Welcome to KPMG’s latest issue of our monthly LIBOR newsletter in which we provide updates on LIBOR and other benchmark interest rate developments that directly impact banks and consider the potential implications of the related regulatory requirements.
Keys steps to further advance the industry transition to a Singapore Overnight Rate Average (SORA)-centered SGD interest rate market by the end of 2021 have been set out by the Steering Committee for SOR & SIBOR Transition to SORA (SC-STS). The Singapore committee, formed by the city-state’s central bank, has reaffirmed its previous guidance for lenders and borrowers to cease using the SGD swap offer rate (SOR), for which USD LIBOR is one of the calculating component, for new SOR-linked cash market products by end of April 2021.
There are a few measures to be expanded across longer tenors in order to support further growth of SORA markets. (1) Central clearing of SORA derivatives will be extended from 5-year tenor currently up to the 21-year tenor, (2) the Monetary Authority of Singapore (MAS) SORA derivatives auction parameters will be expanded to cover more key industry participants, and transaction tenors will be extended from 5-year currently to 20-year and (3) the MAS SORA floating rates notes program will be expanded from current 6-month tenors to 1-year and 2-year tenors in first half of 2021.
KPMG’s perspective: Authorised Institutions (AIs) with significant SGD exposures are advised to follow the new measures announced by the MAS. The affirmation by the steering committee will promote the SORA market liquidity when the banks in Singapore start providing more SORA products during the transition journey. It is expected to increase the demand in SORA-linked products when the MAS provides more guidelines for SORA products. AIs who seek opportunity in the Singapore market should pay close attention to the development of the new SORA products.
2. FCA sees no case for delay on LIBOR cessation ruling
The Financial Conduct Authority (FCA) commented on the LIBOR cessation to most tenors and currencies at the end of 2021. The FCA confirmed 85% of uncleared UK derivatives market are ready for LIBOR transition as 12,500 firms signed the International Swaps and Derivatives Association (ISDA) protocol. This suggests $23 trillion non-cleared derivatives market has been averted from potential chaos on Libor’s demise. Added to the $208 trillion of cleared and exchange-traded contracts, which will undergo transition in line with the exchange and clearing house’s timeline, and contracts expiring before the end of 2021 rolling off naturally, the FCA sees the legacy challenge whittled down from $260 trillion to roughly $15 trillion.
The consultation by LIBOR’s administrator, ICE Benchmark Administration (IBA) was closed on 25 January 2021. It is expected that the cessation plan will be the same as the consultation by extending 18 months to issue the 1-, 3-, 6- and 12-month USD LIBOR tenor rates, until June 2023. All other LIBOR tenor rates of other currencies will cease at the end of 2021. Although some US dollar LIBOR settings are proposed to cease later, the FCA highlights that US regulators have already set out limitation to restrict LIBOR usage in legacy contracts, and defined categories of risk-management transactions used to manage that legacy exposure.
In parallel to IBA’s consultation, the FCA consulted on a framework under which, and the circumstances in which, they stated that they might consider it desirable and feasible to require continued publication of any LIBOR currency tenors on the basis of a changed methodology. This is what the market generally refers to as requiring publication of a ‘synthetic’ LIBOR. As set out in that consultation, the changed methodology they have tabled is also based on the RFRs, combined with a fixed spread that is identical to the spread in the ISDA’s fallbacks.
KPMG’s perspective: The IBA has closed the consultation feedback at 5:00 pm London time on January 25, 2021 and announced that they will share the results for the consultation with the feedback statement soon. Despite the potential extension of major USD LIBOR rates and the synthetic LIBOR, a key point to understand this is not for use in new contracts. It is intended to help the problem of genuine tough legacy contracts, i.e., those that it is not practicable to convert before publication of a representative LIBOR ceases. In terms of restricting new use of a benchmark that we know will cease (e.g., use of USD LIBOR after end-2021), the FCA will consult on taking a similar approach to that already set out by US regulators – i.e., allowing new use only in risk-management transactions. AIs in Hong Kong should continue to follow the HKMA original timeline set out in July 2020 while paying close attention to the future announcement or guideline Banks should prepare to issue ARR-referenced new products and have a LIBOR-exposure reduction plan to wind down the legacy LIBOR exposure. For the new use of the LIBOR benchmark rates, banks should ensure that they have proper fallback languages in place.
