How is Asia-Pacific preparing for the end of Libor?
The current state of play
The end of Libor is fast approaching and much progress has been made around the world in transitioning to alternative reference rates. However, it is complex and challenging process and one where market participants need to be adaptable as regulators give further guidance. At a recent Risk.net roundtable produced in association with Tradeweb, senior risk professionals based in Asia-Pacific gathered to discuss the state of play in the Libor transition.
Over the last few months more certainty has been provided by the announcements of cessation dates and a fallback protocol, as well as the locking in of historical spread adjustments. However, much work remains to be done over the remainder of 2021, followed by the additional period to June 2023 for the transition of USD Libors. For now, the focus for financial institutions in Asia-Pacific is very much on the migration of the various IBORS used in the region. Some of the latest developments in key financial markets are as follows:
Singapore’s regulators are undoubtedly ahead of the curve in terms of setting expectations for financial institutions operating in the country. The Monetary Authority of Singapore (MAS) recently announced that SOR (Swap Offer Rate) will be discontinued from end-September 2021. All financial institutions will then be required to transition to SORA (Singapore Overnight Rate Average), while the use of SOR in lending contracts was already discontinued in April. Lastly, USD Libor may not be used in contracts after December 31, 2021.
Progress in Hong Kong has been slow. The Hong Kong Monetary Authority (HKMA) recently delayed the cessation of Libor-linked products to the end of 2021. Initially it was targeting the end of June. Financial institutions are expected to accelerate their work on reducing their reliance on Libor before the end of the year. Hong Kong firms will be taking a multi-rate approach by using both HIBOR (Hong Kong Interbank Offered Rate) and HONIA (Hong Kong Dollar Overnight Index Average).
As in Hong Kong, regulators in Japan are not requiring market participants to move to a single new benchmark rate. Instead, there will be a multi-rate approach using TIBOR (Tokyo Interbank Offered Rate) and TONAR (Tokyo Overnight Average Rate). Rates will apply depending on whether they are used for interest rate swaps or trade purposes. A third option, TORF (Tokyo Term Risk Free Rate), has also be gaining traction among market participants.
Australia has been less precise about its expectations for the transition, expecting market participants to follow the timelines of other countries such as the UK and the US. The BBSW (Bank-Bill Swap Rate) is a robust benchmark and firms are still comfortable using that for Australian dollar contracts. However, some activity has started to transition to AONIA (Australian Overnight Index Average). Much uncertainty remains about what will happen to cross-currency swaps, with many market participants in a wait-and-see mode as they wait for liquidity to build.
Trading platforms have moved ahead with the adoption of new rates, driven by client demand. The initial focus has been on more liquid products such as the US dollar, sterling, euros and Swiss francs. Australian and New Zealand dollars are also already tradeable, as are products using TONAR. Other currencies that have been left behind are expected to follow shortly. Singapore will be added in June 2021, while developments in Hong Kong will depend on requests from clients and clarity provided by the regulators. Generally, the switch to new rates has been fairly straight-forward from the perspective of platforms, mainly involving work on the technology side.
But how systems-ready are financial firms when it comes to the IBOR systems transition? Major changes are required to be made in areas such as downstream, reporting and general ledger systems. A common solution to managing this complex process is the use of a task force in order not to lose focus and stay on top of the latest developments.
Yet, sticking points still remain, particularly when it comes to the overhaul of loan platforms. A lack of regulatory clarity has led to issues for firms in setting specifications for Loan Management Systems (LMS) - for instance, how interest needs to be accrued. Another challenge particular to Asian firms is the dominance of loans compared with derivatives – the opposite of the situation in the US. This requires considerable customer engagement to help facilitate the transition for customers from a legacy perspective.
A last major issue is how firms are dealing with the use of fallbacks, with contracts that have not yet transitioned by the end of the year requiring a fallback method. There is a question whether these fallbacks will be dealt with through system updates or a manual process. Fallbacks also need to be addressed by platforms, particularly in how they deal with contractual arrangements. Given that platforms have already introduced functionality to move old Libor trades to the new RFR (Risk-Free Rates) business, it remains to be seen whether a large proportion of contracts will indeed require fallbacks at the end of 2021.
Tackling the liquidity catch 22
A large factor driving the Libor transition is the availability of liquidity and here there are discrepancies by market. For instance, sterling has already seen 60-70% of contracts transitioned to SONIA (Sterling Overnight Interbank Average Rate). For less liquid currencies, which account for fewer than 5% of all Libor transactions, it is currently less clear whether market participants are simply waiting to see if more liquidity becomes available, or if there are timing issues in terms of the basis spread. The buy side may also not want to get too far ahead and incur unnecessary transaction costs.
So what can be done to drive liquidity? An interesting example in Singapore comes from LCH Group, which recently extended the central clearing of over-the-counter SORA transactions from 5.5 years to 21 years. LCH had been slow to offer the longer tenor as it felt there were no trades demanding it. Yet in a classic catch 22 situation, liquidity was never going to appear unless LCH made the option available to traders. The move to 21 years means banks can now plan and look at long-term swaps.
There is certainly a case to be made for urging facilitators in the marketplace to get on board with the new reference rates. Similarly, liquidity in the cash product market needs to catch up with derivatives. Anecdotal evidence suggests that this has started to happen, with increased loan activity taking place either through RFRs or a rate switch mechanism.
Regulators may also have a role to play in helping to boost liquidity, but there are contrasting views on what approach they should take. UK regulators have clearly stated that as Libor was a problem created by banks, they should also be the ones that solve it. Conversely, the US has chosen for the legislative route in order to get it over and done with. There is a case to be made for both, but regulators should always try to steer the market in the right direction with clear guidance.
With the US having delayed the cessation of its most commonly used tenors to June 2023, only a marginal proportion of its derivatives market has transitioned into RFRs. Taking into account that the value of the US derivatives market is considerably larger than that of Asia-Pacific, it gives a good indication of the scale of work that still needs to be done, as well as its impact on liquidity. While the delay in the US has provided additional lead time for derivatives to mature before anything needs to be done, firms in Asia-Pacific still need to work with their customers to bring urgency in their thinking about the risks associated with this extension.
Testing systems and other market participants
Financial institutions in Asia-Pacific are generally comfortable with how smoothly the Libor transition is going for the clearing houses, as underlined by LCH now being able to clear SORA contracts up to 21 years. Testing has also given reassurance about the readiness of the clearing process, with firms having completed test runs with compressed legacy trades as well as cross-currency swaps.
Libor has been embedded in systems for so many years that it is an ongoing challenge to identify all individual components that need to be fixed ahead of the transition. Testing is therefore proving to be crucial to ensure that hedge accounting and mark to market changes are all running correctly in financial firms’ systems.
However, banks are the thin end of the wedge and the biggest challenge is getting non-financial entities to transition. Corporates are currently still holding back because they fear they might get locked in as an early mover when the entire market is still developing. There are also concerns about transitioning legacy contracts to RFRs, which may require companies to record mark to market gains or losses.
The transition is proving to be a complex process, because there are so many different nuances that need to be considered. Financial firms are showing real concern about the preparations of their customers. How do customers mitigate all of the risks associated with the transition? How do they ensure their systems are prepared when their business is probably facing disruption from the COVID pandemic? There is still much uncertainty about what the post-Libor world will look like and firms will need to manage conduct risks to ensure their customers are as prepared as they are for the transition.
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A critical point for transition to SONIA from LIBOR