Two decades ago financial institutions faced a major market event with significant effects on operations, pricing systems and even valuations for a wide range of financial instruments. The challenge then was Y2K — the start of the new millennium on Jan. 1, 2000, when computer systems would have to properly account for the date change.
Something of similar impact is about to happen. By 2021, LIBOR will be replaced. The widely used interest rate benchmark has been part of the fabric of financial markets for decades across derivatives, bonds, asset-backed notes, mortgages and other products. By one estimate, financial instruments with a notional value of $240 trillion are linked to the London interbank offered rate.
Replacing LIBOR with an alternative reference rate is a complex challenge for banks, brokers and institutional investors — including limited partners and asset allocators. The Securities and Exchange Commission recently urged organizations to build transition plans, warning that the discontinuation of LIBOR could have a "significant impact on financial markets and may present a material risk for market participants."
The LIBOR transition will affect institutional investors in three major ways:
- First, the introduction of a LIBOR replacement will need to be managed so as not to change the value of investments linked to LIBOR, such as floating-rate notes, securitizations and private debt.
- Second, for investments that use LIBOR as a performance benchmark, such as fixed-income funds, real estate and absolute-return funds, the new benchmarks will need to be comparable without inflating performance. The focus on performance metrics will be key as informed stakeholders may scrutinize whether "outperformance" was due only to a favorable adjustment to the goal post.
- The third, and perhaps most significant LIBOR challenge for asset owners and allocators of multiasset-class portfolios, is addressing LIBOR's role as an input in a range of reporting standards, risk management systems and valuation models. Close coordination with fund administrators, auditors, custodians, data providers and other outside parties will be required.
For these institutions, one of the first steps in the LIBOR transition is to make an inventory of all the models, reports and calculations that now rely on LIBOR and identify and source new reference rates. That sounds simple enough — until you wade into the details and find how extensively LIBOR is used in these systems now.
For instance, LIBOR is available in multiple tenors (i.e., 1, 3, 6 and 12 months), but if risk-free rates are chosen as the alternative, they are overnight rates, so conversion preparation is required because they are calculated differently. The main problem is that when a different reference rate is used, then the tenor of new and existing instruments changes. And it's not only tenor that's impacted. For some markets, adopting an overnight index swap methodology for retroactively calculating rates, for example, will cause both changes in tenor and timeliness of valuation, which may cause more disturbances to product than the intended value of market neutrality of rate definition.
LIBOR also incorporates a bank credit risk premium and a variety of other factors, such as liquidity and fluctuations in supply and demand, while risk-free rates do not. The spread adjustment will vary based on the tenor of the relevant LIBOR, although all of the spread adjustments will be based on the same methodology applied to data for the relevant tenor. Adjustments to the risk-free rates would be required to ensure legacy derivatives contracts referenced to a LIBOR in the system continue to function as close as possible to what was intended if a fallback takes effect.
To make matters more complex, the secured overnight financing rate has been identified as the preferred alternative for U.S. dollar LIBOR, but SOFR is still relatively new and, although trading volumes have been much higher than expected, the jury is still out. Other reference rates have been developed for dollar-denominated instruments. The proliferation of these constructs (with acronyms like SONIA, SARON, TONAR and ESTER) means investors may need to incorporate several new reference rates in their systems and models in place of LIBOR.
For endowments, pension funds, family offices and other owners of multiasset-class portfolios, this is an extremely complex task. Robust data management processes are essential, and, in many cases, technology may be leveraged to help automate the transition process and ensure that new reference rates and required conversions and adjustments are accurately applied to all relevant portfolio reports and analyses.
The end of LIBOR might seem like a far-off event, but it is fast approaching, and there is a lot of work to be done. If an asset owner or allocator is considering transitioning to a more flexible, efficient and scalable technology platform, it should start a transition program now to ensure the right level of portfolio management technology, processes and people are in place to minimize LIBOR disruptions. This type of program has the added benefit of enabling greater institutional agility and adaptability to future regulatory changes and industry shifts — which we know will inevitably come.
Josh Smith is CEO and co-founder of Solovis Inc., a multiasset-class portfolio management, analytics and reporting software-maker, based in Irving, Texas. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.