LIBOR Transition Asia Update Upcoming milestones and recommendation of Term SOFR
19 August 2021
As we approach the end of the third quarter of 2021, regulators and industry-led working groups have continued to publish updated guidelines and recommendations to encourage market participants to actively transition away from LIBOR prior to the respective cessation dates of the benchmarks.
This briefing summarises the key recent developments in Singapore and Hong Kong against what is happening in the US and UK.
We have updated our pictorial LIBOR transition milestone timeline to reflect the latest developments.
Conversion of legacy contracts – recent developments
In the US, the draft Adjustable Interest Rate (Libor) Act was approved by the House Financial Services Committee in late July. This Act is a piece of federal legislation which, if passed, would supersede the earlier New York legislation (see our previous briefing here).
This development is significant as it precludes litigation from affected counterparties and allows LIBOR contracts which do not contain clearly defined fallback or replacement rate to continue to operate.
During the same period in July, the Working Group on Sterling Risk-Free Rates published a note to remind borrowers of the end-Q3 milestone to complete active conversion of all legacy GBP LIBOR contracts expiring after the end of 2021 where viable and, if not viable, ensure robust fallbacks are adopted where possible.
The note specifically highlighted that the Financial Conduct Authority (FCA) has warned market participants not to delay their plans by waiting for a potential synthetic solution.
Despite the warning above, the FCA is consulting on its proposed calculation methodology for synthetic sterling and Japanese yen LIBOR, which the authority indicated should only be used in tough legacy contracts. The final parameters of such guidance have not been released and is pending announcement by the FCA later in the year.
In Asia, the Steering Committee for SOR & SIBOR Transition to SORA (SC-STS) in Singapore recently published a report encouraging market participants to substantially shift out of their legacy SOR exposures by 31 December 2021.
The report contains recommendations for active conversion of loan, bond and derivatives products prior to that date, including:
- conversion of corporate loans that mature before SOR discontinuation on 30 June 2023 but are hedged, and those maturing after SOR discontinuation but cannot (or should not) rely on the fallback rate (SOR);
- commencement of consent solicitation process or consideration of other options for bonds that reference SOR and mature after 30 June 2023, or that have a fixed rate reset after 31 December 2021 which rely on SOR interest rate swap rates; and
- transition and reduction of SOR derivatives exposure and amendment of bilateral credit support annexes that use SOR as interest rate.
Interesting development – Credit Adjustment Spread (CAS)
On determination of the CAS to be added to SORA, the SC-STS recommends using a market-based approach by reference to the SOR-SORA basis swap mid-rate pricing as a starting point. This is known as the forward-looking approach.
It is interesting to note that this differs from the historical formula adopted by ISDA which is currently widely used in the market. ISDA's approach for calculating the spread uses the median of spread between IBOR and the relevant RFR over a five-year lookback period.
SC-STS noted that their recommended approach provides a market-determined pricing (as opposed to the historical formula adopted by ISDA), and allows the interest exchanged on a contract to be broadly comparable over the remaining tenor of the contract after the conversion from SOR to SORA.
Cessation of new LIBOR contracts
In Hong Kong, although the Hong Kong Monetary Authority (HKMA) has not recommended explicit milestones for conversion of legacy contracts, it is our understanding that it requires authorized institutions (AI) to report on their LIBOR exposures in their regular surveys.
Earlier this year, the HKMA extended the deadline for ceasing to enter into new LIBOR contracts to 31 December 2021, which coincides with the deadline set by the Federal Reserve of the United States. In July, the HKMA issued a circular to all AIs reiterating the requirement and updating customer communication materials.
Term SOFR – What is the current view
The UK authorities have expressed their preference for the broad adoption of compounded SONIA in arrears, and made it clear that the use of a forward looking SONIA term rate should be limited (see the recently published FMSB Standard on use of Term SONIA reference rates).
The current position above is interesting as it can be contrasted with the formal endorsement of CME Group's forward-looking SOFR term rates (one-month, three-month and six-month tenors currently available) announced by the Alternative Reference Rates Committee (ARRC) on 29 July 2021.
In its best practice recommendations relating to the scope of use of term SOFR in new contracts, the ARRC:
- supports the use of term SOFR in new business loans where transitioning from LIBOR to an overnight rate has been difficult and where use of a term rate could be helpful in addressing such difficulties, but
- does not support the use of term SOFR for the vast majority of the derivatives markets (except for end-user facing derivatives intended to hedge cash products that reference term SOFR).
It is also worth noting that the ARRC recommended term SOFR loan conventions are very similar to LIBOR loan conventions, for instance, in terms of quotation day and business day and day count conventions.
Given these similarities and the forward-looking nature of term SOFR (rates being known in advance of the interest period), it is generally considered to be the preferred option as the rate can be easily adopted and integrated into existing operation systems and documentation.
On the use of term rates in Asia, the HKMA has not expressly indicated any preference or issued any guidance (yet). It is possible that HKMA may leave it to the market to decide commercially which rate to adopt.
The SC-STS has previously encouraged market participants to prepare to transact in products that reference compounded SORA instead of delaying transition plans in anticipation of term SORA as there is no way to guarantee the development of such term benchmarks.
Further thoughts
Following the developments above, below are the interesting points to consider:
- Whether term SOFR (or other term rates) will be adopted and/or widely used in new loans;
- When contemplating the incorporation of fallbacks in legacy or new LIBOR contracts, whether parties will follow the ARRC recommended fallback language whereby term SOFR is the first step of the waterfall for USD denominated instruments, or follow the convention in the LMA rate switch documents which provides for a switch to non-cumulative compounded risk-free rates;
- Whether regulators and industry-led working groups in other jurisdictions will follow the ARRC's formal recommendation of usage of forward looking term rates; and
- Whether more working groups will follow the SG-STS' approach for CAS and adopt a forward looking methodology instead of the historical formula adopted by ISDA.
Thank you to Susana Chan for her assistance in preparing this article.
