Howard Lee: Benchmark regulation and migration
Closing keynote by Mr Howard Lee, Deputy Chief Executive of the Hong Kong Monetary Authority,
at the Bloomberg-ISDA Benchmark Conference "Benchmark Regulation and Migration", Hong
Kong, 30 May 2019.
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Taran [Khera], ladies and gentlemen,
1. First of all, I would like to thank Bloomberg and ISDA for organising this Benchmark
Conference and for gathering so many speakers and participants to exchange views on the
important subject of benchmark reform. The subject of benchmark reform is always very
close to my heart, as I have been involved in the review of interest rate benchmarks both in
Hong Kong and in the context of the Financial Stability Board's Official Sector Steering
Group (FSB OSSG) deliberations for many years.
LIBOR discontinuation: A turning point
2. If we look back to 2013 when the OSSG started to operate, there was a general agreement
that given the changes in the interbank market, the interbank offer rates, or IBORs in short
must be reformed. But given the long history of IBORs and the huge value of financial
contracts referencing them, moving to new IBORs with fundamentally different determination
methodologies, or switching to alternative reference rates is a very complex task, as we
heard from many speakers just now. Understandably market participants generally took a
'wait-and-see' approach when dealing with benchmark transition issues. But now - with a
growing recognition that LIBOR may discontinue after end-2021 - the situation is changing.
This is an important wake-up call for the financial market, and market participants are
spending a lot more efforts on the transition issues, with the support of ISDA and other
industry bodies.
3. But, with this growing momentum, are we all geared up? I would reply with a simple 'no'.
Clearly, much more remains to be done.
Transition: A challenging process even for the deep USD market
4. Among all the IBORs, USD LIBOR is the most widely used benchmark in the global market.
And the US authorities have been proactively engaging with the industry in promoting the use
of Secured Overnight Financing Rate (SOFR) as an alternative.
5. Since the launch of SOFR in April 2018, the trading volume of interest rate derivatives (IRD)
referencing SOFR has been growing, but it remains relatively small. According to ISDA's
Interest Rate Benchmarks Review, the total traded notional volumes of IRD referencing
SOFR was US$22.6 billion in Q1 2019. This was less than 0.1% of those referencing USD
LIBOR, which totalled US$34.8 trillion.
6. So, even for the USD market, which is the deepest and most liquid market in the world, the
build-up of transactions based on an alternative risk-free rate could take some time. For
other IBORs, this could be an even longer and more challenging process.
Transition: A multi-dimension challenge
Wide-ranging impact arising from the transition
7. As many speakers have pointed out, transitioning to alternative reference rates is a complex
multi-dimension task. It will have potential profit and loss, tax and accounting implications on
market participants. Migration of legacy contracts and adoption of new documentation
involving hundreds of thousands of clients would be another complex exercise. All these
issues will cut across different segments of the financial market, from derivatives, to bonds,
to loans and many others. The implications may also vary greatly across different
jurisdictions given the different market structure and legal environment. Therefore, industry
associations such as ISDA have an important role to play, in helping to address these
wideranging issues with a global and industry-wide perspective.
Global banks should take the lead
8. Likewise, international banks, which have operations across many jurisdictions, will be better
placed to help shape the path for transition for the banking sector. As we all know, IBORs
are used in nearly every aspect of their business - from trading, to risk management, to
pricing and valuation. Preparing for the transition means they need to develop the
necessary operational and system capability for their global operations, probably dealing with
multiple alternative reference rates at the same time. I can see this is a very onerous and
resource-intensive process. But then, given the quantity and diversity of financial contracts
on their book, and their presence and market knowledge in various jurisdictions, these global
banks should be best equipped to take the lead in devising a comprehensive transition plan.
After all, it is in their best interest to act early and get themselves ready for the transition
given the scale of their business.
Smaller banks should not wait and see
9. The flip side of this argument is that smaller banks or non-banks would likely look to the
global banks to act first. But I would caution against waiting until the last minute. Although
there may still be uncertainties for the transition, all banks and corporations should keep
updated of the latest development and understand what aspects of their business would be
affected - this is a fundamental first step. Undertaking detailed risk assessment and
formulating an action plan would be next. For now, some banks may hesitate to trade in
products using the new alternative reference rates, as they want to see better market
liquidity before they start. But this is a 'chicken and egg' scenario - if everyone plays a
waiting game, the market will never be developed. More importantly, going into the market in
a manageable scale would enable your people to learn the rope early before these trades
become more main stream.
Client education is also important
10. While banks are gearing up their own preparation, the wide-spectrum of IBOR users is
adding further complexity to the transition process. Switching to alternative reference rates
is not something that can be done unilaterally. Banks need to work closely with their
counterparties to develop the necessary fall-back arrangements.
