Interbank Offered Rates (IBORs) are the set of benchmark interest rates that measure the average cost of unsecured interbank lending in the financial services industry, the most widely used of these being the London Interbank Offered Rate (LIBOR). LIBOR and other IBORs affect the costs and prices of derivatives, bonds, loans, mortgages, and student loans amongst other securities amounting to about $300 trillion worth of contracts.
After a string of well-documented issues including rate-fixing and low liquidity in markets, the Financial Stability Board suggested the replacement of IBORs with Alternative Risk-Free Rates (ARRs). Following this, the Financial Conduct Authority (FCA) set out a timeline to bring an end to LIBOR and will stop compelling its twenty ‘panel banks’ to submit their daily rate contributions from 31st December 2021.
The proposed alternative benchmark rates measure overnight borrowing costs for either secured or unsecured financial markets. These ‘risk-free’ rates (RFRs) are transaction-based and normally administered by central banks leaving them less susceptible to market manipulation as well as on average lowering the costs of borrowing.
The International Swaps and Derivatives Association (ISDA) is one of the key stakeholders trying to mitigate the costs and risks associated with IBOR transition. It has set up multiple working groups globally in order to identify and solve issues, specifically in the derivatives market. ISDA plans to publish a new protocol facilitating multilateral amendments in legacy derivative contracts. This provides a fallback framework for existing IBOR-linked derivatives contracts that will expire after the 2021 deadline. These fallbacks will be necessary due to the fundamental differences between new ARRs and IBOR rates. The transition away from IBORs has already begun to take place and, despite being designed to solve issues, the reform has caused significant challenges globally and the Asia Pacific (APAC) region is no exception.
Current Situation in Asia Pacific (APAC)
As the U.S. replaces USD LIBOR with Secured Overnight Financing Rate (SOFR), the calculations and repapering are among the various risks that Asian regulators need to manage. Local rates such as Singapore’s Swap Offer Rate (SOR), Thai Baht Interest Rate Fixing, and Philippines Interbank Reference Rate are especially exposed by the risks as they rely on the USD LIBOR in its computation methodology. The discontinuation of USD LIBOR will affect the sustainability of these local benchmarks and needs to be replaced by a forward-looking term rate, such as term SOFR, to avoid big changes in the value of contracts linked to the benchmarks.
RFR working groups in several jurisdictions including Singapore, Japan, Hong Kong, have identified replacement benchmarks and have begun developing strategies for transition. These jurisdictions adopt a multiple rate approach, where each IBOR could be made sustainable and potentially co-exist with the RFR.
Impact and Challenges in APAC
While LIBOR reform is a global change and there are universal difficulties such as transition planning, model recalibration, renegotiation of existing contracts, and new accounting rules, there are some challenges posed that are unique to institutions operating in the APAC region.
Degree of Intervention by Local Regulators
There is a certain degree of isolation for many banks in the region. LIBOR is talked about in financial circles in other parts of the world, and banks have many different reference points and sources of advice during their transition. However, some central banks in APAC have been quiet about LIBOR transition. Banks that are used to relying on local authorities for guidance are somewhat unclear on how they should respond, especially in jurisdictions where local benchmarks have not yet been settled.
Most leading APCA jurisdictions’ benchmarks have a robust calculation system and no history of manipulation. Hence, some regulators see the transition as industry-led rather than needing regulatory framework. An example of this difference being Singapore and Hong Kong’s differing approaches to the reform. Regulators expected Hong Kong banks to perform impact assessments and demonstrate their transition plans but have been providing minimal guidance on how they should manage the transition. Singapore, on the other hand, has a cross-industry working group to help steer the development of industry best practises and conventions for the use of Singapore Overnight Rate Average (SORA).
Lagging Liquidity
As institutions begin to issue securities using new ARRs, a lack of market appetite and trading volume could lead to liquidity issues especially in APAC countries with a multiple rate approach and staggered adoption of new rates. Liquidity needs to build in these new rates to ensure a successful transition. There will be international clients looking for fast change to where global liquidity is, against a portion of regional and local clients preferring a more gradual approach.
