LIBOR Transition Case Studies for Navigating Conduct Risks

After completing this reading, you should be able to:

• Discuss regulatory expectations on LIBOR transition and how these expectations can help market participants in their management of conduct risk arising from the transition.
• Analyze the risks of LIBOR transition from both sell-side and buy-side perspectives and give examples of good practice observations.

Financial market participants and regulators have made efforts since 2012 to strengthen the governance, transparency, and reliability of LIBOR as a benchmark rate. However, reports show that the decline in liquidity in interbank unsecured funding markets in the post-financial crisis period. Thus, LIBOR has been rendered an unsuitable reference rate, necessitating replacing it with a new reference rate.

This has led to the formation of national working groups in efforts to develop risk-free alternative rates (RFRs). Working groups have recommended the Sterling Overnight Index Average (SONIA) in the UK and Secured Overnight Financing Rate (SOFR) in the US as their preferred rates.

The transition from LIBOR to alternative reference rates should be promoted to more robust and effective markets.

Regulatory Expectations on LIBOR Transition

The following are themes are relevant in promoting fair and effective market transitions:

• risk identification;
• governance;
• communicating with customers;
• conflicts of interest;
• treating customers fairly; and
• market conduct.

Risk Identification

“Firms should have a taxonomy for the identification and assessment of common conduct risks that may occur in market transactions and that are relevant to their business.”

Regulatory commentary has focused on:

Identifying and managing risks – Firms should develop effective processes and controls to identify, manage, monitor, and report risks to their business and ensure the safety of their clients.

Conducting impact assessments – Firms should adopt a comprehensive approach to assessing the effects of the transition from LIBOR to other reference rates.

Considering sufficiency of existing conduct risk frameworks – Firms should consider whether some LIBOR-related risks can be handled within the existing risk frameworks or there is a need for a separate risk framework.

Governance

“Firms should develop management information based on their conduct risk taxonomies that allow governance for a and senior management to consider and challenge the conduct risks identified in the market transactions of the firms.”

Key governance themes deriving from regulatory commentary include:

Board level understanding of risks – Senior managers and boards should understand LIBOR transition-related risks and take appropriate action to move to alternative reference rates by the end of 2021.

Robustness of governance arrangements – Firms are expected to have existing robust governance arrangements managing risks in their business.

Record keeping – Firms are expected to appropriately keep records of all meetings as an indication of acting with due diligence, skills, and care in LIBOR transition.

Systems changes – Transition is expected to occur in financial agreements and systems and policies whose reference is LIBOR.

Governance of product – Firms are expected to consider the design and the risks related to new products that reference LIBOR and explain the effects of the LIBOR cessation as part of their product governance obligations.

Communicating with Customers

“Market participants should communicate in a manner that is clear, accurate, professional and not misleading.”

Key themes when communicating with customers include:

Ensuring timely disclosures – Firms are expected to present information on time to enable customers to make informed decisions about relevant products and potential risk exposure.

Comprehensive disclosures – Firms are expected to disclose a comprehensive report on the risks and explain the impacts of the discontinuity of LIBOR.

Discussing product options – Banks are expected to discuss non-LIBOR reliable products with customers and explain potential risks if LIBOR continues to be used as the reference rate. 

Internal and external communication strategies – comprehensive internal and external communication strategies should be developed to enhance education on transition among stakeholders.

Objective overview of alternative products – Firms should consider discussing and presenting alternative products, state the benefits, costs, and risks associated with such products.

Conflicts of Interest

“Firms should take appropriate measures to identify conflicts of interest between the firm and a client, between clients, or between the firm’s employees and the firm and/or a client.”

“Firms should ensure they have effective measures (including appropriate governance) in place designed to prevent or appropriately manage and mitigate those conflicts of interest that have been identified and/or which may arise from time to time.”

Regulatory commentary has focused on:

Identifying conflicts of interest – Firms are expected to identify and manage potential conflicts of interest.

Mitigating conflicts of interest – Firms are expected to mitigate or manage conflicts of interest resulting from the LIBOR transition.

Benchmark performance – conflict of interest could arise when fund managers change performance benchmarks and make sure that these changes correctly reflect performance.

Treating Customers Fairly

There is no FMSB principle that is directly linked to fair customer treatment.

Regulatory commentary has focused on:

Fall back – Firms should insert robust fallback provisions contracts in place prior to or at the time of LIBOR ending to ensure the product continues to operate effectively.