11. It may be relatively easy to discuss the transition plans with counterparties that are also
financial institutions, as everyone is more or less on the same page. But IBORs are also
used by banks' different clients, both corporations and individuals. There is a big gap among
these IBOR users on the awareness of the benchmark reform, so the situation becomes
less straightforward.
12. Therefore, client education is another vital task. Banks should begin outreach to their
clients, and educate them about the benchmark transition early. This could help to minimise
misunderstanding and costly litigation in the future.
Raising market awareness in Hong Kong
13. Closer to home in Hong Kong, the Treasury Markets Association (TMA) has been working
with bank representatives on benchmark reform for many years. More recently it has
intensified its reach-out to other sectors. It has set up a Working Group to engage a wider
spectrum of stakeholders including accountants, lawyers, bank customers and industry
associations like ISDA. It is important that different market participants understand what the
transition will mean for their business operations and how they should prepare for these
changes. The Working Group is now looking at issues like the implications on accounting
and the transition of cash products. It will further engage stakeholders to explore means of
encouraging the adoption of alternative reference rates in their day-to-day transactions and
business activities.
14. At the same time, the HKMA supervisors has also been actively engaging banks. In March,
we issued two circulars to all banks in Hong Kong. The first one reminded them to
undertake risk assessment and make preparation for the necessary transition. The second
one served to clarify that genuine amendments to existing derivatives contracts which are
made to give effect to interest rate benchmark reform will not be considered new contracts
from the perspective of the HKMA's margin requirements. This removes one of the
uncertainties about the transition. For the time being, we have not specified a timeline for
the banks to get ready their transition plan but we will approach them at a later stage to
understand their progress and readiness for the transition.
HIBOR and HONIA
15. As financial institutions in Hong Kong are gathering pace in their preparation for the LIBOR
transition, we are also making progress in identifying an alternative reference rate for
HIBOR. We understand market participants are keen to have forward-looking term rates to
mirror the structure of HIBOR. Therefore, the HKMA conducted a feasibility study of
compiling HKD term rates based on actual wholesale funding transactions by major banks.
But the results showed that while transaction-based wholesale term funding rates generally
followed term HIBORs, they exhibited a high level of daily volatility, which made them an
impractical substitute for term HIBORs.
16. More recently, TMA proposed adopting the Hong Kong Dollar Overnight Index Average
(HONIA) as the alternative reference rate for HIBOR. Similar to many alternate reference
rates chosen in other currency areas, HONIA is an overnight interbank funding rate. While
lacking a term structure on its own, this reference rate is robust and based purely on
transaction data.
17. In early May, TMA completed a consultation with the industry on several technical
refinements to HONIA. This is part of its ongoing initiative to further enhance the robustness
of its benchmarks. It is now reviewing the feedbacks received, and will consider how best to
put in place the relevant enhancements.
18. When these enhancements are done, TMA will work with the industry to promote
development and trading of HONIA-based financial products. Later on, it will also try to
promote trading in the OIS market, and hopefully develop an OIS curve from HONIA. But
this would have to depend on market conditions.
19. While HONIA serves as an alternative to HIBOR, there is currently no plan to discontinue
HIBOR. HIBOR has been in place for many years and is still widely recognised by market
participants as a credible and reliable benchmark. Similar to a few other jurisdictions in the
region, Hong Kong will adopt a multiple-rate approach. In other words, HONIA and HIBOR
will co-exist in the market and market participants are free to choose between them.
Meanwhile, TMA will continue to strengthen HIBOR to ensure that it remains in compliance
with international standards.
20. Of course, we are facing the irony that if HIBOR remains, market players may see little
incentive to develop and trade HONIA-based products. However, I encourage all market
participants to start exploring how to incorporate HONIA into their business. It may be true
that HIBOR will last for some more time. But the transition to SOFR in the USD space could
gradually lead to changes in market practices and conventions that may eventually shift
market preference for interest rate benchmarks. Therefore, if more HONIA-based products
can be introduced in the market going forward, it would help reduce any market impact in
case HIBOR has to discontinue one day owing to changes in market circumstances.
Closing
21. Ladies and gentlemen, as we have learned from speakers earlier this morning, interest rate
benchmark reform is complex, but it is something too important for any market participant to
ignore. When LIBOR ceases to exist, there will certainly be an impact on global financial
markets. Some people may say end-2021 seems a long way off. But it's not, given the
tremendous amount of preparatory work required to ensure a smooth transition. No one in
the market can afford to play a waiting game. Let's all devote resources now, and work
closely together on this important task.
22. Thank you.