LIBOR Transition Background
Interbank Offered Rate ("IBOR") is widely used in financial instruments such as loans, bonds, derivative and structured products as a forward-looking interest rate reference. Amongst all current IBORs, London Interbank Offered Rate ("LIBOR") is the most commonly used interest rate.
Despite the wide application of LIBOR in financial contracts, the current mechanism of determining LIBOR has long been criticised as inadequate and inherently subject to subjectivity due to its heavy reliance on "expert judgement" during the submission of the quotes by the panel banks.
In July 2017, the UK Financial Conduct Authority ("FCA") and the Bank of England raised their concern regarding the sustainability of LIBOR and announced that FCA will no longer compel panel banks to submit rates used for the calculation of LIBOR and required banks across the globe to discontinue the use of LIBOR after 2021.
Global regulators released guidance, which advises banks with financial products and contracts referencing to LIBOR to replace LIBOR with more robust and reliably determined alternative reference rates ("ARRs"). As such, banks are now acting to phase out the use of LIBOR and use ARRs as replacements for the existing and new products and contracts with a maturity beyond 2021, to avoid any market disruption.
To facilitate the use of ARRs in financial instruments, the relevant authorities are designing and testing ARRs with different tenor periods, and further announcements are anticipated in due course as to the availability and readiness of these ARRs for industry use.
Key Industry Guideline and Timeframe
Regulatory authorities, industry bodies and trade associations across the globe have identified ARRs as replacement and working towards on the transition from LIBOR to ARRs when LIBOR ceases to exist after the end of 2021. ARR working groups and regulatory authorities in different jurisdictions have set out their respective paced transition plans. Key milestones are summarised in the table below (Table 1).
Table 1 - Paced transition plan in different jurisdictions
||Key milestones and anticipated completion date
||End of 2021 – Complete transition from LIBOR to ARRs across the globe
||30th June 2021 – HKMA expects authorized institutions to stop issuing new LIBOR-linked products
||By 30th June 2021 – Alternative Reference Rates Committee expects (i) to create a term reference rate based on Secured Overnight Financing Rate ("SOFR") derivatives markets once liquidity has developed sufficiently to produce a robust rate; (ii) market participants to cease issuance of new LIBOR-referencing loans, floating rate securitisation or derivatives trades that increase LIBOR risk
||By 31st March 2021 – Working Group on Sterling Risk-Free Reference Rates expects the UK market to cease new issuance of Sterling LIBOR-referencing loan products that expire after the end of 2021
||30th June 2021 – Cross-Industry Committee on Japanese Yen Interest Rate Benchmarks expects banks in Japan to cease issuance of new loans referencing LIBOR
What Does It Mean for Shanghai Commercial Bank Clients
The LIBOR Transition will impact certain products and services that our clients entered with us and those that may be provided in the future. The extent of the impact depends on different factors, which include the particular LIBOR adopted in the products or services, evolving market and industry developments, changes to valuations, legal documentation and the terms and conditions of the products or services.
Shanghai Commercial Bank clients are likely to be impacted by the LIBOR Transition in the following 4 areas:
- Contract documentation – existing documentation of contracts referencing to LIBOR will be amended with other reference rates so that the contract can stay valid when LIBOR discontinues;
- Product offering – LIBOR discontinuance brings new products to the market which reference to ARRs;
- Interest payment – Unlike LIBOR, ARRs are backward-looking rates instead of forward-looking rates which directly impacts the current interest calculation with new market conventions and repayment schedule. Hence, the cash flow pattern cannot be determined in advance; and
- Valuation – change of interest rate directly impacts the pricing and value of the products. Potential gain and loss could arise from replacing LIBOR with ARRs.
Our Transition Plan and Preparation
When ARRs are accessible, similar to other financial institutions, Shanghai Commercial Bank will be required to adopt the relevant ARRs for loan and other products referencing. In order to ensure a smooth transition away from LIBOR, our Bank will refer to our existing facility agreement with clients and discuss whether it would need to be updated to include a fallback provision.
With this impending transition, Shanghai Commercial Bank has commenced the process to assess and address the associated risks, working closely with our regulators, market participants, and clients to achieve a smooth and orderly LIBOR Transition.
Clients are our priority and we will proactively provide our clients with updated information, including industry practices and the impact on their loan and other products that held with us. From Q4 2020, our branch or relationship manager shall start reaching out to our clients to discuss the necessary arrangements on LIBOR Transition and to answer any questions they may have.
While we will continue to closely monitor any further developments on the LIBOR Transition, implementing appropriate action plans and maintaining contact with our clients as the LIBOR Transition progresses, we would also encourage our clients to keep abreast on the latest developments and seek professional advice whenever necessary.
Shanghai Commercial Bank is committed to work closely with our clients on the transition, taking into consideration the concerns of our clients.
Frequently Asked Questions
We understand that you may have further questions on the LIBOR transition and therefore we have prepared the below frequently asked questions to address your concerns.
1. What is IBOR / LIBOR?
IBOR refers to the different interest rate benchmarks derived from the rate at which major global banks lend to one another in the international interbank market for short-term loans in corresponding markets and currencies. Common examples of IBOR include the LIBOR, Euro Interbank Offered Rate ("EURIBOR"), and Hong Kong Interbank Offered Rate ("HIBOR").
LIBOR is refreshed and published in five currencies (including CHF, EUR, GBP, JPY and USD) on each London business day based on the average of the quotations received from the LIBOR panel banks across the globe. LIBOR can be an overnight rate or a forward-looking term rate which covers six interest periods, ranging from 1 week to 12 months.
2. What is LIBOR reform?
LIBOR has been the most widely used interest rate benchmark in the financial industry. However, it is observed that banks tend to shift away from LIBOR and no longer fund themselves in the benchmark market actively as they used to. This leads to declining transaction volume in the markets which support LIBOR quotations, creating growing concern about them no longer being representative.
