Market structure is not my specialty and I’d wager it isn’t the focus of most of our blog readers. That said, I’ve been keeping an eye on the headlines and ear to the ground on the topic of interest rate changes as of late. Harking back to my days in introductory Financial Markets—which feel very long ago—I recall one acronym that dominated our discussions of banking alongside the fed funds rate: LIBOR. To be honest, I remember little else from that class, which only underscores LIBOR’s importance in determining interest rates worldwide.
LIBOR has caught my attention a few times over the past decade when it played a role in 2008’s market crash and in the front-page 2012 LIBOR scandal (more on that here); but like most of us, I wasn’t exactly on the lookout for LIBOR news. That is, until this year. If you haven’t been following, LIBOR is back making headlines again as its phase-out looms on the horizon.
As of the end of 2021, LIBOR will no longer be officially published (announced by the Financial Conduct Authority). I can picture how this changes Financial Markets finals exams the world over, not to mention the impact on trillions of dollars and a wide variety of investment vehicles. If you are mired in complex technology initiatives like most of us at Citisoft, your projects can easily overshadow regulatory changes “down the line.” But when it comes to LIBOR, the time to pay attention is upon us. There are an immense number of resources available for regulatory aficionados but here is my breakdown on what the tech and ops laymen in asset management need to know.
What is LIBOR?
LIBOR stands for the London Interbank Offered Rate. This interest rate average is calculated from the largest banks with a presence in London based on the overnight rate they offer to lend to each other (which is closely akin to a risk-free rate and complementary to the fed funds rate). While these London bank rates set LIBOR, the rate is used internationally and published for five currencies and in seven maturities, impacting investment vehicles derivative of those rates. Estimates indicate that at least $350 trillion in derivatives and other financial products are tied to LIBOR.
Why are we talking about this now?
We probably should have been talking more about this in 2017 when the Financial Conduct Authority announced that LIBOR would be phased out by the end of 2021...or in 2014 when the official sector warned about LIBOR’s instability. Why weren’t we? Well, many financial institutions believed that LIBOR could not possibly be extricated from the markets.
As we’ve drawn closer to 2021, regulators have noted that financial institutions continue to rely heavily on LIBOR. In June of 2019, the US federal reserve offered a stern warning: “Some continue to speculate that LIBOR can remain in production indefinitely. My key message to you today is that you should take the warnings seriously… it is a matter of how LIBOR will end rather than if it will end, and it is hard to see how one could be clearer than that.” Yikes.
Do these changes impact me?
Yep. This change impacts you, your firm, your neighbor, and probably your neighbor’s dog. But since I don’t know anything about the adjustable rate mortgage on Fido’s doghouse, here’s a quick take on how this will impact the asset management industry: investment instruments that refer to the interbank rate will need to change their contract and terms. That means derivatives, floating rate notes, loans (and so many more!) will all need to be adjusted to a new alternative rate. In short, every buy-side firm is facing significant impact on their portfolios.
What should my firm be doing to prepare?
Consider setting up a LIBOR transition team
Identify which instruments in your portfolio that mature after 2021 are directly tied to LIBOR
Determine which alternative rates will be used in place of LIBOR
Calculate financial impact of new rates
Identify operational impact of new rates (e.g. publishing times)
Perform due diligence on LIBOR-specific legal contracts
Identify replacement benchmarks for performance measurement
Reach out to your vendors to determine how they are supporting these changes
Continue to monitor communications from Alternative Reference Rates Committee and regional governing bodies