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.
1. FCA Clarifies "Reasonable Period" For Publishing Non-Representative LIBOR
On 20 January 2020, the Financial Conduct Authority (“FCA”) provided responses to ISDA's letter on 4 December 2019, which requested clarity on the length of any “reasonable period” during which LIBOR could continue to be published after an announcement made by the FCA that the LIBOR is no longer representative. The FCA urged market participants to recognise the possibility of a non-representative LIBOR being published for a period of time, but no greater than a few months, prior to final cessation. ISDA is encouraged to insert pre-cessation fallback triggers into their derivative contracts to prepare for this. In the responses provided, the FCA also underlined their preference to ensure an orderly cessation of LIBOR and that market participants have been provided with enough time to prepare for the discontinuation of LIBOR when it was initially announced.
KPMG Insight: Given that a non-representative LIBOR is likely to be published for a short period of time, firms should continue to prioritise their LIBOR transition plans and have appropriate milestones given the possibility that there may be a lack of representation of the benchmark prior to the end of 2021. Firms should evaluate their readiness for applying pre-cessation triggers in both derivative contracts and cash products where fallbacks are expected to avoid hedging mismatches.
20 January 2020 FCA
2. Fannie Mae and Freddie Mac Will No Longer Accept Adjustable-Rate Mortgages Based on LIBOR by Year-End
On 5 February 2020, the U.S. Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) made an announcement highlighting that they will no longer acquire adjustable-rate mortgages (ARMs) referencing LIBOR by the end of 2020. The move is to align with the LIBOR transition and also demonstrate their commitment to preparing customers for a successful transition with reduced disruption. Furthermore, Fannie Mae and Freddie Mac plan to accept Secured Overnight Financing Rate (SOFR) capped ARM loans in the fourth quarter of 2020.
KPMG Insight: Investment firms in Hong Kong purchasing ARMs as investments should take appropriate actions to review their systems and booking configurations to ensure the new benchmark rate curve is built in before the fourth quarter of 2020.
5 February 2020 Fannie Mae and Freddie Mac
3. Remarks of CFTC Commissioner at the ISDA/SIFMA AMG Benchmark Strategies Forum
Commodity Futures Trading Commission (CFTC) Commissioner Rostin Behnam has expressed his view on the development of the LIBOR transition in the U.S. Mr Behnam stated that he will take actions and commit to ensuring a smooth transition, specifically related to the derivatives market. Mr. Behnam stressed the importance of operational readiness and noted the recent progress made by the following:
- ISDA on benchmark fallbacks in the derivative space;
- ARRC’s development of paced transition plan in shifting LIBOR to SOFR and its recommendation of fallback language for USD LIBOR loan products;
- CTCF’s relief from the trade execution and the swap clearing requirement;
- U.S. prudential regulator’s reopening the comment period to change swap margin rules; and
- Fannie Mae’s and Freddie Mac’s cessation of accepting adjustable-rate mortgages (ARMs) based on LIBOR. He urged the public sector and firms to collaborate to address challenges from LIBOR reform.
KPMG Insight: Firms should continue to follow the latest developments from various regulatory bodies and industry sectors and continue to assess their operational readiness for the benchmark reform. In Mr Behnam’s view, though the authorities have stood ready to facilitate, firms should be aware that the authorities do not always prefer a compulsory industry standard-setting or change through regulation and they are therefore encouraged to participate in the consultative efforts led by the ARRC, ISDS, and MRAC.
12 February 2020 CFTC
4. FCA Regards LIBOR Transition as One of the Four Priorities in Wholesale Financial Markets
The FCA has highlighted in a report, Sector Views 2020, the transition from LIBOR to alternative risk-free rates is one of the key priority themes under Wholesale Financial Markets in 2020 where the FCA believes it will increase market integrity in the long-run. At the end of August 2019, there was over £25 trillion of outstanding notional in cleared Sterling LIBOR derivatives. It is expected that a large number of contracts and systems still require enhancements for the transition. The FCA will continue to work closely with market participants and other authorities to support the transition effort.
KPMG Insight: While LIBOR is still heavily used in the wholesale market and significant impact may arise from a potential disorderly transition, firms should identify and closely monitor impacted contracts and systems and develop a robust governance framework, assessing risks and possible transition scenarios. Firms should consider any potential conduct risk arising from the transition and consider developing a client outreach plan well before clients come to them.
