Reform of interest rate benchmarks

Our Ref.: B1/15C
23 April 2020
The Chief Executive
All Authorized Institutions
Dear Sir / Madam,
Reform of interest rate benchmarks
I am writing to share with you the results of an earlier Survey on Reform of Interest Rate Benchmarks (the survey) conducted by the Hong Kong Monetary Authority (HKMA) and update you on the latest developments relating to the reform. Survey results The HKMA launched the survey in November 2019 to monitor the banking sector’s progress in preparing for the transition to alternative reference rates (ARRs). The survey results indicate that there were HK$4.5 trillion of assets and HK$1.6 trillion of liabilities in the Hong Kong banking system referencing the London Interbank Offered Rate (LIBOR) at the end of September 2019, representing about 30% and 11% respectively of the banking system’s total assets and total liabilities denominated in foreign currencies. Additionally, there were derivatives contracts involving an aggregate amount of HK$35 trillion in notional value referencing LIBOR. Around one-third of these LIBOR-linked assets and liabilities, and almost half of these derivatives contracts would mature after end-2021 and did not have adequate fall-back provisions. Regarding authorized institutions’ (AIs) preparation for transition to ARRs, many AIs had established a committee or appointed a senior executive to oversee the preparatory work, and were in the process of developing a firm-wide transition plan. Major challenges cited by AIs in preparing for the transition included: (i) the lack of standard and consistent fall-back languages for adoption by the industry; (ii) insufficient liquidity for products referencing ARRs; and (iii) the lack of well-established term structures for ARRs. These challenges are not unique to the Hong Kong market and, as explained below, are being addressed by authorities and leading organisations overseeing the transition. More details of the survey results can be found in Annex 1.

Updates on international and local developments The HKMA has been monitoring developments relating to the benchmark reform closely. The UK Financial Conduct Authority issued a statement in March pointing out that the central assumption that firms cannot rely on LIBOR being published after

the end of 2021 has not changed, notwithstanding the Covid-19 outbreak. Some of the organisations leading the transition to ARRs, including the Working Group on Sterling Risk-Free Reference Rates in the UK and the Alternative Reference Rates Committee in the US, have published their work plans and expected milestones for 2020 to facilitate market participants’ preparation. In parallel, these organisations as well as other industry bodies such as the International Swaps and Derivatives Association (ISDA) have kept on developing fall-back provisions for different types of products and market conventions in using ARRs (e.g. term structure). New issuance and trading volume of products referencing ARRs have continued to increase, thanks to the initiatives undertaken by authorities and industry organisations to promote the use of ARRs in financial contracts. In Hong Kong, the Working Group on Alternative Reference Rates formed under the Treasury Markets Association (TMA) has been following up on issues that need to be addressed locally (e.g. taxation). The TMA has developed a dedicated web page containing a collection of useful information about the benchmark reform, aiming to help local market participants prepare for the transition (https://www.tma.org.hk/en_market_LIBOR.aspx). More details on latest developments relating to the benchmark reform can be found in Annex 2. AIs should continue to closely monitor international and local developments relating to the benchmark reform, leveraging the resources available on the TMA’s web page and other sources. They should take these developments into account in updating their own transition plans. Specifically, AIs should prepare to confirm their adherence to the ISDA Protocol that incorporates fall-back provisions for LIBOR once it is published. The HKMA will continue to use the survey to monitor the banking sector’s preparation for the transition. Should you have any questions about this letter, please contact Mr Gordon Wong on 2878-1272 or Mr Anthony Choy on 2878-1547. Yours faithfully, Raymond Chan Executive Director (Banking Supervision) Encl.

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Annex - Results of Survey on Reform of Interest Rate Benchmarks for Q4 2019 and Latest Developments in Benchmark Reform and Transition to Alternative Reference Rates

Annex 1
Results of Survey on Reform of Interest Rate Benchmarks for Q4 2019

1. Hong Kong banking sector’s exposures referencing LIBOR (LIBOR exposures)
   (HK$ trillion, as at end-September 2019) Assets Liabilities Derivatives Total amount of LIBOR exposures (note) $4.5 $1.6 $34.6 as a % of total assets or liabilities denominated in foreign currencies 30% 11% N/A LIBOR exposures which will mature after end-2021 $1.5 $0.5 $16.1 of which without adequate fall-back outstanding amount $1.4 $0.5 $14.7 as a % of total LIBOR assets, liabilities or derivatives 33% 32% 46% Note: Includes exposures referencing LIBOR in five currencies (i.e. USD, EUR, GBP, JPY and CHF), as well as benchmarks calculated based on LIBOR, including Singapore Dollar Swap Offer Rate (SOR), Thai Baht Interest Rate Fixing (THBFIX), Mumbai Interbank Forward Offer Rate (MIFOR) and Philippine Interbank Reference Rate (PHIREF).

