The London Interbank Offered Rate (LIBOR) was officially adopted in 1986, with roots dating back to the 60s. Underpinning some $300 trillion (Refinitiv, October 2019) of financial instruments, it is one of the most widely quoted reference rates in the world. It is expected that LIBOR and other Interbank Offered Rates (IBORs) will cease to exist after the end of 2021.
LIBOR is based on submissions by a panel of global banks. Each bank is asked every day to provide the rate at which they could secure short term lending from another major bank and those submissions are used to calculate LIBOR in accordance with an agreed methodology.
LIBOR is used as a reference rate in a wide range of financial contracts, including derivatives, bonds and loans. It is set for seven maturities, ranging from overnight to 12 months, and five different currencies for each maturity. LIBOR rates exist for the US dollar, sterling, euro, yen and Swiss franc.
Where there are insufficient actual transactions or transaction-related data on which to base their LIBOR submissions, the panel banks must use their “expert judgement” within certain agreed parameters to provide their submissions.
A significant decline in interbank lending and some high-profile instances of LIBOR manipulation resulted in the publication of the Financial Stability Board’s (FSB) recommendation in 2014 to develop alternative so-called “risk-free” rates (RFRs) for use instead of LIBOR and other IBORs. In July 2017, the former Chief Executive of the Financial Conduct Authority (FCA) Andrew Bailey, said in a speech that “…the underlying market that LIBOR seeks to measure – the market for unsecured wholesale term lending to banks – is no longer sufficiently active.”
In the same speech, Andrew Bailey also said, “In our view, it is not only potentially unsustainable, but also undesirable, for market participants to rely indefinitely on reference rates that do not have active underlying markets to support them”. He went on to say that the FCA would not compel banks to make LIBOR submissions after the end of 2021 which was widely understood as a sign that LIBOR would cease to exist post-2021.
The FCA further confirmed that LIBOR would be discontinued at the end of December 2021 by publishing statements in September 2018 and February 2020 asking for firms’ plans for the transition away from LIBOR and setting out the FCA expectations for the end of LIBOR.
On 25 March 2020, despite the impact of the coronavirus on financial markets, the FCA stated that the central assumption that firms cannot rely on LIBOR being published after the end of 2021 has not changed and should remain the target date for all firms to meet.
Following the FSB’s recommendation in 2014, industry working groups were established to develop the new Risk Free Rates (“RFRs” and also known as “alternative reference rates”) that are expected to replace LIBOR and other IBORs. LIBOR has a clear cessation date, whereas in some markets an IBOR will continue to exist beyond 2021.
The new RFRs selected for the five major currencies of LIBOR are as follows:
New risk free rate
Reformed SONIA (Sterling overnight index average)
US dollar LIBOR
SOFR (Secured overnight financing rate)
TONAR (Tokyo overnight average rate)
Swiss franc LIBOR
SARON (Swiss average overnight rate)
€STR (Euro short term rate)
Schroders has a robust plan for the effective management of the impact on our clients’ investments as a result of the transition away from LIBOR and has established a dedicated team responsible for this task.
Schroders has completed an assessment to determine the impacts of the transition away from LIBOR, and certain other key IBOR, to RFR for our clients and our business. As part of this impact assessment we have analysed the work required to transition investments, change legal documents and update operational and technology systems.
We believe that it is essential for the industry to move together as a whole to define a consistent approach and that remaining in step with the broader industry will ultimately be in the interests of our clients. Schroders is participating in industry working groups (e.g. the Bank of England’s Working Group on Sterling Risk-Free Reference Rates) and following developments in the transition away from LIBOR, with the aim of adopting, in due course, measures aimed at managing transition risks that are consistent with industry best practice.
The new RFRs have been selected for the five major currencies of LIBOR. In addition to this, interest rate benchmark transition is making good progress globally.
Across Asia, a multi-rate approach has largely been adopted for the transition away from LIBOR, which sees existing rates being used alongside replacement rates.
In Hong Kong, it is expected that an enhanced Hong Kong Interbank Offered Rate (HIBOR) will continue to exist alongside adjusted Hong Kong Overnight Index Average (HONIA) as the likely fall back rate.
In Indonesia, the existing Jakarta Interbank Offered Rate (JIBOR) is being supplemented with IndONIA, which is replacing the overnight JIBOR as an overnight interest rate benchmark. JIBOR has also been enhanced with contributor banks having to quote rates by underpinning it to the greatest extent possible with transaction data in order to better reflect market rates.
In Singapore, the existing Singapore Interbank Offered Rate (SIBOR) which is referenced in cash products will continue to exist, although enhanced methodology for its calculation is expected to be implemented following recent transitional testing. The Singapore Overnight Rate Average (SORA) or an adjusted form of the Singapore Dollar Swap Offer Rate (SOR) is expected to be the fall back rate for SOR.