In July 2017, the FCA announced that it will no longer compel panel banks to provide submission for LIBOR and required banks across the globe to discontinue the use of LIBOR after 2021, where no new LIBOR linked products should be offered beyond the time.
Therefore, central banks and industry participants started looking for an adequate replacement that more accurately reflects market transactions. Working groups over the world have reached a consensus is that near risk-free rates ("RFRs"), which are calculated based on actual transactions, would be used as ARRs for LIBOR. The use of ARRs is expected to create a more transparent, reliable and representative interest rate market.
As such, banks are now working toward the goal of phasing out LIBOR and adopt ARRs as a replacement for the existing and new products and contracts with a maturity beyond 2021, upon LIBOR cessation.
3. Are there alternatives to LIBOR?
In the five LIBOR currency areas (i.e. the US, Euro Area, Japan, the UK and Switzerland), relevant authorities and working groups have identified transaction-based overnight interest rates as ARRs for LIBOR. For more background information about relevant transition work being undertaken, please refer to the following websites (Table 2).
Table 2 - ARRs
4. Will HIBOR be discontinued?
In Hong Kong, there is no plan to discontinue HIBOR as it is still seen as a credible financial benchmark by Hong Kong industry groups, such as the Treasury Markets Association ("TMA"). Nevertheless, an ARR has been identified for HIBOR following the international trend, which is the HKD Overnight Index Average ("HONIA").
Unlike HIBOR, HONIA is an overnight interbank interest rate based on actual transaction data and is substantively similar to other ARRs which have been identified for other currencies. Although HONIA is not commonly adopted in the market yet, it is refined to act as suitable replacement rate for HIBOR in the future.
5. How do ARRs differ from IBOR?
ARRs are overnight rates published by central banks daily and the rates vary in terms of being either secured or unsecured. Given that ARRs are overnight in nature and calculated based on historical transaction data, they are backward-looking rates instead of forward-looking rates like IBOR. This implies the future interest rates will not be able to be determined in advance.
Generally, they are regarded as the more transparent reference rates with real transaction data in active markets than IBOR since IBOR is only backed by limited underpinning transactions and is not supported by active underlying market.
6. How can these ARRs be used in financial transactions, given they are overnight rates without a term structure like LIBOR?
Interest payments based on overnight rates are generally calculated using the method of simple or compounded averaging. Currently, the most popular calculation method is compounding in arrears. Certain overseas authorities are also exploring the possibility of deriving a term structure for these overnight rates.
However, a firm timetable for doing this has yet to be established. As such, you are advised to rely on calculation methods that have already been developed in the market and promptly consult us on the preparations required for the transition.
7. What does it mean by "fallback provision"?
When LIBOR ceases to exist, all existing contracts terms referencing LIBOR might turn invalid and subject to legal dispute if there's no mechanism incorporated into the contract to provide a solution to handle the cessation of LIBOR.
A mechanism, fallback provisions, can be developed and incorporated into contracts to provide flexibility to both banks and clients in choosing a replacement for LIBOR, including but not limited to cost of fund, fix rates and ARRs.
"Fallback provision" therefore refers to the legal provisions in a contract that apply if the underlying reference rate in the product (e.g. LIBOR) is permanently discontinued or ceases to be available. A fallback will generally consist of two components, trigger event and fallback rate.
Trigger event is an event that brings about the need to use the fallback, such as the LIBOR rate not being available. Fallback rate is the rate, or approach to determining the rate, which is to be used in place of the relevant LIBOR rate that is unavailable.
Industry groups around the globe have been providing template fallback language for new products and working with market participants in the development of legacy products amendment process.
8. Why should I be concerned?
LIBOR, especially the USD LIBOR, is the most widely used benchmark rate for a variety of financial contracts, including loans and derivatives. As most of the existing LIBOR contracts do not stipulate how contract terms would be managed when LIBOR become permanently unavailable, these contracts could be subject to disputes or litigation if the parties of the contract fail to agree on a replacement rate or other fallback arrangements in advance.
9. What might be the potential risks to our clients?
Under LIBOR transition, key concerns for our clients with existing contracts referencing LIBOR or entered in new contracts referencing LIBOR might include:
- Contract remediation – financial contracts referencing LIBOR may require adjustments to incorporate fallback provisions;
- Mismatch of interest rates – the transition requires the need to determine and agree on an ARR which behaves differently from LIBOR;
- Change in calculation methodology – adoption of ARRs may result in different calculation methodology regarding product valuation, interest accrual, repayment schedule and patterns; and
- Uncertainty on term financings – the conversion from LIBOR to ARRs might result in development of term ARRs, however, this is still under development.
You are advised to conduct your own independent assessment on the potential consequences of the above risks.
10. What steps should I take to prepare for the transition away from LIBOR?
First, you should take steps to identify and review all your existing contracts that use LIBOR as the reference rate (e.g. loans, derivatives, floating rate notes, etc.). If the contracts do not contain provisions on setting out how LIBOR will be replaced when it becomes unavailable, you should talk to us to incorporate ARRs as a fallback1.
Furthermore, you should avoid entering into new contracts with a maturity beyond 2021 using LIBOR as reference rates. Instead, you should consider using the ARRs set out above for new contracts.
1 Please refer to FAQ 7 for further details
11. Who can I contact if I have more questions?
For specific questions about your existing LIBOR contracts and how these should be handled, please contact your branch or relationship managers at the Shanghai Commercial Bank and seek independent advice from your lawyers or financial advisors as appropriate.
For more background information about the cessation of LIBOR and relevant transition work being undertaken, please also refer to the following websites: