Do Asian market Libor preparations pose systemic risk to world markets?

Since Libor was first used in financial markets in 1986, it has become the foundation of the global interbank funding market. However, regulators ruled that Libor’s volatility during the last global financial crisis (GFC) and a rate-rigging crisis in 2012¹ involving the world’s largest banks exposed a fundamental weakness with the rate’s publication methodology. Yet, as of 2019, an estimated $240 trillion of financial contracts are pinned to the funding rate,^[1] which is a troublingly large number considering Libor’s cessation sits at just about twenty-four months away in January 2021. With Libor’s termination on the horizon, a series of locally or regionally published risk-free rates (RFRs) is expected to replace Libor. However, a variety of serious concerns over the transition to RFR remain.

Following a raft of consultations conducted across the US and Europe, replacement RFRs, such as SOFR and SONIA, are gaining liquidity and traction in their respective markets. While market concerns remain, we believe more serious and pervasive concerns over Libor transition lie further East, in Asia. While regulators in more dominant jurisdictions, such as Hong Kong and Tokyo, have conducted consultation work, development continues to lag behind Western jurisdictions overall. In many of Asia’s emerging markets, little to no consultation work has been conducted, and serious concerns over the lack of relevant calculation, risk and legal expertise remain. It should be noted that significant FX exposures to US and European currencies across the APAC region are also likely to be especially troubling to the respective regulators as Libor cessation approaches. Overall failure to prepare presents a direct systemic risk to the world’s markets.

APAC corporates and financial institutions need to establish robust transition plans

The European Union’s Benchmark Regulation (BMR) provides a standardisation of financial market indicators across the EU Area which has allowed for smoother and uniform IBOR transition measures.^[2] The Asian market lacks a similar regulatory structure for its indices, leaving central banks across Asia individually responsible for developing applicable RFRs. While a series of local benchmarks have been developed across different Asian jurisdictions, a Bloomberg study noted local benchmarks continue to be dwarfed by Libor’s presence, severely limiting development of the necessary underlying market depth and liquidity.^[3]

Additionally, Asian regulators have the added pressure of needing to respond to dominant jurisdiction developments. Many of Asia’s local indices are highly correlated to USD Libor. As the Fed phases out USD Libor and switches to SOFR, calculations and legal repapering are among a variety of other risks Asian regulators need to manage. As a result, Asia’s emerging markets are likely to be hardest hit as local currencies and rates are highly correlated with USD Libor and depend heavily on the most liquid currency’s rate environment.

Singapore, Thailand and the Philippines are particularly exposed – respective local rates SOR, THBFIX and PHIREF are currently pegged to USD Libor by FX forward prices against the USD.^[4] All three rates reflect the cost of borrowing in USD before swapping back to their respective local currency at the same tenor. At present, only Singapore has a definitive methodology developed, with the regulator implementing a spread to SOFR calculated via similar methodology currently applied to USD Libor. 

Thailand and the Philippines are in early stages of examining their rate methodologies, but the rate of progress provides little comfort bearing in mind Libor’s soon approaching cessation. A report conducted by the Executives’ Meeting of East Asia-Pacific Central Banks (EMEAP) noted the Philippines’ central bank, the Bangko Sentral ng Pilipinas (BSP), had taken some steps toward IBOR reform through the issuance of marking-to-market guidelines and ‘providing basis for establishment of reliable and market-based benchmark’. However, the report noted that the BSP had yet to identify an alternative reference rate (ARR).^[5] Additionally, the EMEAP report further noted that overall, Asian markets are unprepared for IBOR transition.

Table: USD Libor Linked Indices

Pervasive uncertainties continue across Asian markets

The transition of Asia’s loan markets continues to be of particular concern when taking into account that currently, on Libor, different currencies are priced at the same margin. However, different ARRs are likely to require different margins, especially if they are secured vs. unsecured in methodology. Pegged to Western jurisdictions, this is problematic: the US’s ARR SOFR is secured, while the EU’s €STR and UK’s SONIA ARRs are both unsecured rates.

Additionally, the loan and bond markets have no set amendment protocols, so further consultations are needed to ensure standardization and harmonisation across jurisdictions. Contracts will be subject to re-negotiation and amendment, with stakeholders ensuring all associated risks are identified and mitigated. The derivative market will be subject to similar consideration as current industry-prevailing term structure and pricing frameworks are grounded in Libor; therefore, valuation methods will be subject to reassessment.

While regulators ponder over these issues, they also need to manage their foreign exposures. Singapore is a great example as local regulators have sought to keep SOR, its USD Libor pegged benchmark, by melding a valuation combination of SOFR, FX Forward market trades, and credit spread alongside a new term structure.^[6] Bloomberg highlighted that such cases would benefit significantly from the establishment of a term SOFR. Although currently not in existence, it would serve regulators well to push for such measures to be implemented: such a market instrument could also help to generate term risk-free benchmarks in jurisdictions which currently lack them. In Asia, where such an issue is pervasive, the benefits could be massive. Jurisdictions such as Singapore, Thailand and the Philippines would especially benefit, as a forward-looking term SOFR would be essential to the continuity of a robust swaps market.

How market participants can combat market and SOFR-linked uncertainties

Overall, the ramifications have the potential to be as systemic and widespread as the Asian currency crisis. Of course, while the hope is this is not the case, the similarities to when many jurisdictions chose to de-peg from the USD cannot be ignored.^[7] For these reasons, market participants should seriously consider the stage, if any, consultations, are at within their local region, as well as taking account of developments in the world’s leading jurisdictions.

In terms of Asia, primary attention should be placed on the US. We know that a fully comprehensive assessment of all risks and exposures to Libor is difficult, if not impossible, to implement. However, Asian financial institutions, corporates, and stakeholders with significant Asia-linked exposures would do well to prepare transition plans ahead of time and as granular as realistically possible. Such plans would include undertaking exposure assessments, Profit & Loss impact assessments, and risk measurements. It is also worth noting that firms would do well to consult closely with clients to have a robust understanding of how IBOR transition may impact their needs.

The wait-and-see approach has gone on too long – with Libor transition a scant twenty-four months away, the clock is ticking yet there is still much preparation to be done. For APAC corporates and financial institutions, the time to prepare is now.

Article written by Sophia Chiang and Pauline Pélissier.

^[1] https://www.economist.com/finance-and-economics/2019/06/08/libor-is-due-to-die-in-2021-hurry-up-and-drop-it-say-regulators

^[2] https://www.refinitiv.com/content/dam/marketing/en_us/documents/faqs/eu-benchmark-regulation-faqs.pdf

^[3] https://www.bloomberg.com/professional/blog/end-ibor-asia-take/

^[4] https://www.risk.net/derivatives/6931121/why-asia-is-so-desperate-for-a-term-sofr

^[5] https://business.mb.com.ph/2019/10/26/reforms-up-with-libor-phaseout/

^[6] https://www.bloomberg.com/professional/blog/sofr-impact-asia-getting-know-new-benchmark/

^[7] https://www.newyorkfed.org/medialibrary/media/research/economists/pesenti/whatjapwor.pdf