Managing conduct risk during LIBOR transition
This information sheet (INFO 252) sets out practical guidance on frameworks and practices that both buy-side and sell-side entities can adopt to manage conduct risk during London Inter-Bank Offered Rate (LIBOR) transition. Specific guidance and recommendations for buy-side entities and non-APRA-regulated Australian financial services (AFS) licensees have been noted as such. This guidance is not exhaustive and should be considered in light of the particular circumstances of each entity.
We are committed to working with sell-side and buy-side entities to ensure an orderly LIBOR transition.
This information sheet covers:
- treating clients fairly
- performance of products and services
- client communication
- risk management framework
- buy-side entities’ responsibilities
The publication of LIBOR is expected to cease after the end of 2021 and the financial industry has made substantial structural changes to transition from LIBOR to alternative reference rates (ARRs). Despite the progress to date, entities have significant tasks ahead, especially regarding conduct risk, to ensure they are adequately prepared for LIBOR transition.
Conduct risk is the risk of inappropriate, unethical or unlawful behaviour that can be caused by deliberate actions or inadvertent inadequacies in an entity’s practices, frameworks or education programs.
Acting fairly towards clients requires entities to act with ethical values, fair judgement and professional diligence. Clients should be confident that the entity they are dealing with recognises fair treatment of clients as an essential part of their corporate culture, and that the representatives of that entity are competent and have expertise in the products and services they offer.
Note: Entities that are AFS licensees must, under section 912A(1)(a) of the Corporations Act 2001 (Corporations Act), do all things necessary to ensure that the financial services covered by the licence are provided efficiently, honestly and fairly.
Entities should train their staff appropriately and document their decision-making process during the transition, especially in relation to dates and adjustment methodologies when transitioning from LIBOR to ARRs. This improves transparency, reduces the asymmetry of information and helps the entity to make well-informed decisions and act with integrity.
When interacting with clients, entities should bear in mind that methods such as communicating through warnings and disclosures have limited effectiveness.
While comprehensive and timely disclosure about the risk and impact on clients should still be provided, we recommend the adoption of an outcome-focused approach during the transition process. The focus should be on ensuring that clients understand the impact of LIBOR transition, the implications for their business, and various dependencies associated with the transition process.
Finally, treating clients fairly means that entities should be accountable and take responsibility for the consequences of wrongdoing or poor decision making. We expect all entities to take appropriate and timely actions to identify and rectify issues that relate to the fair treatment of clients.
Strategies to treat clients fairly
- Amend existing LIBOR-referenced contracts to include robust fallback rates that are recommended by relevant international industry bodies and working groups such as the Financial Stability Board (FSB), the Alternative Reference Rates Committee (ARRC) and the Working Group on Sterling Risk-Free Reference Rates (RFRWG).
- Amend existing LIBOR-referenced contracts with the most suitable replacement rate based on industry consensus and recommendations from relevant industry associations such as the International Swaps and Derivatives Association (ISDA).
- Adhere to the 2020 IBOR Fallbacks Protocol (PDF 669 KB) and associated Supplement to the 2006 ISDA Definitions (PDF 874 KB) for all relevant derivative contracts.
- Buy-side entities should exercise due diligence to ensure their LIBOR exposure, and that of their clients, is appropriately managed, and any additional exposure should be carefully justified.
- New transactions referencing LIBOR need to be carefully justified to clients, ensuring they understand that LIBOR is expected to cease after the end of 2021.
- Implement timely, fair and transparent review and remediation arrangements when required, including proactive early and ongoing communication with clients.
We expect clients to be provided with products and services that perform as they were led to believe. Issuing long-dated LIBOR contracts that expire after the end of 2021 without a fallback or adequate communication could be considered misconduct – particularly if clients were led to believe these products or services would continue to perform as they did before LIBOR cessation in the absence of an appropriate fallback.
We also expect entities to ensure new products and services that reference ARRs are properly and objectively explained to clients and that clients understand the differences between their products and services which reference LIBOR, and those that reference ARRs.
If applicable, entities should include the following changes in their discussion: term structure, frequency of payments, interest calculation, exchange of notional principal cash flow, and any other relevant changes.
Term rate expectations should also be managed. Entities are encouraged to discuss the possibility that a robust term rate may not eventuate for all LIBOR currencies. Clients should be provided with relevant information to assess the risks of waiting for term rates.
Recommended actions on the performance of products and services
- As soon as practicable, stop the sale and issuance of LIBOR-referenced contracts that expire after the end of 2021 if they do not have robust fallbacks or appropriate client communication. Entities should consider the international milestones set out by RFRWG (PDF 482 KB) and ARRC.
- Have open and transparent discussions with clients about alternative solutions and options that are suitable to the client’s objectives and needs. Include in the discussion an objective overview of potential risks that may help clients to make informed decisions.
- Be upfront about actions that are required of clients during the transition process, including making changes to their treasury systems to ensure they are able to process overnight rates.
- Discuss and manage term rate expectations of clients.
Clients may not have the same degree of knowledge and understanding of the transactions they enter into when compared to financial services providers and may also have a limited ability to negotiate terms. This asymmetry of power and information between entities and their clients is often present across products and services offered by financial institutions, including those relevant to LIBOR transition.
Information asymmetry is unavoidable in the financial markets where financial institutions are in a position of power and knowledge. However, we expect entities to use their knowledge to help clients make decisions about the appropriateness of products and services, and not to take advantage of their potential lack of understanding about the transition process.
Furthermore, to reduce information asymmetry, we recommend that entities are transparent in their transition process and appropriately share and communicate all necessary information to clients.