The Office of the Comptroller of the Currency (OCC) has provided a LIBOR Self-Assessment Tool for banks to evaluate their preparedness for the expected cessation of the London Inter-Bank Offered Rate (LIBOR). The tool can be used to access (1) the appropriateness of a bank’s LIBOR transition plan, (2) bank management’s execution of the bank’s transition plan and (3) related oversight and reporting. Banks’ LIBOR transition risk can be identified and mitigated when they use the self-assessment tool for evaluation.
OCC issued a reminder that not all sections or questions apply to all banks. It depends on their LIBOR exposures and the size of bank. Most banks should be working toward resolving replacement rate issues while communicating with affected customers and third parties, as applicable.
KPMG’s perspective: AIs can make reference to the self-assessment tool and evaluate their transition risk. It can serve as a checklist and help banks to assess the readiness in (1) exposure assessment and planning, (2) replacement rates, (3) fallback language and (4) progress and oversight. Banks should follow the transition plan and monitor the LIBOR exposures closely in order to be prepared for the IBOR cessation. Besides, customer communication is also one of the key areas during the transition. Banks should conduct proactive communication with affected customers in resolving the issues arising from the LIBOR transition. This is also one of the expectations from the HKMA to mitigate conduct risk according to the circular dated 21 October 2020 .
10 February 2021, OCC
2. ICE Benchmark Administration Launches new U.S. Dollar Reference Rates webpage to assist the market with U.S. Dollar LIBOR Transition
The IBA has launched a new USD reference rate webpage to support the LIBOR transition for market participants. This webpage which provides an accessible and transparent way for the market to compare and view different reference rates which IBA is developing every day, including ICE Bank Yield Index, ICE Term SOFR and Tradeweb ICE CMT rates, etc. to help different segments of the market transition contracts from USD LIBOR. The webpage displays the reference rates for 1-, 3-, 6- and 12- month tenor periods together with historical results.
The IBA reminded market participant that the data and information on the webpage are historical and relate to a period of testing. They are provided solely for information and illustration purposes. These information are not intended and prohibited the use for other purposes, such as reference, index or benchmark in financial instruments or contracts.
KPMG’s perspective: The webpage can be a useful source for AIs to access the historical data and rate comparison for assessing their risk and pricing models or performing certain sensitivity tests during LIBOR transition. However, as advised by the IBA, the data should not be used for actual pricing of the new ARRs products until there is a market consensus in using or referencing to the rates announced by the IBA.
2 February 2021, IBA, Businesswire
3. ARRC Releases Conventions for SOFR-Based Intercompany Loans
The ARRC has issued the latest industry guideline for using SOFR as the reference interest rate in intercompany loans issued by non-financial companies. The guideline recommends computing the interest in advance by using 30-day or 90-day average SOFR interest rate, and the interest calculation is based on the company's monthly, quarterly, semi-annual, annual or other interest reset periods. For the fallback credit spread from LIBOR to SOFR contract, the ARRC recommends using the 5-year median difference between LIBOR and SOFR as the credit spread, which is consistent with the ARRC and the ISDA previously recommended methods for bilateral loans, syndicated loans and derivatives.
The ARRC reminded that the conventions set forth in this paper do not constitute binding rules or regulatory guidance. Market participants should decide for themselves whether, or to what extent, they will adopt and apply the guideline. They should also take into account for relevant supervisory and regulatory policies.
KPMG’s perspective: The latest interest calculation recommendations for intercompany loan issued by non-financial corporations announced by the ARRC is different from the convention recommended for syndicated and bilateral business loans in November 2020. Non-financial companies' intercompany loans are recommended to use 30-day or 90-day average SOFR rates by adopting the in advance calculation method instead of in arrears method, where those average SOFR rates are published by the Federal Reserve. Providing the rate in advance of an interest period benefits the consumer by enabling them to budget their upcoming payment. In terms of the spread adjustments between LIBOR and SOFR-based intercompany loans, the same spread adjustments recommended by the ARRC for business loans will be applied. This guideline provides more guidance to the market on loans for non-financial companies. Banks can use it as the reference for trade finance products where the payables shall be estimated in advance.
