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Rate expectations: Dear CEO letter encourages action from asset managers on LIBOR transition

Rate expectations: Dear CEO letter encourages action from asset managers on LIBOR transition

  • United Kingdom
  • Financial services and markets regulation

28-02-2020

The Financial Conduct Authority (the “FCA”) sent a letter to all UK regulated asset managers on 27 February 2020 (the “Dear CEO Letter”), to encourage the sector to prepare for the cessation of the sterling London interbank offered rate (“LIBOR”). The Dear CEO Letter also provides key milestones for transition.

Regulatory pressure had previously been focused on the sell-side of the market. The Dear CEO Letter however makes clear to asset managers that the FCA expects them to contribute to industry efforts to ensure a successful transition away from LIBOR. 

Background

The Dear CEO Letter follows a previous letter sent by the FCA to asset managers on 20 January 2020 regarding the FCA’s supervision strategy.

In its previous letter, the FCA indicated that it intended to gather information from asset managers in order to enhance its understanding of the preparedness of the sector for LIBOR cessation with a view to further communications setting out its specific expectations. It appears that the FCA has determined that, following its information gathering exercise, preparedness for LIBOR cessation by asset managers is inadequate and that additional regulatory pressure is required in order to encourage satisfactory progress.

Why asset managers should be concerned about LIBOR cessation

Asset managers can be exposed to, or dependent on, LIBOR in a number of ways. Each of these exposures and dependencies will present different challenges during the transition process.

Investments

LIBOR referencing investments may form part of an asset manager’s investment portfolio. Such LIBOR referencing investments might include floating rate debt instruments and derivatives (for more information regarding particular issues in relation to derivatives see our previous briefing, “Buy-side perspective: IBOR transition and derivatives”). Asset managers should consider whether future investments should reference alternative risk-free rates (“RFRs”) such as the Sterling Overnight Index (“SONIA”) (the risk-free rate which will replace LIBOR) as an alternative to LIBOR referencing investments or alternatively include appropriate fall-back provisions in their contracts that set out what happens if LIBOR ceases to be available.

The challenges faced by asset managers in transitioning from LIBOR to RFRs include a lack of liquidity in the markets in investments referencing RFRs. Many of these markets are still relatively new and it is difficult to project how quickly these markets will become as deep as those referencing LIBOR as this will depend upon market uptake.

Asset managers have a duty to their clients to transact in liquid markets. If the markets in RFRs have insufficient liquidity, a tension may arise with this duty. Asset managers will need to give this tension due consideration before migrating transactions to reference RFRs where liquidity is thin.

The depth of liquidity in SONIA referencing investments varies across investment products. For example, liquidity in the SONIA interest rate swap market has continued to increase such that firms should now consider whether continuing to execute LIBOR referencing interest rate swaps (particularly with a maturity date after 2021) is viable. Transaction volumes for floating rate debt instruments such as bonds referencing RFRs still however trails behind.

Benchmarks

Asset managers might use LIBOR as a benchmark for performance. When asset managers transition their fund benchmarks away from LIBOR, they will need to consider carefully any implications for any performance fees and renumeration. As part of these considerations, asset managers should identify appropriate equivalent levels for spreads to address the structural differences between LIBOR and SONIA (or other replacement rate) and ensure that new benchmark definitions avoid any perception of artificially inflated performance.

Operational planning

Asset managers typically rely on service providers such as administrators, custodians, brokers and pricing vendors to assist in operational processes such as front office calculations and risk systems. LIBOR cessation will require asset managers to fully coordinate with these service providers in transitioning to reference rates and to consider the potential impact this might have on each investment portfolio.

In particular, asset managers should:

  • seek assurances from their administrators that their systems are accurate and fully prepared for interest calculation changes;
  • ensure that any systems changes are replicated amongst other service providers to avoid system breaks; and
  • consider whether they need to actively monitor service providers to ensure that the services providers are taking adequate steps to transition from LIBOR.

Conduct risk

Asset managers will be particularly exposed to conduct risk issues when transitioning from LIBOR. The FCA has noted that insufficient preparation for the transition to RFRs could have an impact on the integrity of firms and potentially cause harm to clients and the market. In particular, asset managers should:

  • take steps to address any conflicts of interest that might arise;
  • ensure that their clients do not incur unreasonable costs or losses as a consequence of LIBOR cessation and that they are treated fairly; and
  • not introduce inferior terms.

FG18/7: Fairness of Variation Terms in Financial Services Consumer Contracts Act 2015 contains a list of factors that firms should consider when unilaterally varying the terms of consumer contracts.

In order to adequately demonstrate that the duty to treat clients fairly has been satisfied, asset managers should adopt RFRs that are aligned with market consensus initiatives such as those created by the International Swaps and Derivatives Association, Inc.

Transition planning

The Dear CEO Letter makes clear that the FCA expects asset managers that are exposed to, or dependent on, LIBOR to have a plan in place for transition. Transition plans should consider how the risks associated with transition will be managed. The transition plans should, for example, address any economic, legal, conduct and operational risks which might arise.

Asset managers that do not intend to create a transition plan because they have determined that they do not have any exposures to, or dependencies on, LIBOR will need to be prepared to defend that decision to the FCA.

Key milestones

On January 2020, the FCA, the Bank of England and the Working Group on Sterling Risk-Free Reference Rates (the “Working Group”) published various documents in relation to cessation of LIBOR. Our briefing in relation to the publication of these documents can be found here.

The documents published included a road map setting out the priorities of the Working Group for 2020 (the “Road Map”). The Road Map contains a number of milestones in the transition process and the dates by which those milestones should be reached. A number of the milestones were targeted at the sell-side. The FCA has clarified in the Dear CEO Letter how those key milestones might apply to asset managers. The key milestones and the dates by which firms should have complied are set out in the table below.

Milestone

 

Target date

Create a transition plan

 

Immediately

 

Ensure sterling interest rate swaps reference SONIA rather than sterling LIBOR

 

2 March 2020

Stop investing in sterling LIBOR cash products that mature after 2021

 

Q3 2020

 

Stop launching new products with benchmarks or performance fees linked to sterling LIBOR

 

Q3 2020

How Eversheds Sutherland can assist

Eversheds Sutherland, together with alternative, legal and compliance provider Konexo, can guide asset managers through all of the steps needed to transition from LIBOR to RFRs and wider benchmark reforms.

  1. Developing a strategy - Together Eversheds Sutherland and Konexo can work with you to develop project plans and offer strategic advice at each stage of the transition process.
  2. Keeping you updated - Eversheds Sutherland participates in numerous industry working groups and is therefore aware of the latest market developments. We can also work with you to ensure that that you are up-to-date with product developments and industry documentation initiatives and trends.
  3. Training your team - We can offer tailored training to relevant teams within your business.
  4. Efficient tech solutions - The firm offers AI solutions as a cost and time efficient way of identifying references to IBORs within contracts.
  5. Helping you keep track - We can also develop reports to help firms track progress.
  6. Helping you communicate with your clients effectively - We can also develop a client communication strategy (including documentation that can be used for client education).
  7. Global cross-product coverage - Eversheds Sutherland has a global presence in all of the major financial markets across all major products (including cash and derivatives) and offers buy-side firms a joined up solution across all products.

For more information regarding how we can help with IBOR transition, please see our brochure “Making It Plain Sailing – We can help you navigate through the end of IBORs”.

For more information contact

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