Are you prepared for the end of LIBOR? Four key questions for asset managers and fund administrators
The replacement of LIBOR with new reference rates in 2021 is not a simple substitution – valuations must be calculated in a new way and will require an update of key systems.
By Sern Tham, Product Director, Temenos Multifonds
By the end of 2021, LIBOR (the London Interbank Offered Rate) will be replaced with alternative reference rates. The scale of this change is unprecedented for the financial services industry, given that an estimated $350 trillion of financial instruments including bonds, loans, deposits and derivatives used LIBOR as the benchmark rate.
LIBOR is a forward-looking rate produced daily by the Intercontinental Exchange (ICE), reflecting the average interest rate at which large global banks can borrow from each other. However, the lack of actual transaction data underlying LIBOR and other IBORs is believed to incentivize panel banks to report figures aligned with their own business interests. To avoid the risk of manipulation, central banks around the world have established new ‘Risk-Free Rates’ (RFRs) that are backward-looking, based on actual transactional data of rates offered in liquid markets on the previous day.
The new RFRs that will replace LIBOR will change the way valuations are calculated. The result is wide-ranging consequences on operations, risk calculations and the way institutions will conduct business in the future.
The new observed rates cannot simply replace LIBOR in a floating rate contract, because RFRs are based on observed overnight rates that are compounded over the period. In addition, different market conventions will be adopted to deal with lookback and lockout periods.
Therefore, to accurately reflect the value of the holdings once LIBOR is replaced by RFRs, asset managers and fund administrators will need to make sure their systems are capable of supporting the new methodology. Otherwise, investors buying and selling into a fund could be short-changed, leading to censure from regulators and clients alike.
As 2021 begins, asset managers and fund administrators need to take action now, and start asking the right questions of their teams and their technology providers.
1: Do you know all the securities and contracts that are impacted?
LIBOR’s role as the primary benchmark reference rate for trillions of dollars worth of financial instruments means it is deeply embedded in the financial industry. Firms must assess the scale of their exposure. This could be derivatives linked to LIBOR, cash instruments which reference it, or money market funds, which invest heavily in LIBOR rates. Mapping out all the affected instruments is an essential first step.
2: When will you start migrating contracts to the alternative rates?
Alternative rates are already being published by the Federal Reserve Bank of New York, the European Central Bank, the Bank of England and Switzerland’s SIX Exchange. Regulators including the Financial Conduct Authority in the UK have emphasized the importance of early preparation for the transition.
Because the shift to the new reference rates will happen on an instrument-by-instrument basis, asset managers and fund administrators also need an overview of when instruments mature. If they have instruments tied to the LIBOR rate that mature after 2021, when will they migrate to the new rates in order to meet the current deadline for the end of 2021?
3: Have you tested if your systems can support the change?
Calculating valuations differently will be the biggest change for asset managers and fund administrators. Firms should not assume their systems are going to cope with this change. The bigger the size of assets involved, the more complex the change will likely be. Accounting, collateral management and middle office derivatives programs should all be stress-tested to ensure the fund’s entire ecosystem can cope with the change.
4: Are you giving yourself enough time to carry out any upgrades?
Firms will need to have a solution in place by the end of 2021, which means the timeframe for action is shrinking. Starting with assessing their exposure and then upgrading and testing systems, the transition will take time. Upgrades should be completed in early 2021 to allow testing to start by mid-year, ensuring firms are in a place of strength before the deadline.
Time is running shorter – firms must act now to ensure their systems are ready for the end of 2021.
For more information on the retirement of Libor, read Temenos’ report, “Libor Retirement: are you prepared?”
Sern Tham is a product director for Temenos Multifonds. As a highly-experienced strategist, Sern supports Temenos Multifonds clients with their changing technology needs as they continue to seek new ways of digitising, becoming more operationally efficient and reducing risk. Now in his 10th year at Temenos, he has unrivalled experience of supporting clients through their digital transformation journeys and leads the product development roadmap, leveraging Temenos’ investments across all areas including digital, and AI. Sern is passionate about helping clients innovate as the asset management industry grows and become an ever-more challenging landscape. His previous experience includes five years with McKinsey & Company where his passion for strategy and client-focus began.