Richard Mazzochi and David Lam, King & Wood Mallesons, summarise the key points that are most regularly considered in Hong Kong and the Mainland regarding the transition from LIBOR to risk-free rates (RFRs).
The London Interbank Offered Rate (LIBOR) is a benchmark interest rate at which major global banks lend to one another. The LIBOR manipulation cases post the global financial crisis in 2008, however, exposed the LIBOR benchmark rate weaknesses.
In 2017 Andrew Bailey, the then Chief Executive of the UK’s Financial Conduct Authority (FCA), announced plans for the FCA not to exercise its power to compel panel banks’ submission to determine LIBOR. Almost five years later, the FCA announced on 5 March 2021 that all LIBOR settings will either cease to be published or will no longer be representative at specified future dates (see ‘LIBOR transition timeline’).
The FCA announcement is another important global milestone in the LIBOR transition. It is clear that transition is charging ahead at full speed and there is no time to waste.
Hong Kong and the Mainland
As an international open economy and the world’s third largest US dollar forex trading centre, most debts and bank exposures in Hong Kong are denominated in foreign currencies (in particular US dollars) and are largely LIBOR-based. As of September 2020, the Hong Kong Monetary Authority (HKMA) estimated that there were HK$4.8 trillion of assets and HK$1.4 trillion of liabilities in the Hong Kong banking system referencing LIBOR, representing about 30% and 10%, respectively, of the banking system’s total assets and total liabilities denominated in foreign currencies.
The notional value of derivative contracts referencing LIBOR aggregates to HK$31.6 trillion. More than 40% of these LIBOR-linked assets and liabilities and about 60% of these derivatives contracts mature after 2021 and do not have adequate fallback provisions to cater for a LIBOR discontinuation scenario. The international progress and discussion of the LIBOR transition is therefore extremely important and relevant for Hong Kong.
Domestic banks in the Mainland also carry out foreign currency business based on LIBOR and therefore need to undergo LIBOR transition. The issue is on a relatively smaller scale compared to Hong Kong, with LIBOR exposures maturing after 2021 for 15 major domestic banks amounting to around US$900 billion as of Q2 in 2020.
In this article, we provide an update on the progress of the transition relevant to Hong Kong and the Mainland.
Hong Kong
HIBOR and HONIA’s coexistence
HIBOR (The Hong Kong Interbank Offered Rate) is a set of reference rates owned by the Hong Kong Association of Banks and has been used as the primary local benchmark in Hong Kong. HONIA (the Hong Kong dollar Overnight Index Average) is an overnight interbank funding rate based solely on transaction data. As a member of the Financial Stability Board (FSB), the working group on Alternative Reference Rates under the Treasury Market Association of Hong Kong followed FSB’s recommendation to identify HONIA as the alternative reference rate to HIBOR.
The HKMA has indicated that there is no plan to discontinue HIBOR. Market participants therefore expect HIBOR to coexist with HONIA in the near future. This comes as good news for most Hong Kong market participants as it eases the pressure to develop and transition HIBOR products whilst focusing on transitioning from LIBOR-based contracts.
Hong Kong milestones
In July 2020, the HKMA mandated three milestones to encourage firms to transition away from LIBOR. By 1 January 2021, the HKMA recommended that authorised institutions (AIs) should be in a position to offer products referencing alternate reference rates to LIBOR. AIs should also by 1 January 2021 ensure adequate fallback provisions are included in all newly issued LIBOR-linked contracts maturing after end-2021. AIs are to cease to issue new LIBOR-linked products that will mature after 2021 by end-2021.
Insufficient liquidity in RFR-based products coupled with the lack of forward-looking term RFRs created concerns amongst market participants in transitioning by the original HKMA milestone of mid-2021, a timing earlier than similar milestones in other jurisdictions. For instance, the ICE Benchmark Administration indicated earlier that certain LIBOR tenors will continue to be published until 30 June 2023, whilst the original HKMA milestone to cease issuance of LIBOR-linked products has been set to be two years prior to this date.
For AIs, which should by now be familiar with LIBOR transition, the vast amount of internal coordination amongst different departments and systems, including information technology and systems, the lack of client education and awareness and complex documentation prove early adherence to the milestones to be difficult. Transition is also made more difficult when corporates struggle to understand the potential impact on profits and losses brought about by hedging mismatches and potential value transfer issues.
On 25 March 2021, the HKMA issued an additional circular to indicate that it is no longer appropriate to stick to the earlier timeline to cease new LIBOR-linked products by the end-June 2021, but AIs should continue to press ahead with the LIBOR transition and not issue new LIBOR-linked contracts by the end of 2021.
