By: Sern Tham, Product Director, Temenos Multifonds
The replacement of LIBOR with new reference rates in 2021 is not a simple substitution – existing valuation systems will require an overhaul
LIBOR (the London Interbank Offered Rate) will be replaced with alternative reference rate by the end of 2021. This is a gamechanger for the financial services industry, particularly when you consider an estimated $350 trillion of financial instruments including bonds, loans, deposits and derivatives used LIBOR as the benchmark rate. Asset managers and fund administrators need to act now and start asking the right questions of their teams and their technology providers.
LIBOR is a forward-looking rate produced daily by the Intercontinental Exchange (ICE), and it is the lack of actual transaction data underlying LIBOR and other IBORs that made them so prone to manipulation. To avoid this risk, 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.
Acting on the considerations listed below, will save any operational headaches once LIBOR has had its last dance. Asset managers and fund administrators must be aware of 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.
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, they need to be clear on when they will migrate to the new rates in order to meet the current deadline for the end of 2021.
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.
Finally, the clock is ticking fast. 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. Firms must act now to ensure their systems are ready for the end of 2021.
