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 Financial Conduct Authority (FCA) and the Bank of England (BOE) made an announcement and publication on the GBP sterling LIBOR transition stating it should be completed by the end of 2021. To support this, the Working Group on Sterling Risk-Free Reference Rates (the Working Group) has published an update to its priorities and roadmap for the final year of transition to help businesses to finish planning the steps they will need to take in the coming months.
Fully preparing markets and their users for the end of sterling LIBOR will be the top priority for the Working Group. From the end of March 2021, it is recommended that sterling LIBOR is no longer used in any new lending or cash product with maturity date after the end of 2021. Moreover, firms are recommended not to issue any linear LIBOR-linked derivatives after March 2021, other than for risk management of existing positions or where they mature before the end of 2021. Throughout the remainder of the year, existing contracts linked to sterling LIBOR should be actively transitioned where possible.
The FCA, the BOE and the Working Group anticipate that the large majority of GBP market will be based on SONIA compounded in arrears as the robust foundation for the overall market structure. Nonetheless, market participants may need access to the term SONIA rates. The Working Group welcomes the development of term SONIA reference rates (TSRRs). By engaging closely with the FICC Markets Standards Board (FMSB) on support the develop for a market standard for appropriate limited use of TSRRs, the plan will be consistent with the existing objects and recommendations on use cases of benchmark rates.
KPMG’s perspective: In response to the announcement made by FCA and BOE, it is clear that the regulators in the UK will not delay its current transition timeline from GBP LIBOR to SONIA. AIs should continue to follow their current project timeline for LIBOR transition. Banks are encouraged to monitor and reduce their GPB LIBOR exposures. HKMA requires all Authorised Institutions (AIs) to cease issuing LIBOR linked products with maturity date after 31 December 2021 by 30 June 2021, while the FCA and BOE recommend the market participants to cease issuing GBP LIBOR product by the end of March 2021. We are expecting that SONIA linked products will be more actively available in the market in the upcoming months as a result.
2. LIBOR-based floating-rate notes to be excluded from list of collateral eligible for SNB repos
Swiss National Bank (SNB) issued a circular letter regarding the collateral eligibility for SNB repos. LIBOR fixings in most currencies are most likely to be discontinued at the end of 2021. The SNB is seeking to reduce potential risk inherent in the disappearance of LIBOR and will continue in the supporting for different market participants during the LIBOR transition. As a result, the SNB decided to exclude all LIBOR-based floating-rate notes in all currencies from the list of eligible collateral for SNB repos as of the end of 2021. But other floating-rate notes whose interest rate is determined by other reference rates will remain on the list.
Only a few securities are impacted by the change. Thus, the potential available volume of eligible collateral for SNB repos will only be marginally smaller. The exclusion of the securities affected will be visible in the search modifications utility as of the end of 2021.
KPMG’s perspective: The potential impact of the SNB announcement is manageable, unlike in some other jurisdictions where LIBOR-based securities dominate the collaterals and the potential exclusion of LIBOR-based floating-rate notes from the eligible collaterals for repos can significantly reduce the available volume of eligible repo collaterals in the next year. The industry should be prepared for LIBOR-based collateral being transitioned away in different markets simultaneously. Specifically, Financial institutions in Hong Kong should pay close attention to the announcements from HKMA or HKICL if the requirements on eligible collaterals will be changed during the course of LIBOR transition in the near future. Financial institutions should continue monitoring and reducing their LIBOR exposures. On the other hand, financial institutions should also start seeking to use ARR referenced securities as alternative collaterals.
17 December 2020, SNB
The first forward-looking term rates based on the sterling overnight index average, Term SONIA Reference Rates (TSRR), are being made available for use in new contracts on 11 Jan 2021. ICE Benchmark Administration (IBA) and Refinitiv, have finalised their methodologies after six months of testing since June 2020. They both are offering the TSRR in one-, three-, six- and 12-month tenors.
IBA and Refinitiv both are using SONIA overnight index swap quotes provided by participants in interdealer central limit order books (CLOBs) in accordance with a “Waterfall” Methodology. Differences between these two calculation methodologies include (1) time windows and snapshots used to collect the committed (i.e., executable) quotes for rate calculations are slightly different between IBA and Refinitiv; (2) waterfall structure and thresholds for publications. While IBA adds a third layer, comprising SONIA futures listed at Ice Futures Europe in case there are insufficient eligible input data, Refinitiv is offering an integrated fallback level derived from the Refinitiv Term SONIA benchmark on the previous business day and overnight SONIA compounded to the previous business day.