Replacement rates – In cases where customers prefer new rates, the replacements rates should not be higher than what LIBOR would have been.

LIBOR-SONIA spread – Firms that receive interest linked to LIBOR should not give up the spread between LIBOR and SONIA.

Firms investing on behalf of customers – Firms are expected to protect their customers’ best interest by managing the exposure of customers to LIBOR.

Customer needs – Firms that continue to use long-dated products linked to LIBOR should ensure that these products meet customer needs.

Market Conduct

“Market participants should clearly and effectively identify and appropriately limit access to confidential information.”

“Firms should ensure that the output of their risk identification and assessment process informs the development of monitoring and surveillance to address the identified risks.”

“Member firms should have a clear organizational structure for delivering a risk-based program of conduct training that is appropriate to their firm, taking into account their business model, scale and complexity…”

Regulatory commentary has focused on:

Acknowledging a range of potential risks – Market participants are expected to consider potential risks of market manipulation and ensure traders’ awareness.

Contributing to benchmarks – Potential risks related to contributing to LIBOR benchmarks should be considered.

Risks of LIBOR Transition

Sale or Issuance of New Products (Sell-Side)

With the forthcoming cessation of LIBOR and the increasing risks associated with new LIBOR-linked transactions, traders are switching to alternative RFRs for new transactions. It is believed that a smoother transition can be achieved when LIBOR-linked exposures are avoided. However, while LIBOR-linked products are expected to mature by the end of 2021, part of the products that reference alternative rates are still very immature and are subject to limited liquidity and evolving conventions. Moreover, there is a high uncertainty for these alternative reference rates.

Given this level of uncertainty, banks offering alternative rates and the buy-side are subject to a number of risks.

Market participants may:

• not able to tell how products linked to alternative rate will behave;
• not ready to use products on the basis of alternative rate;
• believe that the use of LIBOR would have worked better for them since:
• lower interest payments are anticipated if LIBOR-RFR spread narrows;
• change in relative derivative value is anticipated if LIBOR-RFRs spread moves unfavourably;
• more time is allowed to change processes and systems;
• waiting for precision on standard industry conventions;
• awaiting alternative products in the future; or/and
• aligning with current portfolios or LIBOR-linked instruments.

The following case studies will help us illustrate the above risks:

Case Study A: Bilateral or syndicated corporate sterling borrowing through a SONIA-based, or Bank of England base rate, loan.

Case Study B: Corporate sterling borrowing through a SONIA-based loan and simultaneously entering into an interest rate swap to fix the interest payments.

Case Study C: Corporate entering into a USD LIBOR-SONIA swap to hedge exposure arising from GBP loan and USD investment.

Good practice observations applicable to Case Studies A, B, and C

Bank perspective

Communicating with Customers

The bank communicates appropriately with clients in an effort to address communication issues noted in FMSB principles. This includes providing information on:

• Background information on LIBOR transition;
• Understanding of client needs and situation;
• Pros and cons of products;
• Independent advice from independent professional advisers on client options; and
• Lending margin (or margin for other products, e.g., derivatives).

Record Keeping

The bank should keep a record of all important information relating to its operations and clients.

End-User/Client perspective

Risk identification – Clients need to understand alternative products offered and the benefits and risks related to these products.

Independent advice – clients should seek advice from independent professional advisers on their options, including understanding alternative products offered and benefits and risks related to these products.

Case Study A: Bilateral or Syndicated Corporate Sterling Borrowing through a SONIA-Based, or Bank of England Base Rate, Loan

Description

Bilateral loan – A UK-based mid-size corporate borrower seeks 5-year finance to enable the expansion of its business. The borrower approaches bank A. Bank A lends money to the borrower referencing alternative rates, fixed-rate loan options, and LIBOR since LIBOR is anticipated to cease by the end of 2021. The borrower takes a SONIA-based loan with a notional of £10 million, maturity of five years, with quarterly SONIA-based interest payments compounded in arrears with a lookback period of five days. The loan is priced at SONIA + 200 basis points compared to indicative pricing for a comparable LIBOR loan of 3m GBP LIBOR + 185bp, implying that we have a spread of 15bps between LIBOR and SONIA.

Syndicated loan – A large corporate is seeking to borrow £100 million. Since the borrowing is big enough, the loan is syndicated. Bank A acts as the lead as the arranger, while Banks B and C act as participants in the syndicate. Both the duration and pricing of the loan are similar to the bilateral loan above.

