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.
The Cross-Industry Committee on Japanese Yen Interest Rate Benchmarks has updated its roadmap to prepare for the discontinuation of Japanese Yen LIBOR by adding the transition plan for interest rate swaps referencing Japanese Yen LIBOR that will mature after end-2021. On the 26 March 2021 meeting, it was agreed that initiation of such interest rate swaps should cease after September 2021 except those initiated for risk management purpose. It was also agreed that the Tokyo O/N Average rate (TONA) would be the major alternative benchmark for the JPY interest rate swaps market while other alternative benchmarks including the Tokyo Term Risk Free Rate (TORF) are still acceptable, therefore, market participants are expected to adopt new quoting conventions for the JPY interest rate swaps based on TONA no later than the end of July 2021.
KPMG’s perspective: The consensus reached by the committee provides a clear picture of the cessation and alternative benchmarks for JPY interest rate swaps. Market participants are encouraged to complete their transition work earlier than the designated deadline and stop the issuance of new relevant products. Also, banks should adopt the new quoting conventions for JPY interest rate swaps as soon as possible as the deadline of July 2021 is approaching.
16 April 2021, BoJ
2. HKMA provides interim reporting guidelines on the reporting of alternative reference rate positions
The Hong Kong Monetary Authority (HKMA) has received enquiries about the reporting of ARR positions in MA(BS)12A “Interest Rate Risk in the Banking Book”, MA(BS)12B “Interest Rate Risk in the Banking Book (Supplementary Information)” and MA(BS)12 “Interest Rate Risk Exposures”. The progress in interest rate benchmark reform results in new ARR conventions, therefore, the HKMA would work to reflect the change in a comprehensive way by updating the Supervisory Policy Manual (SPM) module IR-1 ‘‘Interest Rate Risk in the Banking Book’’ and the completion instructions for related returns. Also, the HKMA has provided interim reporting guidelines for ARRs which would be in effect when the SPM module IR-1 and the completion instructions are updated.
KPMG’s perspective: AIs should review the new reporting guidelines in preparing the new returns, including the report of accrued ARR interest, definition of ‘‘earliest interest repricing date’’, treatment of the ARR component of the coupon cash flows etc. Furthermore, banks should review and assess the SPM and completion instructions carefully when the HKMA issues the updated version to be well prepared for the reporting requirements of relevant returns.
30 March 2021, HKMA
3. FCA and BoE encourage switching to SONIA in the sterling non-linear derivatives market from 11 May
To follow the milestone recommended by the Working Group on Sterling Risk-Free Reference Rates to cease the issuance of new GBP LIBOR non-linear derivatives maturing after end-2021 by end-Q2 2021, the Financial Conduct Authority (FCA) and the Bank of England (BoE) encouraged market participants to shift its non-linear derivatives exposures from GBP LIBOR to SONIA from 11 May 2021 and follow the new quoting conventions for inter-dealer trading, as respondents show strong support on this recommendation in FCA’s survey. Meanwhile, FCA and BoE would communicate with stakeholders to assess if the switch could proceed smoothly according to latest market conditions.
KPMG’s perspective: Based on the new milestone announced by FCA and BoE, AIs are recommended to follow the new convention to switch its GBP LIBOR non-linear derivatives from a GBP basis to a SONIA basis, and take SONIA as the default price for relevant transactions from 11 May this year. To ensure a smooth transition, AIs should closely monitor and consider reducing its non-linear GBP LIBOR exposures gradually within the period and prepare for potential system updates and internal control work associated with the transition.