21 February 2020 FCA
5. Bank of England (BOE) is Seeking Views on Supporting Risk-Free Rate Transition
On 26 February 2020, BOE published a discussion paper to seek views from sterling market participants which aims to accelerate the adoption of SONIA as an alternative rate. As part of the discussion, BOE intended to publish a daily SONIA Compound Index and a set of compounded SONIA Period Averages which can simplify the calculation of compounded interest rates for financial products and provide easy access to SONIA over a range of set time periods. In particular, BOE would like to seek market consensus on where to publish such averages and if so, how to define the relevant time periods. Moreover, the Executive Director of BOE, Andrew Hauser, gave a speech on the same date announcing that from October 2020, the BOE will progressively increase haircuts on the LIBOR-linked collateral it lends against and that these are scheduled to reach 100% at the end of 2021.
KPMG Insight: Firms should evaluate the feasibility and benefits of using the proposed daily SONIA Compound Index and Period Averages and assess the potential impacts arising on their product portfolios in the calculation of relevant coupons and payments which are currently referencing GBP LIBOR. With the new plan of increasing haircuts on LIBOR-linked collateral, firms which have maintained loans, swap contracts, and other cash and derivative products with BOE should note more collateral would be required on the outstanding balance. Firms should also continue to review market developments concerning fallback language and the impact on LIBOR-linked collateral as market practices evolve.
26 February 2020 BOE
1. Consultation on Swaptions Impacted by Central Counterparty Clearing Houses’ Discounting Transition to SOFR
1.ARRC has launched a consultation seeking inputs on whether to recommend a compensation methodology for swaptions referencing U.S. Dollar LIBOR that could be affected by the change of discounting rate and price alignment interest, from the effective federal funds rate (EFFR) to SOFR. For swaptions that can be physically settled or cash settled with the use of the discount curve prevailing at a central counterparty clearing house (CCP), potential economic impacts are expected, along with the change of discounting rate. Some CCPs (e.g. LCH and CME Group) announced a compensation mechanism for cleared swaps at transition which will involve the exchange of cash deriving from the two different discounting regimes and risk compensations, however, the CCP compensation mechanism would not apply to swaptions that have not been exercised. While ARRC would like to seek views on possible compensation methodologies, it states that the recommendations would be strictly voluntary and would need to be bilaterally agreed between counterparties.
KPMG Insight: While the ARRC recognises the valuation transfer (i.e., Day 1 P&L impact) on swaptions as a result of the LIBOR transition, firms should be reminded that the Day 1 P&L impact applies to almost all financial products and it is recommended firms closely monitor the impacted contracts and assess the potential impact on Day 1 P&L.
7 February 2020 ARRC
2. FSB’s Chair Sets LIBOR Transition as One of the Focus Areas for the Saudi Arabian G20
The FSB’s Chair, Randa K. Quarles, has published a letter to G20 Finance Ministers and Central Bank Governors outlining the supervisory and regulatory issues that require attention. While the cessation of LIBOR is due at the end of 2021, Quarles set the transition as a priority for focus by the G20, highlighting that both the official and private sectors should prepare well for the challenge and ensure a smooth transition to a post-LIBOR world. Also, the FSB will further publish progress reports on LIBOR transition in July and December 2020.
KPMG Insight: Regulators continuously provide guidance and issue surveys globally to track progress on LIBOR transition amongst the private sector. Industry-wide bodies should continue to ascertain their preparation progress and identify associated risks and issues from the transition of LIBOR to alternative rates, particularly on areas like fallback language in impacted contracts and negotiation and repapering with clients. Firms should also keep an eye on the progress reports to be published by the FSB later in 2020.
19 February 2020 FSB
3. ISDA Examines Upcoming Developments of the Adoption of Alternative Risk-Free Rates (RFRs)
ISDA issued a research note on 21 February 2020 examining the upcoming developments in 2020 relating to the adoption of RFRs with LIBOR and other IBOR transitions. This issue is considered by ISDA as one of the biggest challenges facing the financial industry. The developments include:
- Calculation and publication by Bloomberg of IBOR fallback rates based on adjusted RFRs for key IBORs in the first half of 2020;
- Amendments to the 2006 ISDA Definitions incorporating the adjusted RFR fallbacks;
- Publication of a protocol to amend legacy IBOR contracts;
- Change of discounting for cleared euro-denominated derivatives from the Euro Overnight Index Average (EONIA) to the Euro Short Term Rate (ESTR) by CCPs in June 2020;
- Change of discounting for cleared U.S. dollar-denominated interest rate derivatives from the EFFR to SOFR by CCPs in October 2020;
- Change of the market convention for sterling interest rate swaps from sterling LIBOR to Sterling Overnight Index Average (SONIA) on March 2, 2020; and
- Expected continued growth in the issuance of RFR-based cash products.
