Since 5 March 2021 when the United Kingdom’s Financial Conduct Authority (FCA) formally announced (Announcement) the impending cessation of The London Inter-Bank Offered Rate (LIBOR), financial markets and governments around the world have taken action to transition to alternatives reference rates.
There are similarities and differences in the way the transition played out in Hong Kong and Mainland China. In the latter half of 2021, we saw transition accelerate in Hong Kong. Market participants spent considerable resources to prepare for 31 December 2021 – the day all Sterling, Euro, Swiss Franc and Japanese Yen settings and 1 week and 2 month US dollar (USD) settings ceased. The remaining USD settings (being 1, 3, 6 and 12 month tenors) continue until 30 June 2023.
In a similar vein, the PBOC has urged commercial banks to transition from LIBOR and to stop signing new contracts or extending contracts referencing LIBOR. It is, however, becoming clear that in practice, Mainland banks operating out of Mainland China (and the Macau Special Administrative Region) are not strictly prohibited by the PBOC from continuing to use LIBOR.
Hong Kong – expect transition to pick up pace in the coming months
As a result of LIBOR transition milestones set by the HKMA, all authorized institutions authorised by the HKMA under the Banking Ordinance (Authorized Institutions) now offer products which:
- reference alternative reference rates
- include fallback provisions in any new LIBOR contracts, or
- adhere to ISDA’s IBOR Fallbacks Protocol to implement fallbacks for relevant legacy derivatives contracts.
Authorized Institutions are expected not to enter into any new LIBOR contracts after the end of 2021, even though certain LIBOR settings only discontinue after 30 June 2023.
We see the following trends in Hong Kong:
- Legacy LIBOR loans - Substantial slowdown in amendments. This is likely due to the immediate focus of new (day one) risk-free rate (RFR) transactions and because remaining USD LIBOR rates will not cease until 30 June 2023. We expect a pick-up over the coming months as market participants establish preferred RFR methodologies and implement the necessary supporting systems.
- Loans market - Lenders with “house” preferences on LMA documentation. This is now common. Since January 2021 the Loan Market Association (LMA) has published multicurrency term and revolving facilities agreements incorporating backward-looking compounded rates and forward-looking interbank term rates with rate switch provisions.
- Bilateral loans market - Relatively easier, smoother transition. Banks often retain ample flexibility to make unilateral changes required from time to time. As LMA language is readily available, LIBOR transitioning in the syndicated market is relatively smooth. The main contention is where “house” preferences differ. Ultimately, however, as facility agents of syndicated loans have the main responsibility of handling calculations, we expect the determining factor may fall to the facility agent’s ability to perform the relevant interest calculations.
- Debt capital markets - slower transition. Most notes issued in Asia are fixed-rate. However, as LIBOR transition gains speed, we have seen more enquiries from issuers on issuing RFR-linked notes. In programme documentation, we continue to see a number of approaches with parties agreeing to appoint a third party to decide on the relevant replacement RFR. The main challenge in the bond market is transitioning outstanding legacy LIBOR issuances – especially where changes to an outstanding bond requires the consent of a large (if not all) bondholders. In the US, federal legislation (the Adjustable Interest Rate (LIBOR) Act) was introduced, effectively overriding contractual references to LIBOR to a SOFR-based rate chosen by the Federal Reserve Board. This means when USD LIBOR ceases on 30 June 2023, any outstanding USD LIBOR bonds will fall back to a floating (SOFR-based) rate. The Adjustable Interest Rate (LIBOR) Act only operates in respect of a US law governed bond. There is no suggestion that any similar legislation will pass in Hong Kong or in the United Kingdom which would apply to Hong Kong law or English law governed bonds. If any LIBOR-linked legacy bonds are not amended, depending on the terms of the bond, those bonds would likely fall to a fixed rate.
Mainland China – transition urged but not strictly followed in practice
Despite the urge from the PBOC to transition, it is becoming clear that Mainland banks operating out of Mainland China (and Macau) are not strictly prohibited from continuing to use LIBOR in practice.
In derivatives, the ISDA and the National Association of Financial Markets Institutional Investors (NAFMII) published two documents that allow firms to incorporate fallbacks provision for onshore derivatives transactions documented under the 2009 NAFMII Master Agreement.
Mainland banks have shown particular interest in Term SOFR (see more on this below) which in practice, requires a lower level of investment than other options such as the in arrears rates – though many Mainland banks are still yet to obtain the required licence from the CME Group to use Term SOFR.
Global shifts to alternative reference rates
Financial markets and regulators for each currency have identified their preferred overnight RFRs as alternative reference rates to LIBOR:
- USD: SOFR (the Secured Overnight Financing Rate)
- Sterling: SONIA (the Sterling Overnight Index Average)
- Euro: €STR (the Euro Short-Term Rate)
- Swiss Franc: SARON (the Swiss Average Rate Overnight)
- Japanese yen: TONA (the Tokyo Overnight Average Rate)
Different approaches to calculating interest using RFRs
LIBOR is a forward-looking rate that is published as a term rate for periods from 1 day to 1 year. Daily RFRs are, however, backward-looking rates that are published overnight only. As a backward-looking rate, unless adjustments are made, the actual amount of interest is not known until the end of the end of the relevant interest period. Furthermore, as an overnight rate, RFRs cannot be used to calculate interest over longer terms such as 1-month or 3-months. To address these differences, various methodologies have been developed to construct RFR-based reference rates to calculate interest, including:
- “In arrears” RFR reference rates
- “In advance” RFR reference rates, and
- Forward-looking term RFR reference rates.
