Moving away from LIBOR? Don’t forget your client
28 October 2019
You’ve thought about repapering, market liquidity, exposure monitoring…But how about your clients? By now, most asset managers are beginning to embark on the LIBOR transition journey and wonder whether they will be ready to pull the plug at the end of 2021. As they ramp up progress though, they mustn’t forget to place client outcomes at the centre of their thinking. Conduct risk now features high on the regulatory agenda, and relevant investor protection obligations under MiFID II are likely to play an important role in helping to manage such risk. In this blog, we consider some of the key aspects of the MiFID II framework that firms should carefully consider in the context of their LIBOR transition programmes.
While all financial market participants should be worried about this, it could be an opportunity for asset managers in particular to start the transition on the right foot. So far, a lot of focus has been placed on the sell-side. Banks were at the forefront of supervisors’ attention and are expected to be driving liquidity in Risk Free Rate (RFR) linked products. But buy-side firms should take action before they’re asked, particularly around the identification and management of conduct risk.
First comes the question of conflicts of interest. The LIBOR transition creates considerable information asymmetries between those who drive it, and clients. An asset manager’s clients may have seen some catchy headlines about LIBOR being phased out, but it is possible that they are unclear about what this means for them in practice. Whether it is to transition underlying instruments away from LIBOR, or to offer new assets and funds based on an alternative RFR, asset managers are likely to have much better knowledge about the consequences for fund performance. In line with the overarching conflicts of interest requirements under MiFID II, firms should assess whether this type of information advantage creates a conflict between their own commercial interests and those of their clients. If any conflicts are identified, the regulator will be looking for evidence that they are being managed or, if not possible, avoided altogether.
Product governance is another area of MiFID II that should be front and centre of asset managers’ approach to LIBOR transition. This will be particularly relevant when moving existing funds and underlying instruments to an alternative RFR, since doing so could have the potential to alter the original target market assessment for the fund, given the pricing differences with LIBOR. Any changes to a firm’s target market assessment would also impact the distribution strategy of a fund, which would need to be communicated with other intermediaries in the distribution chain. Linked to this, asset managers providing investment advice or individual portfolio management services to clients will also need to assess whether the transition alters their assessment of how suitable their funds are for clients.
Best execution obligations should also be considered when investing in instruments linked to an alternative reference rate. For example, a firm choosing to execute an order in an RFR-linked security with limited liquidity or market depth may result in less favourable returns for clients. This may increase the implicit cost of executing RFR-linked securities and raise questions over execution quality. Some firms have indicated that it would be helpful to see guidance from the regulator on how best to manage these types of tension between moving away from LIBOR and compromising execution quality. However, firms should not sit around and wait for this, but should get on the front foot and carry out work to strike the right balance.
Underpinning all of this needs to be a detailed consideration of culture, governance and accountability, including interaction with the Senior Managers & Certification Regime. The FCA has been clear that it expects firms to have senior management oversight of LIBOR transition, with clarity on responsibilities, reporting lines, governance structures, together with the gathering and use of management information. The regulator will want to see that firms have the right culture in place to support a transition programme that gives proper consideration to the identification and management of conduct risk.
Conduct risk has long been a core area of focus for the FCA across many areas of financial services, as you might expect. LIBOR transition is no different. The FCA's current supervisory agenda on MiFID II ‘day 2’ provides it with an opportunity to review how firms are approaching relevant MiFID investor protection measures in the context of their LIBOR transition programmes. With work on product governance and best execution due to begin soon, firms need to be on top of this and ensure that their approaches are robust enough to withstand scrutiny.