In Australia, a modified version of the existing IBOR, the AUD Bank Bill Swap Rate (BBSW), will continue to be used and co-exist alongside the Australian Interbank Overnight Cash Rate (AONIA) Australia’s new RFR.
During the course of 2020 and into 2021 we aim to incrementally reduce our exposures to LIBOR for the investments we make on behalf of our clients. There will be impacts to a number of Schroders’ clients who invest both via segregated mandates and as shareholders in our funds. We will be working with our clients to minimise the impact of any changes. The impacts of LIBOR transition can be categorised as follows:
LIBOR is used in many of the financial instruments in which we invest on behalf of our clients and there are different possibilities to transition away from investments that use LIBOR over the next 18 months before LIBOR ceases to be published.
In addition, for some types of investments in some jurisdictions there are currently no easy solutions to change their terms to incorporate fall back provisions to determine an applicable alternative rate. For example, it is normal for noteholder consent to be required to amend the terms of bonds. Depending on the exact terms of the bonds the threshold for obtaining such consent can range from 75% to 100% of all noteholders.
Where unanimous consent is required, which is often the case in the US market it is unlikely that the issuer of that bond will obtain the requisite consent if that bond is widely held in the market. The Alternative Reference Rate Committee (ARRC) has proposed a change to New York state legislation as a means to solve this issue. Such legislation would apply fall back provisions into the terms of such bonds where none currently exist. However, there are likely to be challenges in making such a proposal become law and at the time of writing Schroders and other market participants are not in a position to rely on this change in law as a certainty.
Industry working groups and associations have raised the existence of these difficulties in passing amendments to certain cash instruments to the FCA and other regulators globally and it remains to be seen what ultimate position regulators will take on these hard to remedy investments, the so-called “tough legacy” investments.
Where funds or segregated mandates have LIBOR benchmarks these will need to be updated. For Schroders’ fund range, there is a plan in place to migrate benchmarks over the next 12 months. Where mandates have LIBOR benchmarks we will be working with our clients to set new benchmarks and will be recommending the same changes that we are applying to our own funds. Our recent article explains our plans to replace the key fund benchmark and what it means for our clients.
Where there are LIBOR benchmarks in our mandates, IMAs will need to be updated, but there may also be further references to LIBOR in IMAs such as in the investment guidelines section that will need to be remediated as part of this transition and we will be working with our clients to make these changes.
We are making updates to our operational processes and technology systems so that we can support this transition.
The FCA confirmed on 25 March 2020 that the central assumption that firms cannot rely on LIBOR being published after the end of 2021 has not changed and should remain the target date for all firms to meet. Schroders is committed to meeting the target of the end of Q3 2020 to cease launching new products with benchmarks or performance fees linked to LIBOR. In addition, we are working towards the transition away from LIBOR for all our clients by the end of 2021 at the latest, in line with market developments, subject to viable alternative investments being available which reference RFRs.
There is arguably an inherent risk of market disruption in any significant transition exercise that impacts a significant number of market participants and instrument types.
However, market participants (including Schroders) are working to minimise the impact of LIBOR / IBOR transition, including impacts on underlying clients, by adopting measures (e.g. protocol arrangements facilitating the remediation of relevant OTC derivatives documentation) developed through market participant feedback on an industry-wide basis.
The conversion from a LIBOR-linked product to a RFR-linked product will most likely result in a payment being made from one party to the other to account for the change in the characteristics of the underlying reference rate. While the use of industry developed methodologies (such as those developed by ISDA for the derivatives markets) to calculate the alternative reference rate should help to minimise this value transfer it will not remove it entirely. This payment could be due to or required to be paid by, a client’s portfolio. These costs related to the transition will need to be considered as part of each client’s transition plan.
LIBOR swaps are governed by the International Swaps and Derivatives Association (ISDA) documentation. ISDA has completed significant work over the last two years to identify a suitable fall back for relevant LIBOR exposures. The intention is to develop revised standard ISDA terms which will include fall back provisions to determine the applicable alternative rate, when LIBOR ceases to exist, or is deemed no longer-representative of the underlying market by the relevant regulatory bodies.
ISDA are also developing a protocol which is a set of terms that will, if two parties adhere to the protocol, have the effect of amending the open OTC derivatives transactions between those two parties to incorporate the fall back provisions in the above-referenced revised standard ISDA terms. This protocol is expected to be published in July 2020 and to take effect towards the end of 2020, and will govern legacy LIBOR transactions following the discontinuation of LIBOR or a formal announcement by the FCA that LIBOR is no longer representative of the underlying market.
The revised standard ISDA terms will be adapted and will be incorporated into the clearing house rules governing cleared derivatives. These changes will be applied automatically as of a particular date to any cleared OTC positions by the clearing houses updating their rules.