29 March 2021, FCA
4. FCA and BoE list out priority areas for LIBOR transition
The Financial Conduct Authority (FCA) and the Bank of England (BoE) expect all institutions to meet the milestones of the Working Group on Sterling Risk Free Reference Rates as the cessation dates for all GBP LIBOR settings are confirmed and the markets have got into the final phase of the LIBOR transition. Thus, the FCA and the BoE will intensify their supervisory focus on banks’ management on the risks correlated with the transition and would collect relevant LIBOR and RFR exposure data to assess the transition progress if necessary. The FCA and BoE have listed out priority areas where further action by firms is crucial to prepare for the cessation of LIBOR: (1) Cessation of new sterling LIBOR business milestones and new LIBOR-referencing syndicated lending; (2) Systems readiness for LIBOR cessation; (3) Active transition of legacy LIBOR exposures; (4) Conduct risk mitigation; (5) Development of RFR markets; (6) Model changes and (7) Selection of suitable alternatives to LIBOR.
KPMG’s perspective: While the market has entered the critical phase for the LIBOR transition, banks should take appropriate action to deal with its outstanding GBP LIBOR exposures according to the FCA and BoE’s instructions and ensure that the bank’s transition plan follows the regulatory milestones. From 1 April 2021, banks should not issue any new products referencing GBP LIBOR as it could be viewed as indicative of poor risk management. On the other hand, banks are suggested to refer to the priority areas proposed by the FCA and BoE to assess its GBP LIBOR transition work and prepare for future regulatory requirements.
26 March 2021, BoE
The Alternative Reference Rates Committee (ARRC) has announced the key principles for the ARRC-recommended forward-looking SOFR term rate as it believes there are conditions in which a SOFR term rate would be necessary. These principles are built on the ARRC’s March 23 update and its ongoing discussions, ARRC would also work continuously to consider the necessary conditions for the recommendation of a SOFR term rate. Under supervisory guidance, the ARRC reminds market participants not to wait for a SOFR term rate while preparing for the transition. Nonetheless, as the ARRC has proposed several actions to build liquidity in SOFR derivatives which could ensure the recommended forward-looking SOFR term rate would be robust, it recognized that the rate could act as a supporting tool for certain uses throughout the transition.
KPMG’s perspective: As the ARRC continues to provide further clarification on the use of forward-looking SOFR term rate and reiterate that banks should not rely on the SOFR term rates for the transition. The key principles are that this rate should:
- Meet the ARRC’s criteria for alternative reference rates, similar to SOFR itself;
- Be rooted in a robust and sustainable base of derivatives transactions over time, to ensure that its use as a reference rate is consistent with best practices and the ARRC’s own standards; and,
- Have a limited scope of use, to avoid (i) use that is not in proportion to the depth and transactions in the underlying derivatives market or (ii) use that materially detracts from volumes in the underlying SOFR-linked derivatives transactions that are relied upon to construct a term rate, making the term rate itself unstable over time.
Banks should consider these principles while planning for the use of SOFR term rates during and post LIBOR transition.
20 April 2021, ARRC
2. NWG endorsed form of switch from CHF LIBOR to SARON for Swiss law governed syndicated credit facility agreements
Baker McKenzie Switzerland has drafted a Skeleton Agreement endorsed by the National Working Group on Swiss Franc Reference Rates (NWG) to introduce the conversion mechanism from CHF LIBOR to compounded SARON for syndicated credit facility agreements governed by Swiss law, as the conventions suggested by NWG is different from other currency working groups. The Skeleton Agreement aimed to facilitate the transition mainly for legacy agreements and new CHF single currency facilities. The Agreement also introduced a mechanism to deal with intra-interest period events such as prepayment for interest calculation under cumulative approach to the compounding of SARON, and provided different options on the use of credit spread adjustment and included fallbacks to deal with situations should SARON become unavailable.
KPMG’s perspective: As CHF LIBOR is set to cease publication by the end of 2021 according to the FCA cessation timeline, market participants are strongly encouraged to finalise the CHF LIBOR transition as planned in terms of legacy agreement re-negotiation and operational capability to issue SARON-linked products. Banks should also consider the latest Skeleton Agreement published by Baker McKenzie to facilitate transition related to syndicated loan transactions governed by Swiss law. Also, as the recommended approach to calculate the compounded rate for SARON is different from other alternative reference rates, Banks should be aware of the issue if they have CHF-linked exposures and monitor closely any new conventions issued by the NWG in the future.
