Investment management firms in the UK are generally doing well in the lead-up to the expected cessation of the London Interbank Offered Rate, the rate at which banks lend to each other, at the end of 2021.
A recent report from the Investment Association, which represents asset management firms in the UK, is sanguine about progress that 'buy side' firms have made in their preparations for the end of 2021. By the end of 2019, according to its survey, 92% of firms had assessed their exposure to LIBOR, 70% had reduced their exposures to it, 75% had approved budgets and 65% had invested in instruments that were based on the Sterling Overnight Index Average (SONIA), the replacement rate that the Bank of England prefers.
The report is less sanguine on the subject of firms communicating with clients, with 73% of firms reporting that they are generally informing clients that LIBOR-related change is on the horizon and that investigations are continuing and 62% reporting that they have sent communications to clients in relation to exposure analysis but only 35% of them saying that they have sent client-specific communications and only 8% reporting "analysing the impact to financial statement disclosures," as the IA puts it.
'Transitioning' existing products
Some firms are drawing up plans to update product documents and 'transition' existing products, while others have already switched benchmarks for existing products from LIBOR to SONIA to calculate PRIIPs performance scenarios, performance fees and pay for portfolio managers.
Preparations for 'transitioning' by trading out of LIBOR-linked instruments are, however, well on the way.
Some firms have 'transitioned' all LIBOR swaps maturing after 2021 with SONIA swaps. Updates and expectations vary by asset class.
For derivatives, SONIA swaps (i.e. swaps that 'reference' SONIA) that are already traded include interest-rate swaps, cross-currency swaps and asset swaps. Some respondents thought that the market infrastructure and liquidity for SONIA overnight swaps was robust and perceived no challenges or marginal costs in moving from LIBOR to SONIA in this asset class, but others reported technology issues with buy-side order management systems.
Cash products present almost as satisfying a picture. Investment managers have been investing in SONIA-linked floating-rate notes or FRNs and expect FRN issuers to start to move their legacy bonds’ terms from LIBOR to SONIA, which would make the products more liquid. Other firms have invested in medium-term notes and certificates of deposits linked to alternative reference rates or ARRs. In general, SONIA is expected to replace LIBOR usage across several fixed-income and derivatives asset classes where a floating interest rate is required as a reference rate.
A much stronger index
SONIA is already used to value around £30 trillion of assets each year. A compliance expert told Compliance Matters: "SONIA is a preferred risk-free rate. it’s a much stronger index than LIBOR. It's based on a very liquid market. SONIA swaps/futures are already out there; it's quite nascent but there is something to build on."
With so many contracts relying on LIBOR rates to determine payments, the sudden collapse of LIBOR would disrupt the markets significantly, hence the lengthy transition period. Regulators all over the world have set up currency-based working groups to select ARRs, which are sometimes called “risk-free rates,” to replace or stand in for the IBORs. In the US the existing rate is Libor and the ARR is the Secured Overnight Financing Rate or SOFR. In Euroland Libor and Euribor are making way for the Euro Short Term Rate or €STR. In Japan Libor and Tibor rule, with the ARR being the Tokyo OverNight Average or TONA. In Switzerland Libor is to be replaced by SARON, the Swiss Average Rate OverNight.
To arrive at LIBOR, banks have always been obliged to submit the actual interest rates that they are paying, or would expect to pay, for borrowing from other banks. In the LIBOR scandal at the beginning of the last decade, they instead submitted bogus figures, falsely inflating and deflating the rates, with the aim of profiting from trades. The US derivatives market uses LIBOR to this day. On 27 June 2012 the old Financial Services Authority fined Barclays Bank £59.5 million - its largest fine ever at that time - for misconduct relating to LIBOR and the Euro Interbank Offered Rate (EURIBOR). When this was combined with American fines, the total that Barclays had to pay came to £290m (US$450m). Bob Diamond resigned as its chief executive shortly afterwards, having attended a Bank of England hearing.