Lack of Regional and Global Coordination
Differences on adoption and timings of daily ARRs globally and especially in APAC may cause issues in foreign exchange swaps with USD, EUR, and GBP markets. APAC banks’ transition planning will need to incorporate moving targets of differing deadlines as well as constant new regulatory information being published about introduction of ARRs in order to successfully navigate the changes. Not keeping up to date with new information could impede the ability of APAC banks to fully capitalise on the opportunities presented by IBOR reform, placing them at a disadvantage to their regional and global counterparts.
Renegotiation of existing contracts
Many long-term contracts will require converting from IBORs to ARRs. Standardised derivatives contracts should present less of an issue due to the previously mentioned fallbacks put in place by ISDA. However, Cash & OTC products can have very limited standardisation and will require changing and renegotiating on step by step basis. This is a global issue and especially difficult and costly to APAC institutions as a result of regulatory uncertainty and lack of regional coordination.
Unclear future on IBOR rates
Most APAC regulators have decided to keep publishing their IBOR rates after LIBOR’s 2021 deadline alongside new RFRs in order to smooth the transition for local institutions. This could lead to a fragmentation of debt markets as some institutions will be quicker to take up the new ARRs than other institutions. This will have the added effect of reducing some institutions urgency for investing into transition planning while they have the option to continue using IBOR-linked benchmark rates, reducing their ability to compete internationally with better prepared institutions.
External market forces
Despite multiple rate approaches being offered to APAC institutions, the differing risk components between IBORs and the foreign risk-free rates could make swaps between them unpopular in international markets. This could lead to a lack of demand from international institutions for IBOR-linked products within APAC and could, therefore, force the adoption of ARRs sooner than anticipated, causing institutions to incur considerable costs to speed up their transition plans.
Conclusion
The move away from IBOR is widely seen as a necessity to solve a range of issues in global markets. However, there are significant short-term costs that will be incurred by both regulators and institutions in order to transition smoothly to the new benchmark rates in time for the FCA’s deadline.
RFRs are structurally different to LIBOR and will require a difficult and complex process that existing IT systems might not be able to deal with. Specifically, institutions will have to implement technology-driven change in their infrastructure to ensure their in-house IT systems are prepared for the new rates and transacting in various ARRs. Reorganisation of technology landscapes will also be required to centralise analytics and improve consistency across various departments and functions. In addition to the impacts outlined, the risks are also likely to vary during the transition. Financial institutions will need to structure their transition and implementation plan around the shifting market and regulatory landscape. A detailed, robust transition strategy plan will help avoid derailment.
Alongside the entire industry, IBOR reform has been impacted by the COVID-19 pandemic. The FCA has been clear that firms can’t rely on LIBOR being published after 2021, despite extending the deadline to stop issuing LIBOR dependant loans from Q3 2020 to Q1 2021. In APAC, the virus has diverted attention away from IBOR reform, leaving regulators with less time and resources to provide the necessary guidelines and framework for a smooth transition. As the December 2021 deadline draws closer, market participants within APAC will be facing considerable universal and unique challenges while trying to catch up with their North American and European counterparts. There are uncertainties about the transition end game and the actual impact of new RFRs in global and APAC financial markets. Being able to adapt to these changes successfully will be vital to maintain profitability.
References:
https://www.fsb.org/wp-content/uploads/r_140722.pdf
https://www.fca.org.uk/news/speeches/the-future-of-libor
https://abs.org.sg/docs/library/consultation-report.pdf
https://www.hkma.gov.hk/media/eng/doc/key-information/guidelines-and-circular/2020/20200423e1.pdf
https://www.boj.or.jp/en/announcements/press/koen_2020/data/ko200219a1.pdf
https://www.rba.gov.au/mkt-operations/resources/cash-rate-methodology/overview.html
https://www.rba.gov.au/mkt-operations/resources/interest-rate-benchmark-reform.html
https://download.asic.gov.au/media/5551249/benchmark-rate-reform-asic-letter-feedback.pdf
https://www.regulationasia.com/transitioning-away-from-ibors-the-view-from-asia/
https://www.lexology.com/library/detail.aspx?g=06b8ad45-906f-41ec-aa7a-0fc19b656057
https://download.asic.gov.au/media/5551249/benchmark-rate-reform-asic-letter-feedback.pdf
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