29 January 2021 ARRC
4. LIBOR’s Endgame in the U.S. Requires Urgent Preparation
The chairman of the ARRC has urged the public and private sectors that they must work together to transition all new activity to SOFR by the end of this year since the USD LIBOR underlines for around $200 trillion of financial contract across the world. The proposed endgame made in last November has provided more specific guideline on how and when USD LIBOR will end. Market participants should stop as soon as possible and no later than the end of 2021 to issue contracts that are still referencing USD LIBOR.
Further to the consultation from IBA on the cessation timeline for most LIBOR tenor rates, the plan allows most existing USD LIBOR-linked contracts to mature on their own terms when some USD LIBOR tenor rates to stop publishing in mid-2023. The chairman reminds that this should not be mis-constructed as a reprieve but a clear path for the transition. For cash contracts which will be matured after mid-2023, market participant should take proactive measures where possible to either renegotiating contracts or incorporating the ARRC recommended fallback language. For derivatives, market participants should follow guideline made by the ISDA.
For tough legacy contracts that do not have effective fallback language and cannot realistically be amended, legislation is the best option to determine what happens to these contracts after the end of LIBOR. The ARRC has put forward legislation in New York State, the jurisdiction with a sizable portion of these tough legacy contracts. The ARRC supports similar legislation at the federal level to safely and legally designate an appropriate fallback approach.
KPMG’s perspective: AIs should include appropriate fallback terms in their existing LIBOR contracts following guidelines from the ARRC and the ISDA. Banks should perform impact analysis on those tough legacy contracts and take proactive measures to convert them. According to the ARRC, the market is now at an Endgame situation for the USD LIBOR transition to SOFR. As a result, AIs should stick with their project timeline for LIBOR transition and should not hope for any delay announced by regulators in different jurisdictions. The ARRC has made a clear announcement that they do not foresee delay in LIBOR cessation. AIs should monitor their LIBOR exposures and reduce them gradually during the transition journey.
28 January 2021, Bloomberg
5. New ISDA IBOR Fallbacks take Effect for Derivatives
Since 25 January 2021, the fallbacks which were published by the International Swaps and Derivatives Association (ISDA) will be incorporated into all new derivatives contracts that reference the ISDA’s standard interest rate derivatives definitions. The fallbacks will also be included in legacy non-cleared derivatives if the counterparties have bilaterally agreed to include them or both have adhered to the IBOR Fallbacks Protocol. It is noted more than 12,000 entities across around 80 jurisdictions have adhered to the protocol already. The protocol will remain open for adherence as there is no cut-off date yet. However, the ISDA reminded market participants that thy reserve the right to designate a cut-off date by giving 30 days’ notice on the website.
The fallbacks cover Australia’s Bank Bill Swap Rate, the Canadian Dollar Offered Rate, euro LIBOR, EURIBOR, HIBOR, the Singapore dollar Swap Offer Rate, sterling LIBOR, Swiss franc LIBOR, the Thai baht Interest Rate Fixing, TIBOR, euro, yen TIBOR, yen LIBOR and US dollar LIBOR.
KPMG’s perspective: AIs should adhere to the ISDA protocol for IBOR fallbacks at their soonest even there is no cut-off date yet. The protocol does not only cover LIBOR but also other IBORs in different jurisdictions. Banks should be vigilant if the generation of derivatives confirmations are automated for vanilla derivatives, especially when they have adhered to the protocol and become effective. Banks should monitor and check if their confirmation templates for LIBOR-linked derivatives have already incorporated the guidelines announced by the ISDA to include fallbacks terms in the confirmation or contract.