“In arrears” RFR reference rates – the most robust option
- Cumulative Compounded Rate – the daily published RFR rate on each business day are added up by compounding them in arrears. This gives a “cumulative” rate which can be applied to the relevant period. This calculation method means that the interest rate will only be calculated at the end of the observation period.
- Daily Non-Cumulative Compounded Rate – this rate is derived from the Cumulative Compounded Rate, where the Daily Non-Cumulative Compounded Rate for any given day is the Cumulative Compounded Rate of that day minus the Cumulative Compounded Rate of the prior business day. This generates a daily rate allowing for the calculation of a daily interest amount. Over the same period, the Daily Non-Cumulative Compounded Rate will derive the same interest amount as the Cumulative Compounded Rate.
What are observation periods and lookback periods?
Waiting until the next business day after the end of an interest period to know the RFR rate (because RFRs are daily overnight rates) is impractical. To address this, participants “look back” 5 business days (the number of days recommended by industry groups) and compound daily RFR rates over a slightly earlier period than the actual interest period. This earlier period is known as the “observation period” and starts 5 business days (the “lookback period”) prior to the start of the interest period and ends the lookback period prior to the interest payment date.
What is an observation shift?
Daily RFRs are not published on weekends or public holidays. This means that for the purposes of a compounding calculation, each daily RFR for any business day that is followed by a non-business day(s) will need to be weighted. For example, the daily RFR for Friday has a weighting of, and is multiplied by, 3 as it will be used for Friday, Saturday and Sunday.
However, as there are two relevant periods to the calculation (the observation period and the interest period), the question arises as to whether daily RFRs should be weighted according to the non-business days in the observation period or the non-business days in the relevant interest period.
“With observation shift” – if an observation shift is used, the applicable rate is weighted according to the non-business days that occur in the observation period.
“Without observation shift” – if no observation shift is being used, the applicable rate is weighted according to the non-business days that occur in the interest period. This is recommended by industry groups.
Industry groups recommend “without observation shift”, but in practice market participants are considering what is more appropriate for them. As a result, we have seen some lenders preferring as their house form to be “with observation shift”.
Adjusting for LIBOR’s credit risk premium – the credit adjustment spread (CAS)
Whilst LIBOR prices in a premium for bank and term credit risk, RFRs by definition do not. As a result, as loans are transitioned from LIBOR to the relevant RFR, there is a risk of value transfer where RFRs will be lower than term LIBOR in the same currency and tenor. To address this, industry working groups recommend the use of a CAS.
It appears that the prevalent approach is the ISDA historical median approach with a five-year lookback period which calculates the difference between LIBOR and the relevant RFR over five years’ worth of daily data points. Other approaches exist, such as SOFR Academy’s AXI Across-Curve Credit Spread Index.
The CAS for each LIBOR currency and tenor were fixed at the date of the FCA Announcement and is published by Bloomberg. Although CAS is a common negotiation point where existing transactions are being switched from LIBOR to RFR reference rates, some lenders maintain this may not be necessary on new (day-one) RFR transactions as the CAS is priced into margins. Other lenders prefer transparency in their margins and so show the CAS even on new RFR transactions. It remains to be seen which approach the market will adopt.
Another question is whether the CAS should change according to different RFR methodologies. It remains to be seen whether the market develops a clear preference, but many market participants now elect to apply the same CAS across methodologies.
“In advance” RFR reference rates – where “in arrears” calculations are difficult
The general view is that overnight RFRs compounded in arrears is the most robust alternative benchmark interest rate. There are, however, certain products which have difficulties applying “in arrears” calculations. For example in receivables discounting products, purchase prices need to be calculated by reference to forward interest rate curves in a discount formula and structures that have debt service accounts require interest to be calculated in advance to permit compliance testing.
In these situations, “in advance” RFR reference rates methodologies can be used which allow a rate to be set on or before the first day of the interest period. Two of the most common “in advance” RFR reference rate methodologies are:
- last reset – the rate is determined by reference to the corresponding rate for the immediately preceding interest period, and
- last recent – the rate is determined by reference to a recent observation period shorter than the interest period.
The main concern with “in advance” RFR reference rates is that there is a lack of alignment between the interest rate to which the rate will apply and the observation period from which it is taken.
Forward-looking term RFR reference rates – based on market expectations
Forward-looking rates are being developed and for certain currencies are already available for use. Where “in arrears” RFR reference rates are historic and reflect actual rates, RFR term rates reflect market expectations on the future movement in the rate over an interest period (but without any premium for credit or term risk). RFR term rates can thus be used to fix rates before the first day of an interest period, similar to “in advance” constructs.
