Learning objectives: Discuss regulatory expectations on LIBOR transition and how these expectations can help market participants in their management of conduct risk arising from the transition. Analyze the risks of LIBOR transition from both sell-side and buy-side perspectives and give examples of good practice observations.
Questions:
22.5.1. The FICC Markets Standards Board (FMSB) explained the principles and regulatory expectations attached to the LIBOR transition. LIBOR is a forward-looking term rate; i.e., one, three, and six months. They supported their recommendations with four case studies. In regard to these principles, expectations, and case studies, each of the following statements is true EXCEPT which is false?
a. The backward shift approach can decrease basis risk
b. Firms who receive LIBOR-linked interest should expect to give up the spread due to the credit risk premium
c. The preferred alternative risk-free rate (RFR) for the Sterling is the Sterling Overnight Index Average (SONIA) which is an overnight, backward-looking rate
d. Because firms should already have a taxonomy for the identification/assessment of common conduct risks, it is possible for some firms that LIBOR-related risk might be best addressed with their existing conduct risk framework
22.5.2. In its review of the LIBOR transition, the FICC Markets Standards Board (FMSB) includes four case studies that illustrate the risks of the LIBOR transition. The second case study ("Case Study B") is about a corporate client who seeks fixed interest payments on a loan. As FMSB explains the case, Bank B offers a SONIA-based loan packaged (i.e., combined simultaneously) with an interest rate swap, as follows:
"A corporate is seeking finance to invest in a new manufacturing facility and wishes to enter into an interest rate swap to fix interest payments. The corporate borrower enters into a SONIA-based loan with Bank B with a notional of £10 million, maturity of five years, with quarterly interest payments referencing SONIA compounded in arrears with a five-day lookback period (lag approach). Simultaneously, Bank B and the corporate enter into a SONIA-based interest rate swap with notional of £10 million, maturity of five years but with interest period ending on the interest reset date with no five-day lookback." -- Source: LIBOR transition Case studies for navigating conduct risks, FMSB, June 2020 (page 17).
Among the following risks--and especially in regard to client communications--which is the most obvious risk that must, at a minimum, be communicated to the corporate client?
a. Basis risk
b. General risk
c. Rotation risk
d. Switching risk
22.5.3. In its review of the LIBOR transition, the FICC Markets Standards Board (FMSB) includes four case studies that illustrate the risks of the LIBOR transition. The fourth case study ("Case Study D") concerns a buy-side fund manager, with three funds, who (given the discontinuation of LIBOR) proposed to change the performance benchmark. Specifically:
"[Case Study D] A fund manager has a number of fixed income funds and alternative strategies with different characteristics that use LIBOR-linked benchmarks or performance targets. Given the imminent discontinuation of LIBOR at the end of 2021, the fund manager proposes that during Q1 2021 it will change each of Funds A, B, and C from the GBP LIBOR benchmark rate to a SONIA-based rate. In each case, the benchmark is updated in March 2021 from GBP 3M LIBOR + 185bp to SONIA + 200bp, reflecting an average spread at that point in time of 15bp between LIBOR and SONIA." -- Source: LIBOR transition Case studies for navigating conduct risks, FMSB, June 2020 (page 21).
The following are the manager's three funds:
a. If the spread of LIBOR over SONIA narrows during H2 2021, the analysis of fund performance might be impacted
b. As these are existing (but not new) funds, it is bad practice for the fund manager to change to a SONIA-based rate
c. It is bad practice for the fund manager to choose the same SONIA + 200 bp as the replacement rate for all three funds
d. Fund A is the LEAST sensitive to governance implications such as investment updates, and Fund B is the MOST sensitive to these implications
Answers:
Questions:
22.5.1. The FICC Markets Standards Board (FMSB) explained the principles and regulatory expectations attached to the LIBOR transition. LIBOR is a forward-looking term rate; i.e., one, three, and six months. They supported their recommendations with four case studies. In regard to these principles, expectations, and case studies, each of the following statements is true EXCEPT which is false?
a. The backward shift approach can decrease basis risk
b. Firms who receive LIBOR-linked interest should expect to give up the spread due to the credit risk premium
c. The preferred alternative risk-free rate (RFR) for the Sterling is the Sterling Overnight Index Average (SONIA) which is an overnight, backward-looking rate
d. Because firms should already have a taxonomy for the identification/assessment of common conduct risks, it is possible for some firms that LIBOR-related risk might be best addressed with their existing conduct risk framework
22.5.2. In its review of the LIBOR transition, the FICC Markets Standards Board (FMSB) includes four case studies that illustrate the risks of the LIBOR transition. The second case study ("Case Study B") is about a corporate client who seeks fixed interest payments on a loan. As FMSB explains the case, Bank B offers a SONIA-based loan packaged (i.e., combined simultaneously) with an interest rate swap, as follows:
"A corporate is seeking finance to invest in a new manufacturing facility and wishes to enter into an interest rate swap to fix interest payments. The corporate borrower enters into a SONIA-based loan with Bank B with a notional of £10 million, maturity of five years, with quarterly interest payments referencing SONIA compounded in arrears with a five-day lookback period (lag approach). Simultaneously, Bank B and the corporate enter into a SONIA-based interest rate swap with notional of £10 million, maturity of five years but with interest period ending on the interest reset date with no five-day lookback." -- Source: LIBOR transition Case studies for navigating conduct risks, FMSB, June 2020 (page 17).
Among the following risks--and especially in regard to client communications--which is the most obvious risk that must, at a minimum, be communicated to the corporate client?
a. Basis risk
b. General risk
c. Rotation risk
d. Switching risk
22.5.3. In its review of the LIBOR transition, the FICC Markets Standards Board (FMSB) includes four case studies that illustrate the risks of the LIBOR transition. The fourth case study ("Case Study D") concerns a buy-side fund manager, with three funds, who (given the discontinuation of LIBOR) proposed to change the performance benchmark. Specifically:
"[Case Study D] A fund manager has a number of fixed income funds and alternative strategies with different characteristics that use LIBOR-linked benchmarks or performance targets. Given the imminent discontinuation of LIBOR at the end of 2021, the fund manager proposes that during Q1 2021 it will change each of Funds A, B, and C from the GBP LIBOR benchmark rate to a SONIA-based rate. In each case, the benchmark is updated in March 2021 from GBP 3M LIBOR + 185bp to SONIA + 200bp, reflecting an average spread at that point in time of 15bp between LIBOR and SONIA." -- Source: LIBOR transition Case studies for navigating conduct risks, FMSB, June 2020 (page 21).
The following are the manager's three funds:
- Fund A has no performance fee and seeks to generate a return near to a benchmark dependent upon GBP LIBOR. Consequently, there is a correlation between the benchmark and underlying assets which will be impacted when transitioning the benchmark from GBP LIBOR.
- Fund B has no performance fee and benchmarks its performance against a GBP LIBOR-linked index as a reference which is consequently the underlying strategy that drives the investment. The investment guidelines do not require that the fund's underlying assets need to correlate to the benchmark
- Fund C has the investment guidelines identical to Fund B but it DOES charge a performance fee.
a. If the spread of LIBOR over SONIA narrows during H2 2021, the analysis of fund performance might be impacted
b. As these are existing (but not new) funds, it is bad practice for the fund manager to change to a SONIA-based rate
c. It is bad practice for the fund manager to choose the same SONIA + 200 bp as the replacement rate for all three funds
d. Fund A is the LEAST sensitive to governance implications such as investment updates, and Fund B is the MOST sensitive to these implications
Answers:
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