The UK’s Financial Conduct Authority (FCA) has instructed regulated firms to cease sterling LIBOR-based lending by the end of March. As a result, the first product referencing the new term SONIA rates are expected to be launched in the market before then. These new rates should help the many businesses, borrowers and lenders who have sought a forward-looking term Sonia benchmark to provide certainty when calculating their interest expenses and other contractual payments in advance.
KPMG’s perspective: Both benchmark providers have started reaching out to clients on the adoption of TSRR. The industry does not expect that the small differences in calculation methodologies will dictate the clients’ choices considering that the quality of CLOBs has significantly improved over the 6-month testing period. Licensing costs and internal data strategies would be bigger consideration factors instead. The market has been asking for the term ARR and this will help the market participants who are seeking for forward-looking rates in their certain products. AIs should also be remindful that there will be multiple benchmark providers available in the market and it may take time to reach a market consensus on which term rates will be the most commonly used.
2. LIBOR Proving Hard to Kill in $200 Trillion Derivatives Market
There are more than $200 trillion of financial instruments are tied to dollar LIBOR around the world, with the vast majority of such exposure is in the form of derivatives. However, the acceptance of alternative products has been slow. The average open interest in three-month SOFR futures barely increased 5% to the euro-dollar contracts last month. Just 5.6% of all U.S. dollar risk in cleared over-the-counter and exchanged-traded interest-rate derivative transactions was tied to SOFR in November, according to data from ISDA and Clarus Financial Technology. While that is almost double the 3% of trading activity that referenced the rate in June, it is well off the record 9.7% reached in October, when global clearing houses made the shift to SOFR. Many participants appeared to revert back to LIBOR after a strong boost pushed from the regulators. If market participants do not want to trade in SOFR market because the liquidity is low, there will not be enough liquidity unless people trade it, thus creating the classic chicken-and-egg scenario. Without enough market data available, the development of term SOFR curve might be delayed.
Creeping closer to the regulatory deadline set by Federal Reserve in the year end of 2021 and the ISDA protocol for derivatives on LIBOR fallback will be effective on 23 January 2021, it is expected the conversion for LIBOR linked contract will be boosted and the trading of SOFR products are expected to be more active, then the issue will be forced a bit.
KPMG’s perspective: While IBA and Refinitiv publish their first forward-looking SONIA term rates, the US market participants seem more pessimistic about SOFR derivatives gaining pace in 2021 which could potentially delay the development of SOFR term rates. With that being said, the FCA still expects that only around 10% of the UK lending market will opt for a forward-looking rate and most products including derivatives, bonds and majority of corporate loans will use SONIA compounded-in-arrears. Different products using in-arrears and in-advance are expected to be seen concurrently in the future financial market. Therefore, following the timeline announced by HKMA, AIs should be ready to issue the new ARR-referenced products by adopting the back-forward looking mechanism and should not solely rely on the term rates as the ultimate solution. AIs are recommended to follow the interest calculation methods announced by the ARRC and ISDA for cash and derivatives market by adopting daily SORA simple or compounded in arrears.
11 January 2020 Bloomberg
3. ASIFMA IBOR Transition Readiness Survey Results and Action Plan
Asia Securities Industry & Financial Markets Association (ASIFMA) and Ashurst released the latest report to highlight the key actions that the industry should focus on for preparing for the LIBOR transition. ASIFMA conducted a regional survey among its members in August last year to clarify the key issues that the industry needs to resolve by the end of 2021. The survey results pointed out four key themes in the Asia Pacific region regarding LIBOR and regional IBOR transition work. These are (1) Lack of standardisation, harmonisation and consensus between different jurisdictions and asset classes, (2) Transition issues of legacy contracts, (3) Litigation, regulatory and conduct risk in connection with IBOR transition and (4) Transition issues in connection with local benchmarks.
KPMG’s perspective: It has been recognized that the Asia Pacific is a very diverse region where the transition readiness spreads a wide range from one jurisdiction to another. This exercise is intended to draw more attention and promote tactical actions in those four key focus areas. The requested actions are divided into regulatory engagements and industry-led actions, mainly including promoting harmonisation in terms of approaches to transition across markets, addressing transition issues through obtaining clarity in term rates/synthetic rates and improving liquidity of ARR products, and mitigating litigation and conduct risk.
07 January 2021 ASIFMA
4. Freddie Mac and Fannie Mae continues to make efforts to support the industry in accepting the new index rates
Freddie Mac clears path for new index rate and is touting its readiness to transition from using the London Interbank Offered Rate or LIBOR to the Secured Overnight Financing Rate (SOFR) as a mortgage reference index. Even there might be a delay in cessation for certain term dollar LIBOR, Freddie Mac remains committed to prepare for a final transition as soon as possible.
