As the primary benchmark for short-term interest rates globally, the London Inter-Bank Offered Rate (LIBOR) is referenced by an estimated US$350 trillion of outstanding contracts in maturities ranging from overnight to more than 30 years. However, following the rigging scandal that was unearthed in 2012, the LIBOR and other inter-bank offered rates (IBORs) have been edging closer to their demise.
Accordingly, alternate reference rates (ARRs) – such as the UK’s Sterling Overnight Index Average (SONIA), the USA’s Secured Overnight Financing Rate (SOFR), the EU’s Euro Short-Term Rate (€STR) and newly reformed EURIBOR, the Tokyo Overnight Average Rate (TONAR) and the Swiss Average Rate Overnight (SARON) – have been developed to ease the crucial transition.
Indeed, these risk-free rates (RFRs) symbolise the willingness of the financial services industry to move to a new lending model with the objective of infusing greater transparency and paving the way for a future where consumer protection and investor interest are upheld above all other considerations.
We shall now go on to discuss why this move has such overarching implications for the funds and asset management universe, of which private debt is becoming an increasingly important part as a new asset class with significant growth potential.
What are the challenges along this journey?
Any party exposed directly or indirectly to non-compliant rates is exposed and at risk. As from 1 January 2020, non-compliant rates can no longer be used for new agreements. For existing agreements, authorities have recommended that due diligence exercises are conducted to assess transition methodologies for products making reference to IBORs and an identification of all associated dependencies.
Transitioning from IBORs into RFRs represents a significant break from the past, whereby a forward-looking rate was agreed in order to factor in the risk represented both by the possibility of default on the part of the borrowing bank as well as the term-liquidity risk inherent in the duration of the lending term.
Conversely, RFRs are overnight backward-looking rates and, while they are clearly less susceptible to collusion or rigging than the notional rate represented by the former IBORs, significant computation is needed to arrive at the IBOR equivalent.
What must asset managers watch out for?
The key takeaway for asset managers who rely on IBORs for their interest rate agreements is that they would need to amend them to factor in RFRs and to revise interest computation and payment mechanics, besides updating their internal systems to reflect such a revised reference rate.
Another area of concern is credit renegotiation, for which private debt firms should consider a fresh review of their credit policies and related documentation. For example, private debt managers are usually reluctant to see their portfolio companies renegotiate credit with the attendant risk of disadvantageous changes being introduced. Indeed, the cost of renegotiation alone could undermine potential returns. However, the fallback language in many current agreements does not account for the outright demise of IBOR and will probably need updating to avoid an automatic conversion of an IBOR into a fixed rate upon permanent cessation, for example.
In addition, it is quite common to have hedging products linked to loan agreements, therefore modifying a loan agreement could cause a payment mismatch. Loan agents must also ensure that they have updated their systems to manage various reference rates following their own calculation methodologies and publication times, creating difficulties for multicurrency loans.
Finally, to compound the issue, the asset management industry, like all other sectors, is still coming to terms with the impact of the COVID-19 crisis, with newer asset classes such as private debt especially affected in view of the future uncertainty for fundraising amid the pandemic. In all fairness, certain regulators have adjusted interim milestones to account for the crisis and its aftermath; however, all regulators have held firm to the final transition deadline of the end of 2021.
How can the private debt industry prepare for this transition?
Keeping in mind the guidance laid out in the UK FCA letter, our recommendation to the asset management industry is around the overarching need to have appropriate strategic planning and risk mitigation initiatives in place that address the key areas of business impact, core operations impact, and managing client expectations.
As such, we propose that all asset managers follow the steps outlined below to minimise the business and operational impact of the IBOR transition and to prepare their clients and other external stakeholders for the new era of inter-bank lending rates based on RFRs:
- Outline a suitable programme governance framework
- Conduct an extensive business impact analysis
- Undertake a firm-wide risk assessment
- Prepare a detailed timeline for the implementation of risk mitigation measures
- Closely coordinate the transition exercise across portfolios, functions and geographic locations
- Develop a strategic transition roadmap that takes into account both internal and investor needs.
Paving the way for a fairer and more transparent interest regime
Looking ahead, as the financial world moves towards a fairer and more transparent interest regime, it is incumbent upon the asset management industry to support the regulators in their efforts to achieve a smooth transition by the end of 2021.
Working hand in hand with regulators may prove to be the key to success for asset managers, including those involved in the growing private debt market, in transitioning to a new lending rate framework that protects the interests of investors and safeguards consumers.
And, as part of this, asset managers that take the initiative to press ahead with serious discussions about how contract terms will change in the new era of RFRs will be the ones most likely to enjoy a favourable outcome when that transition deadline arrives.
Get in touch
If you wish to discuss your IBOR transitioning requirements to see how IQ-EQ could help, please don’t hesitate to contact me:
T: +352 466111 2168