Transition is going to be complex. Over $240 trillion in notional volumes currently reference LIBOR, including derivatives, bonds, securitized products, corporate & syndicated loans, and even some residential mortgages. New alternative rates to LIBOR have been identified – SOFR, SONIA, SARON, TONAR, and ESTER – but are structurally different.
Existing fallback language to be used if LIBOR is unavailable was intended for short term use and is not suitable for complete cessation. Unless derivatives, Floating Rate Notes and other financial instruments are proactively transitioned to other reference rates, there will be value transfer, and as a result there will be winners and losers from the transition, as contracts move to new reference rates.
Impact Of LIBOR Transition On Investment Managers
Investment managers currently use LIBOR in three main ways, each of which will need to be carefully managed through the transition.
First and foremost, managers hold LIBOR based products in their portfolios. 80% of respondents to a recent survey of IA members stated that they use LIBOR based derivatives for hedging. Many firms will also hold LIBOR-based Floating Rate Notes, securitizations, or private debt. Transition of the investment portfolio will need to be carefully overseen to ensure no client value is lost.
Second, managers use LIBOR as a benchmark or performance target for their funds or mandates, particularly in alternatives, asset allocation/ absolute return funds, and fixed income funds. 90% of respondents to the IA survey stated that they use LIBOR as a benchmark for at least one fund. The benchmarks and targets will need to be transitioned while avoiding the appearance of inflating measured performance.
Finally, investment managers use LIBOR as an input into various calculations, systems, and models for operations and administration. Many valuation models, risk models, and pricing models will need to be updated, working with third party providers where needed.
Investment managers therefore face a number of LIBOR transition risks, including economic risk from poor handling of their client portfolios, operational risks, and conduct and legal risk with clients and counterparties.
Planning For The LIBOR Transition
Many investment managers have a critical and difficult body of work ahead of them over the next few years to manage and reduce transition risks. Not all of this work can be started now – much will depend on the development of market conventions and liquidity over the coming years.
For example, liquidity will need to develop in relevant cash and derivative markets, and market solutions will need to emerge for how bonds are transitioned. However, given the size and risk of the work, investment managers should urgently be initiating programmes, and starting work on the areas that can be addressed, including:
- Mobilizing a project with dedicated resources to address transition
- Building an inventory of exposures, and understanding of the economic impact and operational impact
- Beginning transition of investment activity where there is sufficient liquidity (e.g. GBP derivatives)
- Internal and external communications and awareness-raising, including engagement with working groups and industry bodies as well as clients
For more information or advice about the impact replacing the LIBOR rate will have for your business, download the full report below or contact a member of our dedicated LIBOR transition team.
To learn more about our work on the LIBOR transition, please contact LIBOR@oliverwyman.com.