Some significant progress has been made to support the move to the SOFR. Among its most recent achievements, in November, the company for the first time began purchasing and securitizing single-family adjustable-rate mortgage (ARM) loans tied to SOFR. Freddie Mac also launched new SOFR-indexed offerings and announced the discontinuation of LIBOR-indexed products. SOFR-indexed ARMs are enabled for single-family lenders for underwriting them and seller/servicers can sell and securitise them. The company will continue developing liquidity in SOFR-based products. 31 December 2020 would be the last date for LIBOR-indexed ARM purchases for mortgages originated on or before September 30, 2020.
Fannie Mae also highlighted the achievement of key milestones, as it continues advancing the mortgage market's readiness for the anticipated future cessation of LIBOR. It has been actively engaged with external parties on the LIBOR transition program by participating in the Alternative Reference Rates Committee (ARRC).
Regardless to the potential delay in the cessation of USD LIBOR for certain tenor, the company will cease purchasing and issuing LIBOR-based products by the end of 2020 and continue offering SOFR-based products to develop liquidity in the market. The company ceased issuing new LIBOR-indexed CMOs and floating-rate debt securities indexed to LIBOR. Meanwhile, the company has issued the market's first-ever Multifamily and Single-Family Mortgage-Backed Securities (MBS) backed by Adjustable-Rate Mortgages (ARMs) referencing SOFR and began offering new SOFR-indexed Collateralized Mortgage Obligations (CMOs) for REMIC settlements. Furthermore, transparent information will be provided and disclosures to assist the market during the LIBOR transition.
KPMG’s perspective: The market has welcomed the collaboration among industry bodies towards the LIBOR transition. The continuous effort from these organisations on the LIBOR transition increases the level of confidence for investors or financial institutions in accepting the new ARR products. It is foreseen that the SOFR market will become more active in the near future.
New Developments on Products and Pricing Strategy
UOB announced the first capital securities with a reset coupon rate that references the Singapore Overnight Rate Average Overnight Indexed Swap (SORA-OIS) rate is successfully priced in Singapore. The adoption of a SORA-based pricing benchmark in the Singapore dollar (SGD) bond market was promoted by this latest issuance. This will broader industry efforts to develop deep and robust Sora-based cash and derivatives markets.
The reset coupon rate of UOB's perpetual, non-call five-year additional Tier 1 securities on the first call date will reference the five-year Sora-OIS rate, instead of the five-year SOR interest rate swap (IRS) that had been the benchmark reference rate in the market.
KPMG’s perspective: We continue to see Singaporean banks being active in issuing new index rate referenced products in the Asia-Pacific region supporting the IBOR transition journey. These SORA new products can also provide references in structuring the new ARR products to our market participants in Hong Kong. AIs with significant SGD exposures should sit tight and pay close attention to the new SORA products.
08 January 2021 UOB
2. OCBC extends more than S$1b in Sora-linked home loans since launch
OCBC was the first bank in Singapore to offer SORA-linked home loans and it has extended more than S$1b since launch. The SORA home loan package offered by OCBC references the three-month Compounded SORA in arrears published by the Monetary Authority of Singapore (MAS). OCBC emerged as the first bank to offer home loans that are based on SORA as the Singapore Interbank Offered Rate (SIBOR) and Swap Offer Rate (SOR) are set to be discontinued in 2024.
KPMG’s perspective: The development of SORA-linked home loans by OCBC may encourage the peer banks to promote SORA-linked products. This will continue to boost the liquidity in the SORA market. It will increase the demand in SORA-linked products when they are more accepted by the market participants.
23 December 2020 OCBC
3. HSBC Completes Its First Corporate Loan Referencing USD SOFR In Hong Kong
HSBC announced the execution of the first USD SOFR corporate loan transaction for a mid-cap corporate in Hong Kong. The corporate loan is provided with flexible repayment and re-borrowing capability for general business purposes. This marks the first SOFR-referenced corporate loan in Hong Kong. It is another step forward by HSBC in contributing to the development of the SOFR market after its earlier execution of first pilot trade loan referencing to SOFR.
KPMG’s perspective: This new product launch will stimulate the lending for ARRs in Hong Kong. This is a significant milestone in Hong Kong’s LIBOR transition efforts following the HKMA letter issued in July 2020, demonstrating the ability to adopt alternative risk-free rate (RFR) products. Since 1st January 2020, AIs are expected to be in a position to offer products referencing the ARRs. We are expecting that the volume of new ARR-referenced products will gradually grow in the next few months.
15 December 2020 HSBC