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LIBOR replacement to spread headaches

Mark Unferth said benchmark rates need more transparency and credibility.

Institutions facing multiple challenges, contract changes

Updated with clarification.

Replacing LIBOR, the predominant derivatives and fixed-income valuation benchmark that's been bruised by accusations of bank manipulation, could leave institutional investors a little beaten up as well by 2021, the suggested date for moving away from the rate.

That's because many investments pegged to the London interbank offered rate, such as interest-rate swaps and long-duration fixed income, will require investors to renegotiate with counterparties to agree on a new benchmark — with potential negative ramifications on a market that totals trillions of dollars of investments, sources said.

"The issue has always been that LIBOR is the base at which to price a spread," said Mark Unferth, portfolio manager, ACR Alpine Capital Research LLC, Clayton, Mo. He said the leveraged-loan market alone accounts for $1 trillion in assets, all of which will be affected by any change away from LIBOR. "We never had to think about it. Every agreement for loan repricing was LIBOR plus the spread. That makes this a floating-rate asset class. As the Fed raised rates, LIBOR naturally went up, or down in a lower-rate environment. But no one had to think about it."

Added Eric Bernstein, president, asset management solutions, Broadridge Financial Solutions Inc., Lake Success, N.Y.: "There will be a lot of challenges for anyone that uses a third-party administrator — which is basically all of the buy side with accounting and reconciliation systems. People may not be happy with the construct of LIBOR, which is fine. But many don't grasp what it will take to replace it."

The Federal Reserve Bank, the Bank of England and the European Central Bank are recommending a market- or transaction-based rate to replace LIBOR, the interest rate at which banks lend money to each other. That rate is the average of daily estimates submitted by member banks and overseen by Intercontinental Exchange Inc. — and it's the alleged manipulation of those rates that has led to billions of dollars in settlements reached by banks and regulatory agencies since 2012.

LIBOR is set at different currencies, including the U.S. dollar, British pound and euro, but an alphabet soup of replacement rates introduced by central banks relate to their own currencies. They include the Fed's secured overnight financing rate, or SOFR; the Bank of England's sterling overnight index average, or SOFIA; the ECB's euro short-term rate, or ESTER; the Swiss National Bank's average rate overnight, or SARON; and the Bank of Japan's Tokyo overnight average rate, or TONAR.

Different basis

The main issue, sources said, is that LIBOR is based on an average of estimates, while the central bank rates are based on actual overnight money market transactions — making it impossible to have an apples-to-apples transition from LIBOR to any other rate.

"If they replace it, the expectation is that there will be 'winners' and 'losers' — my quotes," said Willa Cohen Bruckner, partner, financial services, at New York-based law firm Alston & Bird LLP. "If they have a contract with LIBOR and replace it with something else, even if it's close to LIBOR, it won't match. LIBOR is based on a certain methodology. If it's replaced by SOFR or another rate, if you compare the two over time, it won't be the same. If the contract says LIBOR and you substitute SOFR, the economics of that is that some will end up ahead and some behind. They'll either get more or pay more."

George Bollenbacher, head of fixed income at research firm TABB Group Inc., New York, said derivatives, securities, loans and deposits are the four major investment categories that will be affected by a move from LIBOR. He said derivatives for most pension funds involve interest-rate swaps, which as one-on-one agreements are relatively easy to transfer from one rate to another. But as for the other investment types, "those aren't as simple," as changing the terms of those agreements will require approvals from multiple stakeholders. "The issue for asset owners if they're doing repo transactions is can they verify the rate they got closest to?"

For example, with securities, Mr. Bollenbacher said: "You must do some sort of tender offer to all holders, one-to-many transactions. If someone doesn't like the replacement terms, what are the options?" Those options depend on what is written into individual covenants, he said. "If the issuers don't modify, and if the lenders then try to sell, there could be a price penalty."

Also, with loans, "Each lender must approve any changes," Mr. Bollenbacher said. "That isn't just for loan participations but also for revolving loan agreements" such as institutional lines of credit. And if any deposited assets are used for clearing, they also must be renegotiated, he said.

Costly change

Broadridge's Mr. Bernstein said changing the terms of long-term investments already in place will prove costly for both asset owners and money managers. "They both will have to reconcile their data with the change. There'll be a cost for everyone. The more forward-thinking people have systems that aren't hard-coded to LIBOR. For them, there will be an operations charge to make the change, but not the huge costs for someone that had to recode everything."

Pension funds like the C$77.8 billion ($59.6 billion) Healthcare of Ontario Pension Plan, Toronto, a previous client of Mr. Bernstein's that has much of its assets in derivatives-based investments, already have adjusted their systems to account for any benchmark rate change, Mr. Bernstein said. "But some systems still in use are so old that people will really have to dig deep to find someone who can make the changes to their codes," he said. Officials at HOOPP could not be reached for comment.

Mr. Bernstein likened the change in the benchmarks to the U.S. equity market's change to decimalization from fractional increments in 2001 "and the huge challenge that was to operations. And that was adding decimals. This goes further than that."

One particular problem, Mr. Bernstein said, would be with rebalancing. He said the inability to settle trades on time — because settlement systems won't be able to keep up due to slow adjustment of systems — will mean cash or margins will have to be accessed to settle trades. "It becomes an onerous process," he said. "There's huge operational overhead. The cost of processing the trades might be more than what the trade gets. That will bring the value of a portfolio down — if I can't access the market quick enough to execute and settle, what is the market impact of that? It won't just affect the counterparties involved; it could impact the entire market."

Cure worse than illness

Some sources wonder whether the cure might be worse than the illness. While Alpine's Mr. Unferth said there's a need for more transparency in setting these benchmark rates, "the amount of LIBOR manipulation ultimately would be the number of basis points you could count on one hand. You could make the argument that by and large, LIBOR does reflect true transactions. … LIBOR got tarnished from a credibility perspective, but the frequency of manipulation wasn't so large that it impacted things that were priced to LIBOR. It might have impacted a trader's profit and loss, but on an overall perspective, on a day when a loan would reprice, the materiality to a borrower or lender is a few basis points. Is that material to them? I think not."

Though Mr. Unferth said, "No one likes LIBOR," he added, "The bigger issue is the credibility and materiality of the benchmark, and that we don't have to think about it. We all want to be able to assume the benchmark's credibility and materiality. From a portfolio manager's perspective, just give us something that's reliable. Our analytics need to focus on the underlying risk of the borrower, not whether the risk of the benchmark should be a concern."

Both Mr. Unferth and Richard Sandor, chairman and CEO of the American Financial Exchange LLC, Chicago, believe regulators and the market will make the transition as smooth as possible.

Mr. Sandor, whose AFX is an electronic trading venue for regional and community banks and non-bank financial institutions to lend and borrow short-term funds, sees parallels with the LIBOR change and the millennium transition, "which ended up being much ado about nothing."