18 April 2021, BakerMcKenzie
3. ISDA opening remarks on the Benchmark Strategies Forum
In the opening of the Benchmark Strategies Forum, the International Swaps and Derivatives Association (ISDA) mentioned the key termination dates for LIBOR and its implications for ISDA’s new derivatives fallbacks. As the new fallbacks that allow firms to incorporate fallback provision into existing derivatives referencing LIBOR and other IBORs came into effect on 25 January 2021, when LIBOR or IBORs become non-representative in the future, the fallback will take effect accordingly which could lower the systemic risk of the cessation event significantly. Also, as the FCA announcement constituted an ‘‘Index Cessation Event’’ under the ISDA 2020 IBOR Fallbacks Protocol, the spread adjustment that reflects a part of the structural differences between LIBOR and RFRs is fixed on 5 March 2021 when the announcement is made, which means market participants could have further information about the fallback rates that would apply across different currencies and tenors.
KPMG’s perspective: The ISDA’s opening remarks clarified the effect of the FCA’s announcement in March on ISDA’s new derivatives fallbacks. Banks are encouraged to adhere to the ISDA Fallback Protocol and Supplement if they have not already done so as it could act as a safety net for a huge portion of derivatives transaction and could also utilize the fixed spread adjustment to develop its pricing strategies and help with transition planning.
13 April 2021, ISDA
4. LSTA guidance on credit sensitive rates to replace LIBOR
The Loan Syndications & Trading Association (LSTA) published a market advisory that addresses adding a ‘credit sensitive rate’ option as part of the hardwired LIBOR fallback language applicable to syndicated loan and bilateral loan, as a great number of its members showed interest in credit sensitive rates. The fallback language included two formulations for members’ consideration: 1) the selection of a specific credit sensitive rate and 2) their preferred hierarchy of credit sensitive rate alternatives. The LSTA has created a slot-in rider that could be incorporated into the hardwired fallback language recommended by the ARRC, so when the major USD LIBOR tenors cease publication after June 2023, such loans could be transit to a credit sensitive rate according to their preference. The use of credit sensitive rate other than SOFR for loans could also complies with the Federal Reserve and the Office of the Comptroller of the Currency’s guidance.
KPMG’s perspective: The slot-in rider developed by the LSTA to its members provides an important insight and industry milestone on the use of hardwired fallback language, which is still underdeveloped in the market. If Banks have relevant exposures that will mature after June 2023, which will or have incorporated hardwired fallback provisions, including syndicated loan transactions, banks may consider using a credit sensitive rate instead of SOFR as a viable alternative reference rate, while monitor the market development ongoingly related to the credit sensitive rate.
8 April 2021, LSTA
5. ARRC affirms decision for signing the New York State LIBOR legislation into law
The Alternative Reference Rates Committee (ARRC) endorses New York State Governor for signing the LIBOR legislation into law. The law is initiated by the ARRC last year to address the concern over legacy contracts that do not have effective fallbacks and will mature after mid-2023, which is the cessation date for 5 USD LIBOR settings announced by the FCA. The ARRC expected that the legislation could minimize legal disputes and negative economic impact associated with the transition as it clarified legal issues for contracts without fallbacks that are written under New York Law, which governs a significant portion of contracts referencing LIBOR.
KPMG’s perspective: The legislation marks an important milestone for contracts referencing LIBOR that are written under New York Law and would mature after mid-2023 by clearing up certain areas of legal uncertainty for the fallback arrangement. To prevent possible legal issues, banks are recommended to monitor its LIBOR exposures by currency as well as tenor to enhance efficiency in planning the legacy contract re-negotiation to complete the incorporation of fallbacks before their designated LIBOR cessation timeline.
