As authorities and banks trial various alternatives to the Libor index in the wake of its manipulation in the past, fund managers and their clients need to decide on a policy for measurement of short-term interest rate movements in the future.
While many managers may well “muddle through” by continuing to use Libor without contingencies, according to EDHEC-Risk Institute, it is possible that the Libor market will collapse, if for example the banks refuse to actually deal at the rates they quote. The institute’s latest newsletter suggests this danger is particularly acute at durations at six and 12 months, where transactions are sparse.
The institute says: “Pension funds with interest rate swaps linked to Libor will have benefited or lost according to which side of the contract they were on. Similar considerations apply to their purchasing loan agreements linked to Libor, packaged as asset-backed securities.
“Floating rate notes comprise another area of interest, but possibly the most important of the potential impacts concern performance fee agreements where fund managers, largely hedge funds, base their performance fees on outperforming Libor. Absolute return funds also come into this category. These funds have been run not only for the retail public but also, for decades, for many institutional and corporate investors in the Middle East, Japan and elsewhere that have been seeking returns exceeding short-term interest rates and paying fees accordingly. Now that fund managers are getting into the bank lending business, Libor becomes relevant here too for some of the deals.
“As to the actual impact of past gains or losses, most investment industry commentators, including pension funds, profess not to have the slightest idea. This is understandable, since to start with there is no precise estimate of how much rigging was actually done or for how long. The only certainty is that there was manipulation.”
Moving away from Libor would result in huge costs to be borne not just by the banks but also fund managers and pension funds. Millions of contracts would need to be renegotiated. But the Bank of England is reportedly drawing up contingency plans in the event that the Libor market collapses.
EDHEC-Risk Institute suggests managers could individually fix some rate which offers stability, as an alternative. But, given the lack of a universal consensus on what this rate should be, every asset management house needs to consider an individual solution together with its clients and/or counterparty.