The impact on derivatives
Most AIs in Hong Kong are global financial institutions which adhere to the ISDA 2020 IBOR Fallbacks Protocol (or with most trades referencing the 2006 ISDA Definitions as supplemented by the IBOR Fallbacks Supplement). All new derivatives entered into on or after 25 January 2021, which reference ISDA’s standard definitions (as supplemented by the IBOR Fallbacks Supplement), include the robust fallbacks for interest rate derivatives linked to major IBORs. Adherence to the ISDA 2020 IBOR Fallbacks Protocol means that legacy non-cleared derivatives referencing LIBOR (where both parties have adhered) have been amended to incorporate similar robust fallbacks. ISDA also published various templates for parties that wish to amend their derivatives contracts bilaterally.
The impact on loans
With the HKMA setting its Hong Kong milestones in July 2020, financial institutions in Hong Kong have developed robust plans for LIBOR transition, which incorporate risk quantification and evaluation, systems enhancements and communication plans with their clients. Most clients appear to be aware of the LIBOR transition issue, but there is relatively little interest in lending or borrowing based on RFRs.
In terms of documentation, most clients previously chose to include the Asia Pacific Loan Market Association (APLMA) form of Replacement of Screen Rate language, which simply provides for a lower consent threshold to agree a replacement benchmark rate (than would otherwise apply), but not final details or methodologies for calculating a benchmark rate upon LIBOR cessation. As a result of the FCA announcement, clients are now considering amendments to their transaction documents.
The FCA announcement on 5 March 2021 constitutes a Screen Rate Replacement Event under the Replacement of Screen Rate language and provides for definite cessation dates for certain LIBORs. We therefore expect corporate borrowers to now actively engage with their lenders on LIBOR transition (including adapting a rate switch approach in documentation (meaning the facility is LIBOR-based at the start and will switch to an RFR-based rate upon a trigger event). APLMA has published exposure drafts which we see lenders and borrowers beginning to adopt.
The impact on notes/bonds
LIBOR transition remains largely irrelevant as most notes issued in Asia are fixed-rate notes. For floating-rate notes, we have seen a number of approaches, ranging from the Alternative Reference Rates Committee of the United States of America (ARRC) language for new issuances of LIBOR floating-rate notes, to the parties agreeing to appoint a third-party to decide on the relevant replacement RFR. Issuances of RFR notes remain scarce in Hong Kong.
The Mainland
The Working Group
The International benchmark interest rate reform working group (Working Group) was formed under the People’s Bank of China’s (PBOC) guidance in September 2019. The Working Group is looking at the transition of various LIBOR-referencing products, including bonds, derivatives, deposits and loan products, tracking the latest updates on international benchmark interest rate reform and monitoring domestic LIBOR exposures closely.
The Working Group includes 15 major national banks, including the Bank of China (BOC), Industrial and Commercial Bank of China, Export-Import Bank of China and China Development Bank. As of August 2020, it had held five meetings to discuss the latest updates on LIBOR transition that impact the Chinese domestic market and each member’s internal progress on LIBOR transition.
Progress on LIBOR transition
Major banks in the Mainland have comprehensively assessed the impact of LIBOR cessation, and coordinated with their foreign branches to formulate internal LIBOR transition guidelines and plans. PBOC has not set any milestones for domestic banks to ensure cessation of LIBOR-based financial products, but PBOC indicated it will do so according to the benchmark interest rate transition progress domestically.
Examples of developing RFR-based products include BOC’s investment in RFR-based bonds and notes, and secured overnight financing rate-based (SOFR-based) debt instruments issuance in the US onshore market since 2019. In early 2020, the China Foreign Exchange Trade System launched new derivative products referencing new RFRs where domestic banks had participated in cross-currency swaps and interest rate swap transactions referencing SOFR and other RFRs.
PBOC had also requested the National Association of Financial Market Institutional Investors to revise derivatives agreements and definitions as soon as possible taking into account LIBOR transition, particularly as the National Association of Financial Market Institutional Investors (NAFMII) agreements have not been included as in-scope documents under the ISDA 2020 IBOR Fallbacks Protocol.
Future developments
The White Paper Participating in International Benchmark Interest Rate Reform and Improving China’s Benchmark Interest Rate System provides an overview of existing interest rates in the Mainland repo and interbank market, including Depository-Institutions Repo Rate (DR), which is the expected RFR to be developed and adopted in the future, given that this rate best reflects the level of liquidity and funding rates in the banking sector, its relatively high market recognition and its close resemblance to an RFR.
The next priority in the development of the Mainland’s benchmark interest rate system is to promote the wider use of DR in derivatives transactions and interbank businesses (especially in certificate of deposit issues, interbank lending and deposits). PBOC also indicated that it will look to construct term rates based on the short-term DR.
Richard Mazzochi and David Lam
King & Wood Mallesons