7 April 2021, ARRC
6. New timelines to stop issuance for SOR derivatives and SIBOR-Linked Financial Products
The Steering Committee for SOR & SIBOR Transition to SORA (SC-STS) has published a report to announce the new timelines regarding the cessation of SOR and SIBOR. By the end of September 2021, the usage of SOR in new derivatives contract and the usage of SIBOR in new contracts should be ceased for all financial institutions and their customers. As the liquidity in SOR derivatives markets has already started to decrease, market participants are encouraged to take active steps to transition to SORA in 2021 and incorporate suitable fallback arrangements. Furthermore, since SOR will now be available until mid-2023, the need for extended fallback rate (SOR) arrangements will be lower, so the original end-date for the fallback rate (SOR) will remain unchanged as end-2024.
KPMG’s perspective: Banks should be aware of their SOR and SIBOR-linked exposure and follow the updated regulatory roadmap to plan out the transition of relevant products accordingly. Early transition is highly recommended especially for derivatives transactions when the liquidity conditions are still favourable, as it could help to minimise both financial and operational risks associated with the transition. It is expected that there will be increasing product development as the industry has made significant progress to support the construction of new SORA markets.
31 March 2021, ABS
7. ARRC releases Approach to use SOFR in New Issuances of a Variety of Securitized Products
The Alternative Reference Rates Committee (ARRC) has issued a white paper which introduced the model for using the SOFR rate in asset-backed securities (ABS) products, including mortgage-backed securities, non-CLO ABS and commercial mortgage-backed securities products. It is suggested that new ABS products may use 30-day Average SOFR with monthly reset, set in advance of the interest accrual period. For operational ease, the ARRC preferred to use the actual SOFR rates from the 30-day period ahead of the applicable reset date for this methodology. As the ARRC observed strong demand from investor for SOFR products, it is expected that the white paper could help institutions to cease issuance of new LIBOR-based securitized products and switch to SOFR-based ABS products.
KPMG’s perspective: The latest approach published by ARRC provides additional guidance for institution to issue new ABS products based on SOFR. Banks could make reference to this methodology and construct its pricing models if it plans to or have issued relevant ABS products. Banks could also keep a close eye on further announcements from the ARRC to get SOFR conventions for different products and latest market development related to new product issuance.
29 March 2021, ARRC
8. JBATA publishes ‘Compliance with IOSCO Principles for Financial Benchmarks’
JBA TIBOR Administration (JBATA) has published ‘‘Compliance with IOSCO Principles for Financial Benchmarks’’, which restated that retaining Japanese Yen TIBOR and discontinuing Euro Yen TIBOR is the most likely option at this stage. As the cessation of the LIBOR benchmarks is confirmed by FCA on 5 March 2021, JBATA expected that the timing of implementing retaining Japanese Yen TIBOR would be at the end of December 2024, as many respondents of the public consultation supported a 1.5 years preparation period. Meanwhile, JBATA will continue to discuss the development of fallback languages for JBA TIBOR to maintain and enhance its transparency.
KPMG’s perspective: As the benchmark cessation date for is confirmed, market participants could refine the relevant transition plan and implementation under the regulatory roadmap. If banks have relevant exposures linked to TIBOR, they should keep a close eye on possible further announcements from JBATA regarding the reform, such as the fallback languages and other relevant issues to ensure that the transition progress smoothly.
29 March 2021, JBATA
9. LMA publishes note on the use of forward-looking SONIA term rates
The Loan Market Association (LMA) has outlined the key considerations related to the use of forward-looking SONIA term rates, which are available for use since 11 January 2021 as the rates could be a valid option for loan transition in some parts of the market. The key considerations included: 1) Consider if the loan is within the specified use cases identified by the Working Group on Sterling Risk-free Rates and the FICC Market Standards Board’s market standards; 2) Choose the SONIA term rate to be used; 3) Prepare the fallback language for the SONIA term rate when it will be unavailable temporary or ceased permanently; 4) Consider the approach to market disruption and break cost as the natures of LIBOR and SONIA are different; 5) Calculation of credit spread adjustment and 6) Interaction with hedging.
