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It has been a busy year so far in the FCA post-room. The regulator has sent out a flurry of Dear CEO letters, including a letter to asset managers on LIBOR transition. The FCA clearly believes that asset managers are behind the curve. The letter calls for ‘immediate action’ if transition is not yet underway. The first step is understanding where you might be exposed.
What is LIBOR transition and why is it happening?
LIBOR – the London inter-bank offered rate – is a benchmark interest rate at which major global banks lend to one another in the interbank market for short-term unsecured loans across a number of maturities and currencies. The rate is traditionally calculated on the basis of estimates made by leading banks of the rate at which they would be able to borrow unsecured funds from other banks. It is the most commonly used reference rate used across the financial services sector and is embedded in a vast range of products and contracts.
However, LIBOR has been bedevilled with problems in recent years placing it under the spotlight of regulators. First, in 2012 it was uncovered that submitting banks were colluding to rig the setting of the benchmark in their favour by manipulating their submitted estimates. More fundamentally, since the 2008 global financial crisis, the unsecured interbank lending markets have largely dried up. As a result, the calculation of LIBOR, particularly for some currency-maturity pairings, is highly dependent on expert judgement rather than any actual transactions.
Regulators are keen for the sector to adopt new reference rates that are calculated objectively on the basis of actual transactions and therefore less open to manipulating. As a result, the FCA has made clear that it will no longer compel submitting banks to make LIBOR submissions beyond the end of 2021. While it is not yet clear whether LIBOR will cease to be published at this date, the FCA expects firms to have contingency plans in place in case it does.
What are the FCA’s expectations on LIBOR transition?
The FCA’s Dear CEO letter sent to asset managers on 27 February 2020 makes clear that the regulator believes that fund managers are behind the curve on LIBOR transition. The FCA expects firms to actively consider their response to the demise of LIBOR.
As a first step, this means considering carefully the extent of your LIBOR exposure and dependencies across the entire business. For example, will products behave in the same way when linked to new benchmarks? How will changes be communicated to clients? And are there any other operational procedures that are linked to LIBOR? If the exposure to LIBOR is big enough, you’ll need to produce a full transition plan with board-level engagement.
The letter also encourages firms to manage any conflict of interest that arises from the transition properly and ensure that customers are treated fairly at all times. It warns that firms should not expose clients to unreasonable costs and to make sure that any plans put in place do not in any way adversely impact the client.
What do asset managers need to think about?
Asset managers may be exposed to LIBOR in a wide range of ways. Areas where LIBOR exposures are likely to arise include the following:
Is it part of a fund’s investment strategy to beat LIBOR by a given percentage or is it used to measure performance in reporting or marketing material?
Investing in debt instruments or direct lending
Rates charged could be linked to LIBOR. If so, you need to think about what alternative rate to use if LIBOR is no longer calculated and consider whether you need to repaper funding agreements. You should also consider how this will affect the economics of any relevant products.
Where deals have been financed through leverage from external parties, is the debt linked to LIBOR? If so, you should be engaging with your lenders to determine what their LIBOR transition plans are. If agreements need to be repapered, it may be necessary to negotiate terms. As above, consider how any new benchmark affects the economics of the relevant deals and whether there could be an impact on investors.
Are any revolving credit facilities used by funds to smooth out drawdowns? As above, you should be engaging with the lender to determine what their LIBOR transition plans are and how this will affect the economics of the relevant funds.
Any derivatives used may be linked to LIBOR. You should be engaging with counterparties to determine what their transition plans are.
Is LIBOR used in valuation models? If so, you will need to identify an alternative to LIBOR, and think about how the switch will impact investors at the point of transition. For example, will the switch result in a material sudden drop or uplift in valuations? Could this result in performance fees being payable/not payable simply because you have switched to a new benchmark rather than as a result of any ‘real’ change in performance?
Late payment clauses
Rates charged on late payments could be linked to LIBOR.
How can Bovill help?
We have twenty years’ experience helping asset managers with regulation and have experts in benchmarks. We can help you get ready for LIBOR transition by:
- Assessing your business’s exposure to LIBOR
- Creating and helping you execute your transition plan
- Supporting client and investor outreach and communications.