With each passing day, we’re getting closer to the end of the London Interbank Offered Rate (LIBOR). The most widely used tenors of USD LIBOR are expected to cease publication after June 2023**, and this will affect everything from funding and hedging to valuing and reporting. As companies plan for the transition, it is becoming clear that unwinding and replacing LIBOR is a far more complicated project than many expected.
We’ve written extensively about the LIBOR transition. In the US, many financial instruments now tied to LIBOR will be pegged instead to the Secured Overnight Financing Rate (SOFR), an alternative reference rate (ARR). Other countries and markets have established their own replacement benchmarks. We now have guidance from the Alternative Reference Rates Committee (ARRC) on suggested transition milestones for floating rate notes, business and consumer loans, securitizations, and derivatives. This is no longer something happening in a hypothetical future.
For the asset and wealth management (AWM) industry in particular, companies have a lot to consider: firms in the sector handle a wide range of asset classes, rely heavily on third parties for critical work and serve a complex investor base including institutional and retail customers.
Some AWM firms see this transition as something that is important but beyond their control. We disagree. In fact, many of the big uncertainties have been resolved. With this increased clarity, there are some decisions to be made. You’ll want to understand how your holdings might be affected (and when), as well as what role you play in the decisions that lie ahead. The steps you take could be very different, given certain assets, liabilities, or derivatives.
The implications are big. It’s time to shift your transition into high gear.
**For years, the industry has been working toward a 2021 transition away from LIBOR. But the benchmark’s administrator, ICE Benchmark Administration (IBA), recently announced that it would continue to publish some LIBOR rates — but not all — for an additional 18 months. See PwC’s LIBOR transition industry and market update (November 16-30, 2020 issue) for more details.
To be perfectly clear: your firm is party to contracts that reference a benchmark rate that will soon be unreported or unreliable. So, you’ll need to remediate those contracts, and you’ll want to establish your strategy for investing in a post-LIBOR world. Your approach will inevitably vary depending on what you hold: by type of investment, currency, and tenor.
You’ll want to have a good understanding of the scope of the challenge by identifying the population that could be affected by this transition. It almost goes without saying that you can’t remediate contracts until you understand where they all are and what they say. You’ll want to update your inventory of contracts that reference LIBOR and the nature of existing fallback language, drawing on sources that are in-house as well as at third parties. We can’t stress enough the importance of handling contract review in a coordinated manner across different contract types, languages, jurisdictions, and file locations. Technology can help here, but you should approach this process with a well-thought out plan to avoid rework later.
Make sure you have a clear sense of your role in the remediation process. This is a key step in updating your legacy book of business, and you’ll want to complete this as soon as possible. LIBOR itself may fade out in 2023, but some tenors will be gone before then, and key transition dates are already upon us. Also, even for contracts that can continue to reference LIBOR until June 2023, it may be advantageous to convert these contracts to new alternative rates before the new end date.
Do you have a strategy? Do you plan to remediate your contracts by including fallback language in contracts, or do you intend to exit these positions and just change to SOFR-linked assets? The industry is moving toward standardized protocols to handle automated fallbacks, but these are merely intended to prevent a worst-case scenario. SOFR and LIBOR have some characteristics that are substantially different, and you will want to understand the economic implications of any fallback process.
Do you know what counterparties want? Your counterparties may have a preference for remediation, but they may not. SOFR is considered a “risk-free” rate, while LIBOR includes a credit risk component. The prevailing approach to remediation uses SOFR plus a fixed credit spread adjustment to approximate LIBOR, though this credit spread isn’t expected to be known until early 2021. There are still some efforts to identify alternative rates, though SOFR appears likely to have the most institutional support and the most liquidity. If you are waiting for additional certainty, you should be clear about what would trigger that certainty — and whether this would preclude you from starting to reach out to counterparties now.
Are you competitive? How does your proposed remediation strategy stack up against others? This is an industry-wide event, and firms are choosing a variety of paths in real-time. To be clear, this goes beyond remediation: your deal teams should be underwriting the transition into new issuances. You’ll want to be sure that they are, and that they are doing so in a way that is consistent with your overall LIBOR strategy. (Don’t take this for granted.)
What rate makes sense? As SOFR and LIBOR do not exactly move in tandem, simply adding a credit spread adjustment may not give you or your counterparties the desired results. You’ll want to analyze the implications of using this approach to determine the components of the rate for new products, including “financial floors” and other features. For example, you might have a security priced at LIBOR + 3% that incorporates an interest rate floor. Would you want to convert this to one using SOFR plus a credit spread adjustment using the same interest rate floor? You’ll want to model different scenarios; depending on the type of product and the remaining tenor as well as your ability and intent to hedge, you may want to use a different floor, or an entirely different approach.
How will you handle “tough legacy” contracts? At this point, there may simply be no way to convert some LIBOR-linked offerings into SOFR-linked products, despite the breathing room offered by IBA’s announcement that it will keep publishing some LIBOR rates through mid-2023. As a result, some contracts may need a legislative or other imposed solution to complete the transition. You’ll want to work with your investment teams to understand if LIBOR status is, or will be, a relevant data point for investment decisions. This applies to legacy contracts that reference LIBOR after December 31, 2021 through maturity, as well as for contracts that mature after June 30, 2023. (Some firms will want to back away quickly, while others may choose to be buyers.) You should put a strategy in place to monitor the liquidity in LIBOR and new alternatives rates, as well as the likelihood of legislative or other solutions for tough legacy contracts.