However, for any bilateral OTC exposures, both counterparties to a legacy swap must agree to adhere to the new protocol for it to become effective. If one counterparty does not adhere to the new protocol and the parties do not otherwise agree to amend the terms of their transactions, the bilateral position will continue to reference LIBOR which may lead to outcomes that were unintended by the parties at the outset of the transaction if LIBOR ceased to exist.
Following a series of ISDA consultations over the last 2 years, on which Schroders has responded, the agreed LIBOR fall back for bilateral OTC derivatives exposures can be summarised as the ‘Adjusted RFR + Spread Adjustment’.
‘Adjusted RFR’ is the compounded set-in-arrears value of the overnight RFR applicable to the LIBOR used in the OTC derivative.
‘Spread adjustment’ is a credit spread adjustment which is intended to allow for the bank credit-risk element embedded within LIBOR which is not factored into the calculation of a RFR. This is to be calculated as a 5-year average of the spread between relevant LIBOR and RFR until the discontinuation of LIBOR.
Bloomberg has been appointed by ISDA to make these calculations in accordance with the methodology agreed through the ISDA consultation process and, in order to give market participants transparency ahead of the transition, has already begun publishing on a daily basis what the calculation would be on the assumption that on that day the provisions in the revised standard ISDA terms resulted in the new fall back rates applying.
More information including the detail of the ISDA methodology to be used to calculate the ‘Adjusted RFR’ and “spread adjustment” can be found in the ISDA consultation papers https://www.isda.org/2020/05/11/benchmark-reform-and-transition-from-libor/
Examples of ‘trigger events’ that would result in LIBOR exposures moving to the ISDA fall back rate are:
Floating rate bonds and loans are not affected by ISDA protocols or the revisions to the standard ISDA terms. The Bank of England’s Sterling RFR Working Group, the UK Loan Market Association, the European Central Bank’s Euro RFR Working Group and the Alternative Reference Rate Committee in the US are amongst other industry organisations that are developing applicable fall back wording for use in loans and bonds. Schroders is monitoring and in some cases participating in, developments by these organisations.
Alternative Reference Rate Committee (ARRC) – a group of financial industry participants focused on the successful transition from United States Dollars (USD) London Interbank Offered Rate to an alternative rate.
Asset-Backed Securities – a financial asset that is supported by a pool of assets, e.g. credit card debt, loans.
Benchmark – a standard against which the performance of a financial asset or a fund can be measured. Benchmarks are used in our funds for a range of purposes including a standard against which to compare the return or “performance” of the fund, as a target for the fund’s performance to try to beat and for defining what types and amounts of financial assets the fund will invest in. In some instances, they are also used to calculate performance fees, being fees that are paid to the investment manager of the fund if the fund’s performance rises above a set threshold.
Bonds or Notes – a form of financial asset that represents a loan from a financial investor (the bondholder or noteholder) to a borrower called the “issuer” (usually corporates or governments).
Credit Risk – the risk that a borrower will become bankrupt or otherwise fail to repay a loan.
Derivatives – a financial asset with a value that is set by reference to other assets e.g. shares, bonds, interest rates.
Derivatives exchange – a form of organised market place for the trading of derivatives on certain prescribed terms.
Fall back – a contractual term of a financial asset that outlines the alternative rate to be used if London Interbank Offered Rate or Interbank Offered Rate is discontinued.
Financial Conduct Authority (FCA) - the conduct authority for financial services firms in the United Kingdom.
Financial Stability Board – an international body that works to promote international financial stability.
Floating Rate Notes (FRN) - a note (see above) with a variable rate of interest that resets at specified intervals.
Interbank Offered Rate (IBOR) - a rate at which major global banks expect they can borrow from other major global banks. This is often not based on actual loans between those banks but is created from estimates submitted by those banks.
Interest Rate – the amount a lender charges a borrower for a loan.
International Swaps and Derivatives Association (ISDA) - a trade association representing participants in the derivatives market.
Maturities - represents the number of days before a financial asset must be repaid.
Note – see bonds above.
Noteholder consent – a process whereby the issuer of a note has to obtain the consent of a certain percentage of the noteholders before the terms of that note can be amended.
Over-the-counter derivative – a derivative entered into bilaterally between two parties and not traded on a derivatives exchange.
Portfolio – a range of investments held by a person or company.
Reference Rate - an interest rate benchmark used to set other interest rates in financial assets. London Interbank Offered Rate and Interbank Offered Rates are examples of reference rates.
Risk Free Rate – a reference rate that does not include in its calculation the credit risk of the borrower.
Risk Free Rate Working Group (RFRWG) - the Bank of England and Financial Conduct Authority’s group of financial services members focused on the transition away from London Interbank Offered Rate.
Swaps – a type of derivative between two parties to exchange the cash flows or liabilities of two financial assets for a defined period.
Important Information: This document should not be considered as legal or regulatory advice or relied upon as such. We encourage all our clients to seek independent legal advice in respect of their legal and regulatory obligations.
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*Schroder International Selection Fund will be referred to as Schroder ISF throughout this website
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