5 minute read 23 Jul 2019
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How to remain future-flexible under IBOR’s frame of reference changes

By

EY Global

Multidisciplinary professional services organization

5 minute read 23 Jul 2019

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IBOR transition has major repercussions for wealth and asset management – and organizations should act now to absorb those repercussions.

We’re rapidly entering a new era where trillions of dollars of financial products will be benchmarked to a new form of reference rate. Phasing out  Interbank Offered Rates (IBORs) will have a huge impact on the wealth and asset management (WAM) industry – from wealth managers to private banks, asset managers to asset service providers and universal banks, from pension funds to corporate investors.

Many asset managers apply hedging strategies using London Interbank Offered Rates (LIBOR) - referencing interest rate derivatives. Many also invest in bonds or other securities in which interest payments reference an IBOR. Migrating from IBORs will affect how asset managers benchmark their mandates, manage assets in their portfolios, calculate fund net asset value, manage risks and communicate with clients.

Three core opportunities

IBOR migration creates opportunities for the industry in three core categories – starting with fiduciary responsibilities:

  1. There’s evidence in the US of concern about the reputational and legal risks of failing to have new contracts ready for pension plan sponsors, with resulting value transfer implications. Similar concerns are likely to grow in Europe and Asia-Pacific. Well-managed firms have an opportunity to protect their brand from reputational damage – while avoiding the cost of losing investor business.

  2. WAM firms can boost their brand strength by enhancing their product strategies. They can use IBOR transition to introduce new and profitable products, while improving client intimacy and strengthening client relationships. Firms can reach out to clients – offering education and training support, and holding more useful conversations about their investment and financing needs.

  3. There’s potential to simplify business and operating models. Products based on the new Alternative Reference Rates (ARRs) will be simpler than those pegged to the old IBORs. For example, they won’t be transacted on a term structure or using indicative rates. Instead, they will be linked to real, risk-free rates, making it easier to net down existing positions, swap and compare assets, and facilitate simultaneous cross-currency transactions. Alternative investing could also experience a boom, with over-the-counter (OTC) investing becoming more like a mainstream, flow business.

Future flexibility is essential

Why is it important for WAM firms to focus on a strategy that is future-flexible? Because so much uncertainty exists not only around IBOR transition, but also about the future shape of the market and various players’ response within it.

We know things will change; in fact, they already have. ARRs are being developed, such as SOFR in the US, SARON in Switzerland, and SONIA in the UK or €STR in the EU. But unlike the response to the global financial crisis of 2008, there is a comparative lack of international regulatory coordination when it comes to pacing. There is no consensus on whether ARRs should be secured, unsecured or some form of hybrid (e.g., spread applied to a secured rate). Similarly, there is no cross-jurisdictional harmony on the timeframes for when the transition from old to new rates should be completed.

Given this environment, WAM firms need to stay future-flexible to accommodate different approaches in different markets. They need to build and maintain systems, processes and models that can adjust to a range of developments and uncertain timeframes. Firms need to avoid undertaking efforts that become redundant in a fast-changing landscape; i.e., staking everything on an ARR that fails to generate sufficient liquidity would be unwise.

Firms are, of course, affected by the response of vendor solutions providers such as market data providers and application providers. If data feed providers fail to prepare for IBOR transition in time – if they can’t provide swap curves or data in the right formats and at an affordable price – WAM firms will feel the impact. Therefore, maintaining the flexibility to adopt and plug in the best solutions is important, as is staying tuned to the promise of innovative solutions in the algo trading and artificial intelligence spaces.

Encouraging disruption

It’s also worth highlighting that IBOR transition could encourage developments in disruptive technologies, cloud computing and artificial intelligence to help with valuations or enable more flow-driven or algorithmic trading. This could shake up the market, even beyond the basic IBOR transition impact. We estimate that upwards of 10%-15% of larger asset managers and asset servicers are considering providing solutions in the IBOR space, as well as adjusting their own investment and hedging models.

Another good reason for maintaining flexibility is the buy-side’s dependency on the sell-side’s response. Banks are assessing the impact of IBOR transition on their own cash and derivative products and services, but they face significant time pressures in providing the liquidity the buy-side needs.

At the other end of the value chain, pension funds, corporates and other clients must also respond to the IBOR challenge – clarifying their own needs and preferences. This is another good reason why WAM firms need to be proactive in holding conversations with clients; helping them understand the scale of the transition, and the importance of both agreeing new contract terms in good time and embracing new products.

Transition challenge

Clearly, the scale of work triggered by IBOR transition is significant. Some firms believe that most IBOR transition costs for the WAM sector could arise from reprioritizations within the business – actions taken to avoid the major costs that would otherwise be incurred. Others hint at the significant costs of installing new fall-back provisions, modes of disclosure or securing client consents.

For example, to address legacy contracts referencing IBORs after 2021, firms will need to put substantial effort into repapering contracts. They will also need to invest in new systems to revalue instruments and manage risks, and consider potential accounting and tax repercussions. Such actions combined could well result in program structures similar to those incurred by MiFID II compliance – or in some cases, possibly even exceeding them.

Overall, WAM firms will need some 10 different work streams to address all necessary issues. These would cover:

  • Overall project/program delivery and planning
  • Governance, risk and controls
  • Market liquidity and uncertainty modeling
  • Enterprise risk management
  • Valuation and risk management
  • Product design
  • Legal issues
  • Operations, data and technology
  • Accounting and tax
  • Client communications

Many firms have been slow to get started with IBOR transition activities. Only around 35% of leading asset managers have identified the senior management and governance structures they need. The figure is likely to be far lower for wealth managers, pension funds and corporate entities.

Asset managers who are the most prepared at this juncture tend to be US headquartered or bank and insurance captives, and liability-driven investing firms employing OTC derivatives, inflation swaps, cross-currency swaps and floating rate note money markets – all of which are impacted by IBOR transition. Larger wealth managers, which could also feel the impact through structured products, packaged loans, complex products and securitizations, are also starting to perform their impact analysis. However, small and medium-sized firms and wealth managers have tended to focus on other competing priorities with closer deadlines.

Moving forward

Those firms yet to prioritize IBOR will need to do so over the next few months, assess what impact the transition to ARRs is likely to have on their business and plan their response accordingly. They need to consider the impact on the broader ecosystem, communicating with banks, issuers, financial market infrastructures and enabling vendors.

Whatever response they settle on, it needs to be one that’s future-flexible – and allows them to make the most of all available opportunities. By doing so, firms should eventually find themselves counting the benefits, rather than the cost of the IBOR transition.

Summary

The wealth and asset management industry will benefit from adopting a future-flexible strategy in response to the transition from interbank offered rates (IBORs) to new alternative reference rates (ARRs) for investment products. Firms should prioritize their needs to make the most of new opportunities that the switch to ARRs will create for the sector.

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By

EY Global

Multidisciplinary professional services organization