KPMG Insight: Firms should assess the implications from the amended ISDA definition, protocol, and publication of adjusted RFR fallback rates. Where necessary, firms should take mitigating actions on their impacted contracts and products to cope with the fallback mechanism and change of discounting methodology beforehand. The comprehensive developments provided by ISDA provide market participants with clarity to help facilitate their LIBOR transition.
21 February 2020 ISDA
4. ISDA Seeks Input on LIBOR Pre-cessation Fallback
On 24 February 2020, ISDA launched a new consultation on pre-cessation fallbacks that it is implementing for LIBOR-linked derivatives. Following ISDA’s May 2019 consultation on pre-cessation issues, the majority of respondents will stop referencing LIBOR in derivative contracts when LIBOR is no longer representative, but there is a wide range of views on pre-cessation fallback triggers. The new consultation asks whether ISDA should publish a Supplement to the 2006 ISDA Definitions so that Rate Options for LIBOR, including fallbacks, would apply upon the first to occur of a permanent cessation trigger or a “non-representative” pre-cessation trigger. If the supplement is published, all transactions incorporating the 2006 ISDA Definitions which are entered into on or after the effective date of the supplement will have to include the amended terms (i.e., updated pre-cessation fallback provisions). ISDA also intends to publish a protocol to facilitate multilateral amendments to incorporate the amended terms, and therefore the fallback provisions, in legacy derivative contracts.
Firms should closely monitor the development of pre-cessation triggers and assess whether the amended definitions (i.e., the definition with the combined permanent cessation and pre-cessation fallback provisions) should be included and necessary for their legacy derivative contracts. Firms should also evaluate whether they are prepared to apply pre-cessation triggers in both derivative contracts and cash products where fallbacks are expected and avoid hedging mismatches.
24 February 2020 ISDA
5. International Accounting Standards Board (IASB) ‘s Update on IBOR Reform and its Effects on Financial Reporting
ISAB met on 26 February 2020 to discuss issues related to IBOR reform and its effects on Financial Reporting in Phase 2. The IASB tentatively decided the proposed amendment in relation to modification of financial instruments should apply only to the changes made in the context of IBOR reform. For hedging relationships amended to reflect modifications, the IASB tentatively decided to provide a temporary relief where a non-contractually specified risk component has to satisfy the separately identifiable criteria specified in IFRS 9 or IAS 39. In Phase 2, the IASB tentatively decided application of all proposed amendments should be mandatory and entities should apply the proposed amendments for annual periods beginning on or after 1 January 2021 with retrospective application. The comment period for the proposed amendments is tentatively set as 45 days. The IASB plans to issue an exposure draft for Phase 2 of the project in April 2020 for balloting process.
The IASB provides additional guidance and information for LIBOR cessation accounting issues in respect of modification of financial instrument and hedge accounting which could result in significant P&L impact. Firms should note that amendments will be mandatory and applied retrospectively. The temporary relief to amended hedging relationships can only be applied if separately identifiable criteria specified in IFRS 9 or IAS 39 is satisfied.
26 February 2020 IASB
6. International Capital Market Association (ICMA) Publishes Guidance on IBOR Transition
The ICMA published a Quick Guide for the transition to risk-free rates in the international bond market on 27 February 2020. The Quick Guide is intended to highlight the key issues on which ICMA is focused for the transition from IBORs to alternative risk-free reference rates in the international bond market (including floating rate notes (FRNs), covered bonds, capital securities, securitisations and structured products), and to provide links to relevant resources.
The ICMA Quick Guide is a comprehensive document which discusses the background of the IBOR transition and tackles specific issues in respect of bond markets. Compared to derivatives and other cash products, there are specific complexities for firms to address for bond products, such as consent solicitation, for which the Quick Guide provides the latest global updates. Firms with both bond holdings and issuances should refer to the Quick Guide when determining commercial and operational changes as part of their wider LIBOR transition programmes.
27 February 2020 ICMA
Partner, Head of Financial
Financial Risk Management
Financial Risk Management