6.Bloomberg, IHS Markit join race for SOFR credit add-on
Bloomberg and IHS Markit will provide the market with new indices to support IBOR conversion. The Short-Term Bank Yield Index (BSBY) released by Bloomberg is a supplement to SOFR to meet the market's demand for credit spreads and support the global IBOR transition. IHS Markit will provide a spread index similar to Bloomberg in the second quarter of 2021 for market reference but is yet to publish the proposed methodology.
BSBY has been published on the Bloomberg Terminal since October and is set to go live for use in contracts “soon”, according to Umesh Gajria, global head of index-linked products at Bloomberg. The rate faces stiff competition. IBA, Libor’s current administrator, has been testing Bank Yield Index (BYI) methodology since 2017.
IHS Markit, Bloomberg and the IBA are also constructing the SOFR curve, which will also be similar to the LIBOR class, providing 1-month, 3-month, 6-month and 12-month term interest rates, and the pricing method will also be different, details are yet to be published.
KPMG’s perspective: In addition to the previous recommendation made by the ARRC and the ISDA to use a static 5-year median difference between LIBOR and SOFR as the credit spread for fallbacks, Bloomberg has begun to publish a Short Term Bank Yield Index (BSBY) to meet market demand for a credit sensitive index to serve as a supplement to SOFR, and support the global IBOR transition since October 2020. These new indices will help to formulate a dynamic credit spread to provide a more accurate estimation of the systematic credit risk under different market scenarios between LIBOR and SOFR. In the meantime, Bloomberg and IHS Markit are both working on the SOFR term rate construction which is expected to be published by the second quarter of 2021.
7. Why US Dollar LIBOR Spread may be mispriced
The market reaction to the extension to some widely used USD LIBOR tenor rates until the mid of 2023 is swift. Short-term US dollar LIBOR spreads collapsed nearly 30% as traders priced in the delay. Hedge funds and dealers that had bet on an earlier end to Libor are said to have suffered losses of up $2 billion as a result.
The FCA will confirm the future date for the cessation of LIBOR publication. The date of the announcement has its own significance. It will be the anchor for a five-year lookback period for calculating the spread between LIBOR and SOFR, which is a method advised by the ARRC and the ISDA by taking the 5-year median difference between LIBOR and SOFR as the credit spread during fallback.
Cross-currency markets could see a significant disruption if fallback spreads for opposite legs of a transaction are fixed at different times. The discrepancy over the life of outstanding derivatives contracts would be locked by delaying the pre-cessation announcement for most USD LIBOR tenor rates by 18 months. FCA wants to provide clarity to the market on all 35 LIBOR tenor rates as soon as practicable.
KPMG’s perspective: The FCA foresees potential chaos in the market when different LIBOR tenor rates adopt different cessation schedules, especially for cross-currency markets. AIs should monitor the exposures on their cross-currency swaps or cross-currency products where one leg is referenced to USD LIBOR. For these instances, they should follow the fallbacks advised by the ISDA. AIs should also pay close attention on the date that will be announced by regulators for the pre-cessation.
19 January 2021, Risk.net
New Developments on Products and Pricing Strategy
OCBC announced the completion of two USD SOFR corporate loans in Hong Kong extended by its Hong Kong Branch and its wholly-owned subsidiary OCBC Wing Hang Bank. The corporate loan extended by OCBC Hong Kong Branch is offered to a corporate customer in the real estate investment industry while the corporate loan extended by OCBC Wing Hang Bank is used to fund customer’s procurement.
The two loans are the first SOFR loans for the OCBC Hong Kong Branch and OCBC Wing Hang Bank. It is another milestone in the industry towards adopting ARRs. OCBC will continue to engage their customers in the coming weeks and months to ensure the smooth transition from IBORs to ARR.
KPMG’s perspective: We are expecting to see increasing liquidity in the loan market in Hong Kong over the next few months. Singaporean banks continue to be more active following the MAS’s recent letter on the transition timeline without further delays. Since 1st January 2021, AIs are expected to be in a position to offer products referencing the ARRs. It is foreseeable that the volume of new ARR-referenced products will gradually grow in the next few months and we will see more activities from regional banks.
8 February 2021 OCBC