KPMG’s perspective: As there are more conventions provided by different parties on the use of the forward-looking SONIA term rates, AIs could have a more comprehensive idea on when and where should they use the rates to develop relevant internal policies. However, as recommended by the Working Group on Sterling Risk-free Rates in a previous paper, SONIA compounded in arrears will be deemed as the primary vehicle for LIBOR transition for new deals as there may be a risk of reintroducing structural vulnerabilities similar to those associated with LIBOR if the use of a forward-looking SONIA became widespread, therefore market participants should not rely on the development of a forward-looking SONIA when progressing the transition.
26 March 2021, LMA
10. FMSB publishes draft standard on proper use of Term SONIA
The FICC Market Standards Board (FMSB) has issued a draft regarding a new standard on the use of SONIA term rates. The FMSB has listed out some special circumstances that term rates would be more appropriate than rates compounded in arrears. For instances, when market participants need to know their interest rate obligations in advance or when the rate would be used to discount future cash flows. The standard also contains eight major principles, which requires institutions to have a strong rationale and adequate policies and controls to support and justify the use of SONIA term rates. However, the UK authorities and the Working Group on Sterling Risk-Free Reference Rates expected that the use of this forward-looking term rate would be limited, as in GBP fixed income and wholesale lending market, transition to SONIA rates compounded in arrears would continue to be the major practice.
KPMG’s perspective: The new standard helps clarify the circumstances when a forward-looking SONIA term rate could be use. Banks could follow the principles covered in the standard to construct its pricing methodology for different products, while considering SONIA compounded in arrears as the main vehicle for the transition. Market participants should observe the SONIA term rate closely to understand the nature and behaviour of the rates before considering its usage in ARR products.
24 March 2021, FMSB
11. ARRC issues White Paper on Suggested Fallback Formula for the USD LIBOR ICE Swap Rate
The Alternative Reference Rates Committee (ARRC) has published a white paper, which provides the formula to calculate a fallback to a spread-adjusted SOFR Swap rate from the USD LIBOR ICE Swap Rate. Originally, contracts that linked to USD LIBOR indirectly by referencing to USD ICE Swap Rates are not covered by existing fallback provisions yet, therefore, the paper aims to facilitate communications and actions within market participants on incorporating effective fallbacks for both legacy and new contracts referencing the USD LIBOR ICE Swap Rate. The formula presented to calculate the fallback provides a similar approach suggested by the Working Group on Sterling Risk-Free Rates for fallback calculation of contracts referencing GBP LIBOR ICE Swap Rate.
KPMG’s perspective: The white paper presents the fallback formula for contract referencing USD LIBOR ICE Swap Rate, which could assist banks to incorporate robust fallback languages to its relevant contracts before their designated LIBOR cessation dates. Banks are recommended to start the contract renegotiation process with clients and educate them on the fallback arrangement at an early stage to meet the important milestones for LIBOR transition, and also pay close attention to future industry updates on fallback provisions for other LIBOR currencies referencing the LIBOR ICE Swap Rate.
24 March 2021, ARRC
New Developments on Products and Pricing Strategy
Bank of America (BoA) announced that it has issued a $1 billion six-month floating rate bank note referencing the 1-month tenor of the Bloomberg Short-Term Bank Yield Index (BSBY) to multiple investors, which adheres to the International Organization of Securities Commissions’ Principles for Financial Benchmarks. The BSBY is credit sensitive, dynamic and reflects the marginal funding cost at Overnight and 1, 3, 6 and 12-Month tenors by measuring the average yields at which global banks receive USD unsecured wholesale funding. BoA expected that the development of strong alternative term rates including BSBY could help the market to transit away from LIBOR. As BoA also observed US market participants’ interest for a credit sensitive rate besides SOFR, it is believed that BSBY would be a feasible option.
KPMG’s perspective: The issuance of the floating rate bank note referencing BSBY could serve as a useful reference for Banks on the use of alternative term rate in LIBOR transition, as it provides an option to use credit sensitive rate rather than SOFR to substitute USD LIBOR. Market participants may also expect to observe more transactions referencing BSBY or credit sensitive rate for different currencies in the market as we approach towards end-2021 as well as greater flexibility in the choice of alternative reference rate.
21 April 2021, Bank of America