reference rate in various guises. The answer to this question remains open to debate, so firms need to decide whether to put an interim solution in place or hold fire until industry trade bodies lead the charge. In any case, firms should map out prospective solutions for stakeholders and build a transitional period into their business plans.

Complying with the BMR

The start of this year also saw the EU’s Benchmarks Regulation (BMR) come into force. In another response to benchmark manipulation scandals, BMR introduces mandatory authorization and registration of benchmark administrators, contributors, and supervised entities. In particular, it calls for the use of actual transaction data where possible. Regulators enacted a transitional period to be in place until January 1, 2020, providing EU index providers already providing benchmarks by specified points a grace period in which to apply for authorization or registration. Third country providers will also benefit from this moratorium until the end of the transition period.

As funds form the user base of benchmarks, the rules impact UCITS management companies and alternative investment fund managers (AIFMs). Most importantly, managers should ensure that any benchmarks used are approved under the Benchmarks Regulation and referred to correctly.

As supervised entities, UCITS management companies and AIFMs are subject to several requirements:

  • Ensure that only benchmarks produced by authorized benchmark administrators are used
  • Review the fund prospectus to ensure that any reference to a benchmark is supported by information on the administrator’s compliance with the Benchmarks Regulation
  • Create contingency plans in the event of a material change in the provision of a benchmark, and what substitutes could act as a reference point
  • Be able to disclose such actions plans to relevant regulators and in client contracts

These changes should already be afoot in firms caught by the supervised entity definition, not least because the standards introduced by the International Organization of Securities Commissions (IOSCO) have been defined as the best practice principles since 2013. Several EU regulators, including the FCA, have publicly stated that supervised firms must comply with IOSCO Benchmarking Principles.

Failure to comply could result in a wide range of sanctions at the firm and/or individual level. Regulators have the power to access documents and telephone recordings, enter the premises of the supervised entity, and freeze assets. What’s more, some investors are said to be searching for IOSCO compliance before investing in products linked to relevant benchmarks.

Planning Ahead

The industry is welcoming of both SONIA (and its various global equivalents) and BMR in that they aim to restore integrity and investor confidence after legacy incidents which reduced confidence in such indices. Regulators have provided a lengthy transitional period, recognizing the scale and complexity of this transition but it is essential that firms now start thinking about how the changes will affect their business, ensure they are complying with the rules, and consider benchmark rate alternatives. Planning ahead will stand firms in good stead in a more transparent and reliable benchmark rate environment. This is especially important from a Brexit perspective, which once again shines the spotlight on firms’ reliance upon the machinations of the equivalence regime, since benchmarks from providers in the UK and US are considered third countries under BMR. That is even though their use occurs on a global basis and as such, the industry hopes this critical element of markets is not disrupted within the Brexit process.

LIBOR Benchmark Timeline