How the Buy Side Can Prepare for LIBOR Transition and Stay Ahead of the Curve
We sat down with Market Alpha Advisors LLC's Managing Principal, Michael Koegler, to interview him on how buy side fixed income firms in the USA can prepare for the new LIBOR regulations changes due to come in the autumn 2021. Discover how fixed income trading in the US will be affected, how this new regulation will change trading in the next two years and much more.
How do you think buy side firms will be affected by the LIBOR transition in the next two years?
The cessation of LIBOR represents a significant challenge for the buy-side. Navigating this transition will affect firms in many ways. The buy-side needs to understand that they now have a new risk in their portfolios – the fallback language in their LIBOR-based instruments.
Although the Fed is pushing for firms to convert their USD LIBOR positions to SOFR before the end of 2021, there are many complicating factors. LIBOR fallback language is highly inconsistent from one deal to the next. Even if a deal has fallback language for temporary disruptions in the setting of LIBOR, many do not anticipate a permanent cessation. This creates unintended consequences, including fallbacks that effectively turn a floating rate note to fixed at the last LIBOR setting if there are no banks willing to set a LIBOR level. Given the historically low level of LIBOR, this disincentivizes issuers to alter their fallback language.
Another potential landmine for the buy-side is that some states require 100% consent in order to modify a deal. This means that a single investor could hold up the conversion of a deal to an alternative reference rate if they do not give their consent to the new terms. This is already happening and has the potential to create a wave of litigation throughout the industry.
The cessation of LIBOR does not only affect certain parts of a buy-side firm. It affects the entire organization – portfolio management, trading, marketing, operations, technology, risk management, etc. The entire organization needs to be engaged in the process through a top-down governance structure established by senior management.
What advice would you give to those buy side firms that are struggling to plan a roadmap for transitioning from LIBOR?
At this phase of the transition process we would advise firms to do the following:
- Establish a proper governance structure that will educate and empower the entire firm to deal with the LIBOR transition
- Identify and evaluate your firm’s LIBOR fallback exposure. Firm’s typically have a solid grasp on the basic details of their floating rate instruments – reset dates, maturity, spread, credit quality, etc. However, when it comes to the LIBOR fallback language embedded in documents many firms do not know what will happen to deals if LIBOR fails to set. Understanding fallback risk is no easy task if a firm has thousands of deals tied to LIBOR. We recommend getting a handle on LIBOR fallback risk as soon as possible to identify problematic deals before they lose value. Investors may opt to sell rather than take the risk of an unfavorable outcome if LIBOR doesn’t set. See “CLO Libor fallback language proposal fails as investor balks at change”, Reuters, October 8, 2019.
- Attempting to tackle the entire transition all at once is not manageable. Breaking the process down into discrete phases will help firms manage this very complex process. Create a plan that includes milestones and hold people accountable for meeting deadlines.
- At this stage firms should not focus too much on the ultimate replacement rate. SOFR is most likely going to be the alternative reference rate that many contracts convert to, but there is planty of time to focus on this after setting up a proper governance structure, identifying fallback risk and formulating a transition plan.
How have you helped buy side firms adopt new compliance solutions and strategies in the past year?
Market Alpha is a market structure and FinTech advisory firm with expertise in every financial market asset class, including fixed income, futures, derivatives and interest rate benchmarks. Our firm specializes in helping clients unpack complex aspects of market structure, which requires understanding the granular details along with an ability to tie data and information to strategic insights and recommendations. As it relates to the LIBOR transition, we advise our clients in the following areas:
- Governance Structure
- Communication Strategy
- Exposure Identification
- Product Strategy
- Contractual Remediation
- Accounting, Tax and Regulatory Matters
- Implementation and Conversion
What can buy side firms do to help reduce their exposure in cash instruments (bank loans, securitizations, mortgages etc.) when planning for transitioning away from LIBOR?
The most important thing that a buy-side firm can do at this point is to generate a LIBOR Fallback Report like the one shown below. Once that task is completed they can then sort, categorize and evaluate their positions.
Sample LIBOR Fallback Report
As you can see, the fallback language embedded in some documents can be highly complex. Just looking at one example, the perpetual preferred issued by RBS will convert to a fixed rate at the last LIBOR setting plus the spread if the calculation agent cannot obtain a LIBOR quote. This deal is a perpetual (i.e. no maturity) so the duration would increase dramatically if LIBOR fails to set.
Would you want to own this bond if it converted to fixed at the last LIBOR setting plus a spread?
What steps can buy side firms do now to overcome internal challenges such as silos and out-dated legacy systems when implementing new regulatory compliance procedures?
This is where a proper governance structure becomes critical. It is important that firms take a top-down approach since LIBOR touches virtually every part of a financial institution. It does a firm no good to transition positions to an alternative reference rate such as SOFR if its systems and infrastructure are not able to handle it. All parts of an organization must be in sync with each other and be held accountable for coordinating their approach to the LIBOR transition. Senior management from the CEO on down must be involved in the process.
This graphic illustrates the approach:
There should be no silos when it comes to the LIBOR transition.
What can buy side firms with multiple global locations do to help smooth their transition away from LIBOR in 2020?
Once again the correct governance structure must be implemented on a global basis, with accountability by department and geographic location.
What new innovative technology do you think will be most beneficial for buy side firms to implement to maintain and improve their regulatory compliance protocols in 2020?
One of the first things that buy-side firms must do to prepare for the LIBOR transition is to review all of their documents that reference LIBOR. An efficient method for doing this is to fully digitize the documents first and then generate reports highlighting those deals that contain problematic LIBOR fallback language. Our firm spends a great deal of time advising clients about digital transformation initiatives and believes that the buy-side can take this opportunity to fully digitize their documents as part of the LIBOR transition process. Since the documents need to be analysed anyway we think that there is an additional benefit in creating fully digitized copies that have all of the critical elements indexed and searchable. There is a tremendous amount of value in taking unstructured data as it exists in legal documents and converting it to structured target data sets. We believe that this technology is extremely powerful and will be instrumental in modernizing the operations of financial institutions.
Market Alpha has proprietary software that utilizes natural language processing and rule-based algorithms to read unstructured documents and convert them into structured data.
The Unstructured Data Challenge
Our platform runs in a secure cloud environment and can be scaled appropriately depending on a client’s needs. Unstructured documents are uploaded to a secure folder in the cloud where they are read, indexed and transformed into a structured target data set, like the LIBOR Fallback Report shown above.
LIBOR Fallback Extraction Process
What are you most looking forward to at the Fixed Income Leaders Summit USA event this year?
At this point of course, we are hoping that the conference can take place as scheduled. The Coronavirus pandemic has obviously placed a damper on the overall economy, but the issues facing the financial markets, such as the cessation of LIBOR, have not gone away. We are very much looking forward to networking with our clients and industry professionals at the event this year.
Download the agenda today to find out what other fantastic speakers, sessions and activities we've got lined up at the event this year.