Why is Libor being phased out?
The London interbank offered rate (Libor) is the interest rate at which banks lend to and borrow from one another in the interbank market, and covers anything from corporate lending to bonds, trade financing and securitisations. However, due to issues surrounding its manipulation, the rate is being phased out and central banks everywhere, including in Asia are looking, for alternatives.
What are Asian jurisdictions doing as the deadline for the Libor phase out approaches?
To ensure that rates in interlinked transactions are based on similar frameworks, there needs to be alternatives that work across all transactions. A number of Asian jurisdictions are turning to so-called risk-free rates (RFRs) which are overnight rates based on transactions in a liquid market.
"Asian markets with significant cross-currency swap activity will be pressured to adopt a risk-free rate"
Richard Mazzochi, partner at King & Wood Mallesons, said that Asian jurisdictions are generally adopting their own domestic overnight rates. For example, Hong Kong will likely use the Hong Kong dollar overnight index average (Honia) while Japan will use the Tokyo overnight average (Tonia) and Australia will retain the Bank Bill swap rate (BBSW).
“Jurisdictions are setting rates for their domestic currencies because they reflect actual, local market conditions,” said Mazzochi.
These RFRs look to existing actual transactions. One advantage of this approach is that it reflects actual transacted rates rather than quotes for future rates, like Libor.
Many Asian jurisdictions don’t have any existing, widespread RFRs so developing one is the first step. Industry and regulators will need to work together to develop them.
“For some jurisdictions like Hong Kong, where Honia already has a 17-year trading history, there are obvious candidates to consider. For Australia, it’s also easy as the RBA [Reserve Bank of Australia] cash rate has been around for 35 years,” said Keith Noyes, regional director, Asia Pacific, International Swaps and Derivatives Association (Isda). “But for other countries, there is no obvious choice yet.”
“To transition away from existing benchmarks which the market is familiar with and move towards risk-free rates, there needs to be sufficient liquidity in transactions referencing the risk-free rates. There is gradual liquidity buildup in the US secured overnight financing rate [Sofr] and we already have Sofr futures and cleared Sofr swaps.”
One of the areas that has raised interest and could motivate more Asian markets to adopt RFRs is cross-currency swaps. For example, Australia uses the offshore market to meet funding needs through the issuance of US dollar bonds that are hedged back in Australian dollars via cross-currency swaps.
“After the majority of the US dollar market has adopted Sofr, traders may not want to trade an overnight RFR against a term, unsecured Australian dollar rate and this should lead to greater take up in trading of the Australian dollar RFR as the preferred basis trade,” said Noyes. “Australia already has an RFR, and other Asian markets with significant cross-currency swap activity will come under pressure to adopt such as rate.”What will be most challenging for market participants as they transition away from Libor?
As Libor has been used as a benchmark rate globally for over 30 years, the adoption of new benchmark rates is challenging as central banks decide on what is an appropriate rate to move to. One of the challenges is that RFRs aren’t forward-looking rates which borrowers can use to better determine funding costs.
According to a banking source, for syndicated loans specifically a forward-looking term SOFR rate that is publicly available to borrowers and lenders is currently the closest replacement for Libor. The forward looking Sofr is easiest for the market to understand and adopt because the rate will be known at the time the loan is made, and it will have a term that is relatively consistent with current Libor tenors.
However, an overnight Sofr would not be appropriate because using one day’s rate for an entire interest period may be prejudicial to the lender or the borrower depending on the direction of rates for the life of the interest period. This problem is exacerbated for longer interest periods, such as six or 12 months. Certain days of the month/quarter might see artificially high rates due to normal market fluctuations.
The source adds that a daily compounded Sofr rate may work at some point in the future, but it would require significant systems and accounting changes before it can be operationalised as a viable Libor alternative.
In addition, the potential mismatch between the loan market’s use of a forward-looking term Sofr rate and the derivative market’s use of an overnight Sofr rate may make hedging of these loans even more difficult.
It is extremely important from an operational and transparency perspective to have the rate and spread adjustment published on screen, by any third parties, up front. For the borrower, it is important to know the rate for cash flow management purposes. For the lender, it is important to manage receivable and revenue calculations.
Another challenge is to look at how legacy agreements are to be amended if alternatives to Libor are used in agreements that originally reference Libor – bond terms and conditions, for instance, will likely need to be re-worked, and this could prove difficult for issuances with hundreds of debtholders. Since the calculation methodology will also likely change, any amendments in benchmark rates means a change of coupons, rates and other terms. For products that are interdependent on the reference rates of one another, the determination of fallbacks and timing to transition to a new reference rate will be required.
What are market participants doing to prepare for the phase out of Libor?
Between now and when the RFRs are officially adopted, there is much work to be undertaken by market players and market participants.
“Borrowers, issuers and swap counterparties need to assess how and when their funding and hedging will be affected,” said Mazzochi.
Existing documentation, whether it be for loans, bonds or derivatives, will also need to be amended. For loans, amendment mechanisms will be agreed as existing benchmarks using Libor will no longer be available. As for bonds, it’s more complicated in that there are many investors who invest through clearing systems. There needs to be adequate risk disclosure on the benchmark transition and issuers either nominate fallback mechanisms or impose lower thresholds for making amendments to the interest rate setting conditions.
Isda senior counsel Jing Gu said that the organisation is working on addressing concerns around the robustness of derivative contracts referencing key Ibors.
"Borrowers, issuers and swap counterparties need to assess how and when their funding and hedging will be affected"
Isda is amending certain ‘floating rate options’ in its 2006 Definitions to implement fallbacks for certain key Ibors. The fallbacks will apply if the relevant Ibor is permanently discontinued, based on defined triggers, and the fallback rate will be a RFR. Upon publication of the amendment for the relevant Ibor, transactions incorporating the 2006 Isda Definitions that are entered into on or after the date of the amendment will include the amended floating rate option with the fallback. Isda also expects to publish a protocol to facilitate multilateral amendments to include the amended floating rate options, and therefore the fallbacks, in legacy derivative contracts.
If fallbacks are triggered, an adjustment will apply to the relevant RFR.
Isda recently consulted on methodologies for calculating this adjustment and requested input on whether the same methodology should be used for each relevant benchmark or whether different benchmarks require different methodologies, such as hypothetically, GBP or US dollar Libor, for which the fallbacks are expected to be Sonia and Sofr.
In-house counsel: start LIBOR transition sooner than later
Primer: the secured overnight financing rate (Sofr)