The London Interbank Offered Rate ("LIBOR") has been in use as the key interest rate benchmark for a wide range of financial products worldwide. According to the Results of Survey on Reform of Interest Rate Benchmarks for Q2 2020 (the "Survey Results") published by the Hong Kong Monetary Authority ("HKMA"), the total Hong Kong banking sector's exposures referencing LIBOR in Q2 of 2020 in terms of assets, liabilities and derivatives amount to HK$4.8 trillion, HK$1.6 trillion and HK$34.7 trillion respectively. However, according to the UK Financial Conduct Authority ("FCA"), which regulates LIBOR, LIBOR will likely be discontinued after the end of 2021 as there is a very high chance that LIBOR panel banks will stop making submissions for LIBOR determination after that date.
What is LIBOR?
LIBOR provides an indication of the average rate at which each LIBOR contributing bank, selected by the British Bankers Association, can borrow unsecured funds in the London interbank market for a given period, and in a given currency. It is calculated and published on each London business day in five currencies (GBP, USD, EUR, JPY and CHF) and seven maturities (overnight, 1 week, and 1, 2, 3, 6 and 12 months) by the ICE Benchmark Administration, based on submissions by a panel of banks using available transaction data and their expert judgment.
The LIBOR Reform
With the tightened bank capital requirements after the global financial crisis in 2008, the transaction volume in the unsecured inter-bank lending market has been significantly declining. Due to the decreasing liquidity in the inter-bank lending market, LIBOR submissions have been increasingly relying on expert judgment of the panel banks, thus giving rise to concern over the sustainability of LIBOR. In 2017, the FCA announced that it would cease to compel the panel banks to submit quotes for determining LIBOR after the end of 2021. Given that LIBOR may cease after that date, the FCA has already warned market participants to prepare for transition away from LIBOR.
Working groups in many jurisdictions are taking steps to identify alternative risk-free rates ("RFRs") to LIBOR. RFRs are overnight rates calculated according to the actual transactions in the underlying market, making RFRs more representative of the true cost of funding in the underlying markets. However, since RFRs and LIBOR are calculated on a different basis, the transition from LIBOR to RFRs may potentially be riddled with challenges. The table below sets out a non-exhaustive list of differences between LIBOR and RFRs.
|Multiple tenors (overnight, 1 week, and 1, 2, 3, 6 and 12 months)||Overnight rates|
|Contains a premium for bank credit and liquidity risk||Contain little or no additional premium|
|Administered by a single administrator for all LIBOR currencies||Administered by a distinct RFR administrator for each currency|
LIBOR and most other interbank offered rates (IBORs) are intended to measure unsecured interbank lending rates, whereas the proposed RFRs are based on short-term wholesale transactions for unsecured RFRs (such as Sterling Overnight Index Average (SONIA) for GBP, Tokyo Overnight Average Rate (TONAR) for JPY, and Euro Short-Term Rate (€STR) for EUR) and repurchase or "repo" transactions to secured RFRs (such as Secured Overnight Financing Rate (SOFR) for USD and Swiss Average Rate Overnight (SARON) for CHF). As a result, IBORs include a credit spread on top of RFRs.
There is ongoing work by different industry bodies aimed at developing term rates based on the FRFs to cater for the cessation of LIBOR.
Many contracts benchmarking against LIBOR do not anticipate permanent cessation of LIBOR as the benchmark interest rate, and therefore lack contractual provisions for alternate benchmark interest rates. This raises the issue on how to maintain continuity of contracts affected by LIBOR cessation. To transition existing contracts and agreements that benchmarking against IBORs to the alternative benchmark rates, adjustments for credit and term differences may need to be incorporated and applied to the alternative benchmark rates to avoid value transfer.
Many industry bodies, such as the International Swaps and Derivatives Association ("ISDA"), the International Capital Markets Association ("ICMA"), the Loan Market Association ("LMA") and Alternative Reference Rate Committee ("ARRC") are currently developing legal language known as fall-back provisions to supplement the existing affected LIBOR referencing contracts.