We expect entities to present timely, clear, accurate and comprehensive information to clients using language that is easy to understand.
Recommended components of a communication strategy to address information asymmetry
- Tailor communication strategies to the sophistication of respective client segments and the complexity of the products and services they are associated with, including timing, content, channel and framing.
- Ensure that communications are client focused by:
- including the content that clients need to be familiar with
- prioritising clients’ understanding of the range of possible ARRs and ensuring they are familiar with the language used in benchmarks reform
- considering the time or transition stage at which clients would be most receptive to this information
- being clear about what the transition means for the client in practical terms
- layering messages so that key messages, or more relevant messages for the client, are upfront
- making additional information repositories available for clients, including general education content on benchmarks reform and ongoing disclosure of the entity’s approach to transition.
- Consider providing information on how certain developments in the industry may affect the process of LIBOR transition and how that may change the current products and services on offer.
An adequate risk management framework with appropriate governance is a fundamental step in managing conduct risk.
All AFS licensees, regardless of size, should already have in place an established enterprise risk management framework to oversee the identification of risk, the establishment of appropriate risk mitigation measures, and the monitoring and management of risk.
This framework could therefore provide effective processes that allow entities to approach LIBOR-related conduct risk in a way that is consistent with existing conduct risk management procedures. However, consideration should be given to how this framework applies to the specific LIBOR transition-related conduct risk and whether additional measures or a separate, dedicated program should be implemented.
To adapt an existing enterprise risk management framework to the context of LIBOR transition, entities should consider whether their current framework supports risk management as a continuous process that requires ongoing evaluation and adjustment. LIBOR transition has constantly evolving dependencies and processes. The overarching risk management framework should be flexible and reflect policy changes, industry consensus and additional information as they become available over time.
Risk factors should be considered both in isolation and in connection to one another, including how they interact with different segments of the business. As such, a board level understanding of risks is expected.
Key components of an effective risk management framework
- The LIBOR transition’s overall responsibility and accountability is placed with the board and senior management.
- A centralised governance structure efficiently allocates resources, including using relevant technology and analysis to generate useful information for decision makers, who are of appropriate seniority and have the experience, qualifications and skills needed to evaluate and interpret relevant information.
- Policies and procedures are informed by the risks identified in connection with LIBOR transition, and are detailed enough to address those risks. Adequate records are kept which demonstrate that policies and procedures are being followed.
- The framework provides for conflicts of interest to be appropriately identified and mitigated – for example, in relation to value transfers that may result from contract transition, or where entities have discretion around the operation of contractual fallbacks.
Buy-side entities have a duty to ensure their clients are not disadvantaged during the transition and they have acquired appropriate resources in an environment where there is a potential skills shortage.
Buy-side entities often rely on third-party service providers during LIBOR transition, including custodial services, trading platforms and external investment managers. They therefore should perform adequate due diligence, risk assessment and contingency planning in relation to third-party service providers in the context of the transition.
It is important for buy-side entities to engage with the service providers early and ensure they obtain appropriate information to choose the best available option. Where services are obtained from a related entity, LIBOR transition preparation should have the same level of rigour, and responsibilities cannot be delegated to the related entity.
Buy-side entities who perform services internally need to be equally prepared and ensure there are adequate business continuity arrangements in place so that services such as portfolio management, risk management and regular reporting will not be affected by LIBOR transition.
Some buy-side entities also need to assess the quality and effectiveness of their trustee duties and as responsible entities in relation to LIBOR transition. Inadequate preparation for LIBOR transition may affect the entity’s effectiveness as a trustee, especially regarding the duty to supply information, duty to invest and duty of loyalty to beneficiaries.
Recommendations for buy-side entities
- Ensure sound understanding of LIBOR transition-related topics, including technical knowledge and the potential impact the transition has on performance fees, borrowing agreements, portfolio management, client reporting, market trend and product liquidity.
- Ensure adequate information has been supplied to clients, especially regarding the performance of invested products and the potential impact on investment management agreements under which assets are managed.
- Assess indirect LIBOR exposure, including investments in entities or portfolios that may have extensive exposure to LIBOR in their underlying assets.
- Manage indirect exposure in coordination with third-party service providers.
- Ensure that new investments in LIBOR-referenced assets and the transition of existing LIBOR-referenced assets are carefully justified and appropriately factored into risk mitigation plans. All investments that extend beyond 2021 should include robust fallbacks.
- Assess the risk of delaying transitionary action, including waiting for term rates. Entities should be prepared for a scenario whereby no term rates will be available post-LIBOR cessation. Entities are also encouraged to consider scenarios where appropriate credit spread may not be readily available for certain ARRs.
- Adhere to the 2020 IBOR Fallbacks Protocol (PDF 669 KB) and associated Supplement to the 2006 ISDA Definitions (PDF 874 KB) for the transition of LIBOR-referenced derivative contracts.
- Maintain regular engagement with both internal and third-party service providers to ensure they are providing products and services which are in the best interest of clients.
- Ensure both internal and external portfolio managers are subject to adequate governance and oversight.
- Understand delivery and capability risks of vendors.
- Seek independent advice.
See our website for more LIBOR transition-related publications.
Please note that this information sheet is a summary giving you basic information about a particular topic. It does not cover the whole of the relevant law regarding that topic, and it is not a substitute for professional advice.
You should also note that because this information sheet avoids legal language wherever possible, it might include some generalisations about the application of the law. Some provisions of the law referred to have exceptions or important qualifications. In most cases your particular circumstances must be taken into account when determining how the law applies to you.
This is Information Sheet 252 (INFO 252), issued in November 2020.