Small corporate borrower – A small corporate borrower is seeking to enter into a new GBP loan. The borrower approaches bank A. Bank A lends money to the borrower referencing alternative rates and fixed-rate loan options. The borrower takes a Bank of England base rate loan with a notional of £0.5 million. Both the duration and pricing of the loan are similar to the bilateral loan above.

Risks to Market Effectiveness or Market Fairness

Based on future developments, customers would think that it would have been better if Bank A could adopt an alternative approach.

For example:

• if LIBOR-based interest rate payments had been lower than SONIA-based rates in the 2^nd half of 2020, then customers would conclude that it would have been better if LIBOR loan were extended until the end of 2020; or
• corporates would have been better in cash flow forecasting and liquidity management if term rates which are forward-looking become available for use in the 3^rd quarter of 2020; or
• additional changes are needed by corporate treasury systems in processing future loans since conventions in the loan market are developing.
• if only a small number of banks participate in a syndicate, then the cost of borrowing may be greater since we might have operational constraints.

Good Practice Observations

Bank

Communicating with clients – product options and pros/cons

The bank communicates with the borrower about the future availability of forward-looking term SONIA rate.

The bank also informs the borrower of the anticipated changes in products conventions.

Treating customers fairly – lending margin

The methodology and the data sources used to calculate the 15bps spread between LIBOR and SONIA are provided by the bank.

Treating customers fairly and communicating with clients – small corporate borrower

When we have information that is not clear enough to customers, the bank should make additional efforts to explain such issues to customers.

Corporate

Understanding of product options and operational readiness

The corporate evaluates whether to wait for a potential forward-looking term rate. However, it may prefer to use available SONIA-based loans instead of waiting for future LIBOR loans.

While upgrading its treasury system, the bank should determine whether it can book the SONIA-based loan.

Independent advice

The corporate may seek advice from other independent advisors on what SONIA loans imply.

Case Study B: Corporate Borrowing through a SONIA-Based Loan and Simultaneously Entering into an Interest Rate Swap to Fix the Interest Payments

A UK-based corporate borrower seeks 5-year finance to invest in a new manufacturing business. The borrower approaches bank B. The borrower takes a SONIA-based loan with a notional of £10 million, maturity of five years, with quarterly SONIA-based interest payments compounded in arrears with a lookback period of five days. Simultaneously, Bank B and the corporate enter into an interest rate swap based on SONIA with a notional of £10 million, maturity of five years but with interest period ending on the interest reset date with no five-day lookback.

Risks to Market Effectiveness or Market Fairness

• There is no link between the five-day lookback period on loan and the interest period in the swap.
• Future loan conventions may change from, say, five days look back to a two-day look back. If this happens, corporates may feel wasted having used a five-day lookback.
• The evolution of loan conventions to a backward-shift approach could mitigate basis risk if the interest period of loan and swap are aligned.
• If LIBOR-based interest rate payments had been lower than SONIA-based rates, in the 2^nd half of 2020, then corporates would conclude that it would have been better if LIBOR loan were extended until the end of 2020; or
• Corporates would have been better in cash flow forecasting and liquidity management if forward-looking term rates became available for use in the 3^rd quarter of 2020.

Good Practice Observations

Banks

Communicating with clients – product options and pros/cons

• If the corporate wants fixed interest payments, Bank B will include in a fixed-rate loan and floating rate loans with a swap.
• The bank should also inform the corporate of the anticipated changes in products conventions.
• The bank should provide alternative swaps to hedge the Sonia-based loans and explain the effects, costs, and basis risk.

Additional considerations

• Additional information relating to the loan to be hedged can be accessed if Bank B wall-crosses its interest rate derivative salesperson. The salesperson will, in turn, provide alternative options for the swap. Conflicts of interest should be considered and apply appropriate protections.

Corporate

Understanding of product options and operational readiness

• The corporate, in this case, considered a fixed-rate loan but preferred a SONIA loan with a swap to enhance more flexibility.
• The corporate paid attention to the transaction costs and hedging accuracy, and the basis risk associated with different product options.

Case Study C: Corporate Entering into a USD LIBOR-SONIA Swap to Hedge Exposure Arising from GBP Loan and USD Investment

Following on from Case Study B, while the corporate borrower is based in the UK, the manufacturing facility is based in the US. The UK-based corporate wishes to borrow in GBP, and Bank C offers the borrower a loan referencing alternative rates, and the corporate selects a SONIA-based loan. Among the available options, the corporate also chooses to enter into a USD LIBOR-SONIA swap to allow hedging of the cross-currency exposure arising from the GBP loan and USD investment. This way, corporate is paying USD LIBOR-based interest rate.