2. Hong Kong banking sector’s exposures referencing HIBOR (HIBOR exposures)
   (HK$ trillion, as at end-September 2019) Assets Liabilities Derivatives Total amount of HIBOR exposures $4.7 $0.2 $12.2 as a % of total assets or liabilities denominated in HKD 49% 2% N/A

3. AIs’ preparation for transition to alternative reference rates (ARRs)
   Key components in AIs’ preparatory work for transition to ARRs % AIs having the component in place Establishment of a steering committee and/or appointment of a senior executive for overseeing the preparation for transition 63% Development of a bank-wide transition plan 38% Quantification and monitoring of LIBOR exposures 48% Impact assessment across businesses and functions 42% Identification and evaluation of risk associated with the transition 38% Identification of affected IT systems and development of a plan to upgrade these systems 39% Identification of affected internal models and development of a plan to modify these models 36% Development of a plan to introduce ARR products 28% Development of a plan to reduce LIBOR exposures 25% Development of a plan to renegotiate LIBOR-linked contracts 24%

4. Key challenges identified by the industry in preparing for the transition
   i. There was no standard and consistent fall-back languages in the industry for
   adoption by AIs and other market participants in their existing contracts referencing LIBOR.
   ii. The liquidity for products referencing ARRs was comparatively low.
   iii. There was no well-established term structure for ARRs.
   iv. There was limited guidance available to assist smaller institutions in preparing for
   the transition.
   v. AIs needed to implement significant changes to their information technology
   systems, internal models and processes within a short timeframe to cater for the transition to ARRs.
   vi. Certain types of financial contracts referencing LIBOR were difficult, if not
   impossible, for AIs to renegotiate with their customers or counterparties.
   vii. AIs might face conduct risk when dealing with their customers along the
   transition to ARRs.
   viii. Awareness of the benchmark reform and the need for transition to ARRs were
   comparatively low among non-AI customers and counterparties.
   ix. It was not clear whether and, if so, how the transition to ARRs would affect AIs in
   respect of taxation, accounting and regulatory framework.
   x. The status of Hong Kong Interbank Offered Rate (HIBOR) vis-à-vis Hong Kong
   Dollar Overnight Index Average (HONIA) as the local interest rate benchmark over a longer term was uncertain. Note: The HKMA, in consultation with the Treasury Markets Association, will consider providing more assistance to the banking industry in overcoming these challenges.

Annex 2
Latest Developments in Benchmark Reform and Transition to Alternative Reference Rates

1. Transition targets and roadmaps
   i. The Working Group on Sterling Risk-Free Reference Rates in the UK (RFRWG)
   published in January 2020 its priorities and updated roadmap for the year. These include some specific transition targets, such as ceasing the issuance of cash products linked to GBP LIBOR by the end of September 2020 and taking steps to enable a further shift of volumes from GBP LIBOR to Sterling Overnight Index Average (SONIA) in derivatives markets.
   ii. After discussing the impact of the Covid-19 outbreak with the Bank of England
   and RFRWG, the UK Financial Conduct Authority (FCA) issued a statement in March pointing out that the central assumption that firms cannot rely on LIBOR being published after the end of 2021 has not changed.
   iii. The Alternative Reference Rates Committee in the US (ARRC) announced in
   April 2020 its objectives for the year to support the transition away from LIBOR and voluntary use of the Secured Overnight Financing Rate (SOFR). These objectives include, among others, introducing measures to support SOFR use and liquidity, and creating tools to aid market participants in making the necessary changes (e.g. proposals for industry timelines, checklists and market conventions).
2. Development of fall-back languages for contracts referencing LIBOR
   i. The International Swaps and Derivatives Association (ISDA) announced
   preliminary results of its consultation on implementing pre-cessation fall-back provisions for derivatives referencing LIBOR, and will move forward to update the 2006 ISDA Definitions and publish a protocol accordingly.
   ii. The ARRC released recommendations on the fall-back languages for certain USD
   LIBOR cash products, including residential adjustable rate mortgages, bilateral business loans, floating rate notes, securitisations and syndicated loans.
   iii. Loan Market Association and Asia Pacific Loan Market Association have
   proposed changes to loan facility documentation to cater for the transition to ARRs.
3. Development of products referencing ARRs
   i. New issuance and trading volume of products referencing ARRs, such as floating
   rate notes, futures and swaps, have continued to increase. For example, according to an ISDA report 1 , trading volume of SOFR futures increased from US$4.3 trillion in the first quarter of 2019 to US$11.0 trillion in the fourth quarter of 2019,

1
Interest Rate Benchmarks Review: Full Year 2019 and the Fourth Quarter of 2019, ISDA, January 2020.

while the trading of SOFR swaps also increased from US$6 billion in 2018 to USD393 billion in 2019 in notional value.
ii. OTC Clearing Hong Kong Limited issued a circular in March 2020 to propose the
transition to the use of SOFR and Euro Short-Term rate (€STR) in discounting USD and EUR interest rate swaps and non-deliverable interest rate swaps.
4. Development of term structures and calculation conventions for ARRs
i. The RFRWG issued a paper in January 2020 to discuss the potential uses of
SONIA compounded in arrears and Term SONIA Reference Rate (a forward￾looking term rate representing the expected average of SONIA over a given period) for various types of derivatives and cash products.
ii. The Federal Reserve Bank of New York started publishing in March 2020 a
SOFR compounded index and rolling period averages to provide a simple means for users to compute SOFR-based compound interest over a given period.
iii. The Bank of England is consulting on publishing compounded indices and
averages for SONIA similar to those for SOFR.
5. Guidance on preparation for transition to ARRs
i. The ARRC is developing a set of best practices for the industry to help support the
transition away from LIBOR, in addition to the Practical Implementation Checklist for SOFR Adoption issued in September 2019.
ii. The Treasury Markets Association developed a dedicated web page containing a
collection of useful information on benchmark reform and transition to ARRs (https://www.tma.org.hk/en_market_LIBOR.aspx).