Life After LIBOR: What Benchmark Changes Mean For Wealth Managers
A relatively small circle of Tier 1 banks may be on top of changes to the LIBOR inter-bank interest rate regime, but the wider wealth management industry around the world needs to step up its game rapidly. The new system is not a narrow technical issue - it affects everything from borrowing costs to derivative pricing.
The Brexit psychodrama last year and this year’s COVID-19 pandemic have obscured a number of regulatory changes affecting financial services, and one of the most important is how commercial interest rates are set. For years, a mortgage, savings account and derivatives price was set with reference to the London Interbank Offered Rate, or LIBOR. A decade ago, however, revelations that bankers fiddled the daily prices fed into the system for calculating LIBOR led to calls for change. A different system comes into force at the end of next year. This means that wealth managers, for example, must ensure their sales and marketing literature which refers to LIBOR is updated. That’s only a part of it.
What should the wealth management sector do between now and the end of 2021 to ensure that it is ready for life after LIBOR? In this article, Tej Dosanjh, managing partner, UK, for Evolution Partners, explores the terrain. Evolution Partners is a managing consultancy which operates in a number of countries.
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Following the rate-rigging scandal nearly a decade ago global regulators (including the UK’s Financial Conduct Authority) advocated for LIBOR (the London Inter-Bank Offer Rate) to be replaced and the Bank of England will cease mandating banks to contribute to LIBOR after 31 December 2021. As at 1 January 2020 there was approximately $300 trillion LIBOR exposure that will need to be run off or transferred to new Alternative Reference Rates (ARRs).
Regulators in each of the five LIBOR-setting jurisdictions (the US, the UK, Japan, the eurozone and Switzerland) have nominated ARRs and the financial services sector is currently transitioning positions referencing LIBORs to the new ARRs as liquidity builds in the new rate.
All segments of the financial services sector are affected, including wealth managers, and robust transition plans need to be in place to meet regulatory goals and milestones. The critical questions are what does LIBOR transition mean to wealth managers? And how ready are you?
We see significant work already underway with “Tier 1” organisations with complex global operations, less so with domestic focused organisations and boutique firms. Managing the COVID-19 crisis has and is still the priority but the deadline of 31 December 2021 remains. It is something that, so far, the regulators have continued to reaffirm.
So what is the impact? In short, all portfolios that hold a LIBOR
related instrument. Whilst the most material risk lies with
positions maturing after 31 December 2021, transactions with a
shorter maturity are also at risk if LIBOR rates were to cease
prior to the end of 2021 and any fallback mechanisms in contracts
were to be triggered - sometimes these fallback rates would
result in a significant risk/valuation change to the relevant
Affected products include private debt, fixed income bonds, derivatives and other overlays. In addition, where LIBOR is a benchmark or performance target, particularly in alternative, asset allocation/absolute return funds. Specialist credit arrangements for financing real assets will also be affected if interest rates are related to LIBOR.
As an example, a managed portfolio service that comprises a multi-asset strategy may well have Sterling LIBOR (3, 6, 9 or 12 month, the term component) as a benchmark above which return could be expected, this performance definition will no longer be valid. This type of proposition will have to be redesigned based on a new Alternative Reference Rate, which are overnight rates and do not, currently, have a term component. Additionally, all technology systems and platforms will have to be changed accordingly.
Portfolio managers and relationship managers need to be fully aware of how this affects individual clients’ portfolios and wealth creation arrangements. One of the key features of migrating to an alternative or risk-free rate is that they are subject to different calculation methodologies (e.g. being based on transactions in the government bond repo market) , and so contracts created under the new rate will differ from those under LIBOR.
There will be a change in contractual arrangements along the “value chain” from the broker, fund manufacturers and ultimately the wealth manager and its clients. ISDA is currently in the process of publishing its LIBOR Protocol which will provide further details on how market participants will manage LIBOR exposure transition for positions transacted under ISDA Master Agreements. Existing affected mandates will need to be reviewed, amended and then agreed with each client - the amount of effort and the time it takes should not be underestimated
In our experience some or most of the transitionary work is likely to be initiated by the “sell-side” who will be looking to support their clients, the wealth and asset managers, as part of regulator-mandated client outreach activities. However, adherence to regulatory requirements is still down to the manager.
What is the regulator looking for? They are increasing their monitoring of firms’ preparations, especially in the following areas:
-- Exposure identification and management, where you need to
demonstrate that firms have clearly identified their LIBOR
exposure across client mandates, and that there is a robust
transition plan including fallback provisions;
-- Client education and outreach, arguably the most important area for wealth managers in accordance with their fiduciary duties. Regulators are also playing close attention to how firms ensure that they are mitigating conduct risk by tailoring client engagement strategies to the client’s level of sophistication;
-- Product, ensuring that LIBOR referencing products are withdrawn prior to regulator imposed deadlines and that new products, referencing Alternative Reference Rates have gone through appropriate internal suitability approvals; and
-- Conduct Risk mitigation, where firms need to ensure that relationship managers, sales and distribution professionals, portfolio managers and operational staff are fully trained and sufficiently aware of the post-LIBOR operating environment.