The transition away from LIBOR will clearly have big implications for how derivatives are created and valued. There could be a variety of scenarios in which derivatives are addressed: trade compression to reduce risk, changes to settlement processes, differences between on-market and off-market terms, and more. If derivatives are a meaningful part of your investing strategy, you’ll want to be aware of — and prepared for — some upcoming market events. Some firms will look at the transition with the goal of reducing risk; others may view it as an opportunistic investing strategy.
Fallbacks: The International Swaps and Derivatives Association (ISDA) has now published its official “IBOR Fallback Protocol” for derivatives. The intent is that, in the absence of LIBOR or any other interbank offering rate (IBOR), any reference to that benchmark rate in existing contracts that are governed by Master ISDA agreements will “fall back” to the new definition — provided that the counterparties have adhered to the protocol. Soon, the new definitions will automatically apply regardless of whether or not market participants adhere to the protocol.
As with fallback plans for cash products, though, the protocol is intended as the starting point for negotiations — not the end. We expect that most AWM firms will choose to sign on to the protocol, if only to avoid the potential chaos of contracts with undefined terms. But you should expect that your counterparts will soon approach you to negotiate better agreements. You’ll want to prepare for this by modeling the implications for the full range of your positions. (For more information, see our related article on the Fallback Protocol.)
How will your liabilities be affected by the LIBOR transition? The implications may be broader than you expect. If your firm uses leverage in its funds, you’ll want to analyze your credit facilities to understand your LIBOR exposure and any remediation requirements. Asset and Liability Management (ALM) is an important risk management mechanism for AWM firms. The timing of changes to your liabilities relative to your assets could affect limited partnership (LP) returns, as well as other aspects of your ALM program. You’ll want to analyze and develop a timing strategy around these changes. As we’ve shown, lenders will begin to approach borrowers to negotiate an effective transition away from LIBOR, or they may exercise early opt-in triggers in contracts, if applicable. You’ll want to be prepared for discussions around your financing facilities, particularly so you’ll understand how the timing of any liabilities transition will match against your asset transition plans.
It should be clear that there is no single “best” way to remediate contracts that rely on LIBOR. Within a single firm, a manager might choose to amend some positions and close out others based on a variety of criteria: product, currency(ies), remaining tenor, value, and more. Asset and wealth managers have some unique considerations, given the variety of their holdings and the extensive reliance on third parties.
It certainly might have been easier if markets used a single convention to calculate a transition between investments linked to LIBOR and those linked to SOFR and other ARRs. That’s not where we ended up. As we’ve described, there are subtleties involved in converting from LIBOR to SOFR plus a credit spread adjustment, and companies may modify agreements as they see fit. There are different recommendations on how institutions should approach business loans, derivatives, and securitizations.
Similarly, it might have been easier if market participants could use a forward-looking term rate based on SOFR, similar to LIBOR’s structure. We expect to see one, but we don’t know if it will be available by the transition date. Conventions have emerged. In some cases, you may apply Daily “Simple” SOFR: it’s easy to operationalize, but it has clear economic disadvantages. In other cases, you may find yourself using SOFR compounded in arrears over the actual term of the investment. This uses a look-back period to reflect how the market actually moved during the period. But, it is clearly operationally more intensive, because rates won’t be known in advance when products are first booked.
There will undoubtedly be accounting and tax implications depending on how you remediate a given product and how you book it. You’ll want to calculate interest and accruals to understand your choices and communicate with your counterparties. This is true even if, or especially if, there is still some uncertainty around the process.
AWM firms rely more heavily on third party providers than nearly any other sector. In some cases, you’ll need to update systems that are explicitly in your control. In others, you’ll need to communicate with your suppliers to be sure that their technology and operations are going to be updated to address your requirements on your timeline. With so much handshaking involved, you’ll need to make sure responsibilities are clear.
For example, many of your legacy contracts will likely have LIBOR trigger provisions, such as “if there is a regulatory statement finding that LIBOR is no longer considered reliable, we will replace it with a defined alternate rate.” In an AWM environment, it may not be clear if a manager or administrator is responsible for monitoring the status of these agreements, identifying which triggers have been invoked, communicating with affected parties, and deciding what needs to happen. Even contracts that have already been digitized may not have been done with an eye to identifying provisions that could be triggered.
The operations choices you make could have accounting and tax implications, though many firms may not have built this assessment into their remediation process. Consider a swap that might be (1) amended via a standard protocol; (2) closed out and settled in cash and replaced with a new, on-market swap; or (3) closed out and replaced with a new, off-market swap. Economically, these three scenarios are intended to be equivalent. But there could be tax effects associated with cash compensation, there may be opportunities to defer certain taxes, and there might be cash flow implications too.
There is now increased certainty on the timing of the end of LIBOR. That clarity should be a call to market participants that the time for action is now. There continues to be much to do on each the risk/change management, operations and strategic fronts. While the end date for most US LIBOR tenors will be June 30, 2023, the call for the end of new LIBOR products is set to be December 31, 2021. The period between those dates will present interesting markets for AWM firms as LIBOR securities decline in liquidity and SOFR (or other ARRs) liquidity increases. Risk? Opportunity? or both?
Financial Services, Principal, PwC US
Asset & Wealth Management, Partner, PwC US
Partner, PwC US