Impact of the LIBOR Reform
According to the Survey Results, for Q2 of 2020, the total Hong Kong banking sector's exposures referencing LIBOR which will mature after end-2021 with no adequate fall-back position in terms of assets, liabilities and derivatives in Q2 of 2020 amount to HK$1.7 trillion, HK$0.6 trillion and HK$17.4 trillion respectively.
Given the aforementioned figures, the potential cessation of LIBOR will likely result in sweeping effects on a large variety of financial products using LIBOR as the benchmark interest rate, including but not limited to bilateral loans, syndicated loans, derivatives, adjustable rate mortgages, floating rate notes and etc.
The LIBOR reform may necessitate changes in product valuations, payment obligations, internal contract documentation and other operational processes/technology systems of parties to financial product transactions. The extent of such changes will essentially depend on a number of factors, including but not limited to the following: (1) the nature of products, (2) the cessation date of LIBOR, (3) the terms of products, (4) the availability/unavailability of fall-back provisions covering the unavailability of LIBOR; (5) the duration of LIBOR referenced (Overnight, 1 week, and 1, 2, 3, 6 and 12 months); and (6) the relevant LIBOR referencing currencies ( GBP, USD, EUR, JPY and CHF).
How to react to the impending LIBOR abolition
According to the statement issued by the Financial Stability Board dated 1 July 2020 ("FSB"), financial and non-financial sector firms across all jurisdictions should continue efforts to remove remaining LIBOR dependencies by end-2021.
The HKMA has, in consultation with the TMA, developed the following milestones (the "Milestones") which authorised institutions ("AIs") in Hong Kong are expected to achieve:-
- From 1 January 2021, AIs should be in a position to offer products referencing the alternative reference rates ("ARRs") to LIBOR;
- From 1 January 2021, adequate fall-back provisions should be included in all newly issued LIBOR-linked contracts that will mature after 2021; and
- By 30 June 2021, AIs should cease to issue new LIBOR-linked products that will mature after 2021.
With a view to achieving the aforementioned Milestones, financial institutions are suggested to consider taking the following actions:
- Establish a steering committee and/or appoint a senior executive for overseeing the preparation of the transition away from LIBOR (the "Transition"); and
- Develop a detailed work plan (by products and by business lines) for the Transition;
- Quantify and monitor LIBOR exposures;
- Assess the impact of the Transition across businesses and functions;
- Identify and evaluate risks associated with the Transition;
- Develop a plan to introduce ARR products;
- Identify the affected IT systems and develop a plan to upgrade such systems;
- Identify the affected internal models such as those on pricing, valuation and cost of funds and develop a plan to modify these models;
- Develop a plan to reduce LIBOR exposures; and
- Develop a plan to renegotiate the terms/build in the fall back provision in LIBOR-linked contracts.
Financial product users
Pursuant to the ARRC Recommendations and the Self-Explanatory Note prepared by the HKMA, financial product users should begin identifying and reviewing their existing LIBOR referencing contracts to understand their own LIBOR-linked exposure.
Next, they are recommended to devise a transition strategy for their existing portfolio of contracts using LIBOR as the interest rate benchmark. If the existing LIBOR referencing contracts do not contain any provision which caters for the situation where LIBOR becomes unavailable, they should consider contacting their banks and the counterparties involved to build in a fall-back provision.
Lastly, financial product users are recommended to avoid entering into any new contracts adopting LIBOR as the reference rates with a maturity beyond 2021.
Given LIBOR may be quoted for tenors of up to 12 months and the potential discontinuance of LIBOR after the end of 2021, institutional and other financial product users should devise and implement a comprehensive and practical work plan to cater for the change early. Considering the complexity involved in the process, financial product users should seek professional advice in assessing the potential financial and legal consequences whenever necessary.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.