ASIC has published INFO 252, a long-awaited information sheet which addresses conduct risk issues for both sell-side and buy-side firms arising out of the discontinuation of LIBOR. As the transition from LIBOR rates to alternative reference rates (ARRs) enters its final stage (with the end of 2021 assumed to be the deadline by which transition must be achieved), Australian institutions will no doubt find ASIC’s articulation of the ways in which they can seek to mitigate the clear risk of conduct issues arising from their engagement with customers useful. However, fundamental concerns will remain and those institutions will need to continue to undertake their own analysis, and monitor the LIBOR transition landscape carefully to reflect what remains a highly dynamic situation, in the way that they prepare for the end of 2021.
The end of LIBOR, and the replacement of those rates by ARRs, raises profound issues for the financial services industry. LIBOR rates appear in huge volumes of contracts (both in number and value) and the fall-backs which have typically been incorporated within those contracts are uncommercial or impractical. Moreover, the switch to any of the available ARRs have economic consequences (i.e. they will change the rate payable under the contract, benefiting one party and causing detriment to the other) which are not possible to predict (and therefore fully mitigate) in advance.
We have often heard financial services regulators, over the last few years, seek to place the onus on the sell-side institutions to engage with their customers and encourage them to agree to amendments to their contracts so that a smooth transition can be achieved. On one level, that is perfectly understandable. Banks are sophisticated counterparties to high volumes of impacted contracts, and are subject to a range of regulatory duties which are of relevance in the transition process. However, there is a clear danger that the pressure which is being placed on banks to transition their customers from LIBOR may cause those customers to believe that the banks are accepting greater responsibility than they in fact are for the decision to agree to proactive amendments to legacy LIBOR contracts, and the outcomes which follow. In particular, a real concern will be that customers are left with the impression that, as a result of the educational role which banks can no doubt play, they are being advised by the banks that a particular ARR is the most suitable one for their individual circumstances.
It is against that background that the ASIC information sheet will be welcomed. However, it is fair to say that significant concerns remain.
The information sheet provides some helpful reminders about the steps that banks can use as they seek to satisfy the requirement to treat clients fairly, and (for entities that are AFS licensees) to do all things necessary to ensure that the financial services they provide are provided efficiently, honestly and fairly. It is broken into four sections: Treating clients fairly; performance of products and services; client communication; and risk management framework.
A critical part of getting this aspect right is for buy-side firms to ensure that their staff, particularly those with customer-facing roles, are appropriately trained to undertake the important task of reducing any asymmetries of information. Unpacking this, it is vital that those staff-members understand both the substance of the issues which LIBOR transition raises, as well as the nature of the duties which the institution owes to its customers in the process. The former is particularly challenging in the context of LIBOR transition – not only are the adjustment methodologies which are used in many of the ARRs complex, but many remain (even at this late stage in the process) under development. For example, forward-looking term rates (in broad terms, the closest equivalent replacement rates for LIBOR terms rates) are still very much in the process of being developed, with no certainty that they will be available for all (or any) LIBOR currencies. Accordingly, whilst banks are expected by ASIC to explain the benefit of transition to ARRs, it will be important also to explain the risks inherent in the process. However, importantly, ASIC have put down a marker that attempts to rely on warnings and disclosures will have limited effectiveness. It will therefore be necessary for banks to carefully articulate, in clear and objective terms, what the potential range of outcomes might be, and what factors may impact on those outcomes, instead of warnings which amount to no more than a generic exposure to risk. This will be a significant undertaking.
An area in which the information sheet does not provide much guidance is in relation to the performance of the products and services which it makes available to customers, and the customer communications which will ensure that the customer understands the way in which it will perform. This is a difficult area in which to generalise because the point is that what an appropriate decision looks like for a given customer will be highly dependent on individual circumstances; there is no one size fits all approach. Slightly unhelpfully, ASIC uses the straightforward example of a long-dated LIBOR contract with an expiry after 2021 without adequate fall-backs being sold to a customer who is led to believe that it will continue to perform in the same way before and after 2021, as its example of misconduct. The overwhelming majority of situations will look very different to this example and will require far more detailed analysis. As such, the ASIC guidance does not in this respect take banks very much further forward; they will have to form their own views on what products to propose to particular customers. Moreover, whilst unsurprising, banks will need to treat the blanket statement that they should adhere to the ISDA Protocol for “all relevant derivative contracts” with appropriate caution. Whilst that may well be the right outcome in respect of many derivative contracts, there will be some for which that may expose clients to basis risk or where the amendments introduced by the Protocol need more careful consideration.
There is clearly an important governance aspect to banks’ approach to LIBOR transition. In order, ultimately, to be able to explain and address questions regarding the process which they have followed, banks will rely on the frameworks which they have in place as well as their record-keeping practices which record those frameworks. In the risk management framework section of the information sheet, ASIC has provided a reminder about the importance of these governance arrangements to address the complexity and the “constantly evolving dependencies and processes” which are involved. Whilst much work has been done across the industry to form consensus on appropriate adjustment methodologies to apply to ARRs and contractual fall-back language to use to bring them in effect, there are many twists and turns which can be expected between now and the end of 2021. Just to take one particularly topical category of such developments, the contractual and extra-territorial scope, as well as the ultimate economic effect, of the legislative proposals for LIBOR currently being considered by various legislatures around the world may well affect outcomes for contractual counterparties in ways that will remain uncertain well into 2021. Planning a transition programme, including oversight of the design of communications to clients to explain the issues involved, is an even more challenging task given the evolving landscape. Given that ASIC’s clear statement that overall responsibility and accountability for that programme rests with the board and senior management, it is obviously critical that they are closely engaged in its direction and the impact on it of developments (including those in other jurisdictions).
The information sheet also helpfully provides some useful pointers for buy-side institutions. As ASIC notes, the impact on buy-side institutions is broad, and focus is needed on the relevance of LIBOR to performance fees, borrowing arrangements, portfolio management, client reporting, market trends and product liquidity. Buy-side institutions will need to be particularly careful in managing their indirect exposures to LIBOR transition through the investments which they have with third parties portfolio managers, by conducting adequate due diligence, risk management and contingency planning for each of those providers.