Risks to Market Effectiveness or Market Fairness

• Since the USD leg of the swap references LIBOR, it may need to be amended at some future point which could increase transaction costs and operational constraints for the corporate borrower.
• As in case A, the risks related to the refinancing of the loan are also evident here.

Good Practice Observations

Bank

Communicating with clients

• Bank C informs the corporate borrower of applicable additional considerations for cross-currency swaps.

Monitoring

• The bank also monitors liquidity evolution in the SOFR markets and passes this information to the corporate borrower.

Additional considerations

• Regulatory reliefs, applications of accounting, and hedging treatment are considered by the bank.

Corporate

• Regulatory reliefs and applications of accounting are also considered by the corporate borrower.

Understanding of product liquidity

• The corporate borrower may also consider the liquidity in swaps based on SONIA and SOFR and decide whether to amend or delay amending the USD leg because SOFR derivatives have lower maturity.

Buy-Side Focused Risks – Switching Performance Benchmarks

Case Study D: Fund Manager Switches Performance Benchmark of Fund to SONIA

Several fixed income funds and alternative strategies with distinct characteristics that use benchmarks based on LIBOR or performance targets are available to a fund manager. Following the anticipated ceasing of LIBOR, the fund manager proposes that it will change its Funds, A, B, C from GBP 3M LIBOR + 185bp to SONIA + 200bp, which implies a spread of 15bps between LIBOR and SONIA.

Fund A – seeks to generate an investment return that is closer to a benchmark based on GBP LIBOR. Therefore, a correlation exists between the benchmark and underlying fund assets. No performance fee is charged.

Fund B – GBP LIBOR-linked index is used as the benchmark for the fund performance. The investment is therefore driven by the underlying strategy. Again, no fee is charged.

Fund C – is similar to fund, however, it charges a performance fee.

Risks to Market Effectiveness or Market Fairness

• Based on future developments, investors would think that it would have been better if the fund manager could adopt an alternative approach. For example:
• The underlying portfolio investment and the resultant fund analysis would be affected if the spread between LIBOR and SONIA narrows during the second half of 2021.
• The fund manager faces difficulties in selecting an appropriate benchmark and adjustment spreads that should be added. In the case of Fund C, if the benchmark is not correctly determined, the performance fee may be affected.
• Investors may think that the fund manager transition timing was in its own favor.
• In the case of Fund A, since a correlation exists between the benchmark and underlying fund assets, the benchmark timing changes, and sometimes, the transitioning of the underlying assets may be sensitive in particular.

Good Practice Observations

Communicating with clients

• Alert – Investors and distributors should be alerted of the potential risks related to new RFR products.
• Documentation updates – Updates on the appropriate documentation concerning an investment strategy or fund’s objectives should be made.

Treating customers fairly

• Investor approvals – In some cases, a change in benchmark could be viewed as a significant change event, and therefore the fund manager needs to make investors aware of a reasonable time before switching to a new benchmark.
• Choice of replacement reference rate – The fund manager should choose an alternative reference rate that aligns with the developed market consensus to ensure that customers are treated fairly. The fund manager may also inform investors of the anticipated changes in future conventions.

Governance

• Senior managers – Creating awareness to senior managers of the risks associated with transitioning of benchmarks.
• Benchmark options – The decision-making processes and governance structures for analyzing different benchmark options should be reviewed, and relevant benchmarks to switch to for each fund and the applicable spread should be identified.
• Performance fees and return – For Fund C, where a performance fee is charged, the fund manager should consider the effects of the change in the benchmark on performance fees and returns to investors.
• Product governance – The fund manager should analyze whether switching the benchmark affects the product’s characteristics and whether the product still meets the objectives and still remains suitable to be marketed in the targeted market.
• Investment updates–For Fund A, in which both the benchmark and the underlying fund assets change, the effects of such changes should be considered in decision-making.
• Investor approvals – In some cases, a change in benchmark could be viewed as a significant change event, and therefore the fund manager need to make investors aware of a reasonable time before switching to a new benchmark
• Record keeping – Fund managers need to keep appropriate records to reflect decision-making based on the available information at a specific point in the transition.

Conflicts of interest

• Record-keeping – A record of conflicts of interest and needs of different clients should be kept when deciding alternative spread and timing of the change in the benchmark.
• Incentives – Fund managers should ensure that sales targets or incentives are not linked to changing benchmarks.