Alternatives
The difficulty of finding an appropriate alternative lies in the way Libor is calculated. The proposed alternatives, including Sonia in the sterling market, are all overnight reference rates, while Libor rates are published for multiple terms, with the most commonly used tenures being one, three and six months.
An overnight Sonia rate is very similar to an overnight Libor rate.
However, 3-month Sonia is different to three-month Libor. That is because three-month Sonia is sourced from the overnight index curve that assumes that investments are made overnight with a bank, with continual reinvestment on a daily basis for the next three months.
While Sonia involves one-day credit risk, three-month Libor reflects the credit risk taken with the counterparty over a three-month period. In short, there is a greater risk that a financial institution goes under within three months of an investment than from one day to the next. This explains Libor’s premium in comparison with Sonia.
In essence, as the new contracts and products using an alternative to Libor will not be economically identical to the existing ones, the transition from one to the other is not a simple, direct process and will involve significant legal, product design and risk management implications.
What will this mean for asset managers? The Investment Association suggests that the switch from Libor to new benchmark rates will affect asset managers in three main areas: portfolio construction, fund benchmarks and operations.
A wide range of fund managers have exposure to Libor through derivatives for hedging portfolios, or through investment in floating rate notes and asset-backed securities. The termination of Libor may affect the functioning, liquidity and valuation of these instruments.
Outside portfolio construction, Libor is a widely referenced benchmark for investment and performance targets, especially for absolute return and money market funds.
These benchmarks will need to be replaced before it is discontinued. Preliminary conversations with fund managers who will be affected by this change suggest that many plan to switch to similar benchmarks such as Sonia, plus some spread.
However, the methodology for determining this spread has not yet been standardised, despite the clear need for industry-wide consistency.
Operationally, investment managers will need to update their models and systems because Libor can be used across several processes.
These could include calculations used for allocation and pricing in front office systems, yield curves used for discounting and calculating the present value of assets and liabilities and scenario analysis and stress-testing by risk management systems using Libor as interest rates.
Furthermore, Libor is used by third parties such as custodians and fund administrators for valuations and risk analysis. Consequently, investment managers need to make the appropriate preparations in their systems and operations to integrate the new rates. It will be important for managers to work with clients to alert them to, and guide them through, this process.
