Since the UK’s Financial Conduct Authority announced in 2017 that it would withdraw its support for the London Interbank Offered Rate (Libor) by the end of 2021, various regulators and market participants have joined forces to discuss and prepare their proposed transition plans.
Yet the transition is proving to be challenging, despite global efforts to agree on the most appropriate benchmark fallback mechanics and the relevant replacement rate for Libor. Owing to the complexities involved, it is not clear if the funds community, their counterparties and their respective regulators will be able to develop a consistent approach on how to deal with the Libor transition across different asset classes.
The Bank of England’s Working Group on Sterling Risk-Free Reference Rates (WG) has recommended Sterling Overnight Interbank Average rate (Sonia) as its preferred alternative.
But there is a risk that the proposals being put forward by industry bodies will not produce consistent approaches across different asset classes. Key risks relate to the potential lack of consistency on methodology to be applied for determining the spread costs across the industry, and divergence in transition timing across different markets and asset classes.
It is important for funds to work closely with their managers, custodians and counterparties to assess their exposure to Libor and the consequences that its discontinuation might have. Funds will need to consider, at fund level, the potential use of Libor as benchmark or performance targets, particularly in the context of money market funds and alternative funds; and at portfolio level, the potential exposure to Libor across their investments through the use of Libor-referenced derivatives for hedging, holding of Libor-based floating rate notes, securitisations or private debt referenced to Libor.
Fund administrators, managers and custodians may make use of Libor as an input to their valuations and risk assessments – so certain valuation and risk models will need to be updated to reflect the transition. Once funds’ exposures to Libor have been mapped, it is important to consider whether there are any contractual restrictions on their ability to effect the change to the benchmark and to continue servicing relevant contracts.
Funds will also need to assess if they would be required to reflect the change to the benchmark in their disclosures and other fund documentation to include a statement of Libor risk.
It is important for funds to consult with their legal and commercial advisers on the implications that the Libor transition will have on their operations and investments. This will ensure a smoother transition as funds will be better placed to formulate their own plans and discuss them with managers, custodians and counterparties. Funds should monitor liquidity in Libor-based contracts to assess the timing for transition in relation to each asset class – it is expected that liquidity will start to wane ahead of 2021; work on amendments to their existing contracts to deal with Libor fallback mechanics; and assess any regulatory, accounting and tax implications resulting from amending their contracts - for example, loss of regulatory grandfathering, significant accounting or tax gains or losses.
By Jonathan Gilmour and Vanessa Kalijnikoff Battaglia of Travers Smith LLP
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