ReportontheReviewofHongKongInterbankOfferedRate

November 2012

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CONTENTS

Chapter1: ExecutiveSummary 3

Chapter2: ImplicationsoftheglobalfinancialcrisisforHIBOR 10

Chapter3: Clearguidanceforreferencebanksonratesubmission 21

Chapter4: DevelopingaCodeofConduct 27

Chapter5:

Enhancing the independentadministrationof theHIBORfixingprocess

33

Chapter6:

Confining the scopeofHIBOR fixing to tenors thathavestrongmarketdemand

39

Chapter7:

Reviewing and enhancing provisions in contracts thatreferenceHIBOR

44

Annex1: TMAHIBORreviewworkinggrouptermsofreference 46

Annex2: TMAHIBORreviewworkinggroupmembershiplist 48

Abbreviations 50

Chapter1:ExecutiveSummary

Introduction1.1 HKDInterestSettlementRate(HongKongInterbankOfferedRateorHIBOR)referstoasetofreferenceinterestratesownedbytheHongKongAssociationofBanks(HKAB). Havingbeeninplaceforover20years,HIBORhasbeenusedasasetofbenchmark interestratesfordeterminingthesettlementofabroadrangeoffinancialand loancontracts. It isestimatedthatasattheendofSeptember2012thebankingsectorofHongKongheldoverHK$2trillionofonbalancesheetcontractsthatreferenceHIBOR.1.2 The LIBOR incident in the UK has attracted worldwide interest in therobustness of benchmark fixings in global financialmarkets. In response, theHKABhasinitiatedareviewofthefixingmechanismandgovernancestructureofHIBORandinvitedtheTreasuryMarketAssociation(TMA)toassistinthisreview. Subsequently,TMAestablishedaworkinggroup(WG)forthispurpose(seeTermsofReferenceatAnnex1andMembershipListatAnnex2). Toensurebalancedviewsareheard,theWGhasabroadcompositionwithrepresentativesfromthebankingsector,thecorporatesector,thelegalandaccountingprofessions,aswellastheHongKongMonetaryAuthority(HKMA).1.3 The WG is cognizant of the work currently conducted by internationalstandardsettingbodies,inparticular,theInternationalOrganisationofSecuritiesCommissions(IOSCO)andtheBankofInternationalSettlements(BIS),onfinancialmarket benchmarks. The WG believes that Hong Kong as an internationalfinancialcentreneedstotakeintoaccounttherelevantinternationalprinciplesorbest practices that may emerge from such international organisations. It is,however,unclearat this stagewhether these internationalorganisationswouldpromulgateinternationalstandardsonthesettingoffinancialmarketbenchmarksand, if so, how long, it would take. The WG also noted that the WheatleyReview of LIBOR: final report (Wheatley Review) contains usefulrecommendations that can be considered for adaptation in Hong Kong forenhancingthegovernanceandcontrolsoftheHIBORfixingprocess.1.4 Againstthisbackground, therecommendationsmade in thisreport focusonimmediatelyactionablestepsthatwillenhancetherobustnessofHIBORfixing,whilekeepingaclosewatchoninternationalstandardsthatmayemergefromtheinternationalstandardsettingbodies. Inparticular,thereviewhasfocusedon(i)assessingtheimplicationsoftheglobalfinancialcrisisonthewayreferencebanksmakesubmissionsforHIBORfixingpurposeand(ii)identifyingmeasuresthatcan 3

be taken to enhance the robustnessofHIBOR fixingunder the currentmarketconditions.Assessment1.5 The WG considers that the HIBOR fixing mechanism remains basicallysoundduetothefollowingreasonsandobservations.

(a) Referencebanks forHIBOR fixingdonothavesignificant incentivesto misreport. Unlike in the case of LIBOR fixing where thecontributing banks are asked to estimate their own funding costs,referencebanksforHIBORareaskedtoestimatethefundingcostsofprimebanks inHongKong. There is lessconcernabout the stigmaeffectoftheirsubmissions indistressedmarketsituationswhichmaycreate a strong incentive to underreport the rates in suchcircumstances.

(b) Backtesting of HIBOR fixing results before, during and after theglobal financialcrisisshowednoanomaly. Bymaking reference toother market prices data including USD/HKD swap, forward rateagreement, yields of Exchange Fund Bills, overnight index swaps,aggregateHKD composite interest ratespreparedby theHKMA, theWG considers that the HIBOR fixings before, during and after theglobalfinancialcrisishaveperformedwellinrepresentingthefundingcostofprimebanks.

(c) A survey of the existing reference banks conducted by theHKMAduring the review indicated that reference banks have madereasonable adaptations in their rate submissions for the fixing totakeaccountofthesignificantshrinkageofunsecuredterm lendingin the interbank market. They are making use of other relevanttransaction data sources (e.g. foreign exchange swap, forward rateagreement,etc.) toderive theHKD funding costofprimebanks forsubmissionpurpose.

1.6 Inviewoftheabove,theWGconsidersthatthereisnoneedtochangethecurrentdefinitionofHIBORor to replace itwith alternativebenchmarknotingthat such fundamental changes to the current regime will cause significantdisruptions to the largenumberof existing contractswith reference toHIBOR. ThisisinfactalsotheconclusionoftheWheatleyReviewinthecontextofLIBORfixing.Roomforrefinement 4

1.7 Despite the WGs conclusion that HIBOR remains the best availablebenchmark,theWGseesroomforenhancingtherobustnessoftheHIBORfixingmechanism. In particular, the WG notes that the significant reduction inunsecured interbank transactionsince theoutbreakof theglobal financialcrisishasincreasedtheneedforreferencebankstoexercisejudgmentinestimatingthefunding costs of prime banks. This in turn has created the need to provideclearer and more comprehensive guidance to reference banks on ratesubmissions. Thiswillhelp imposedisciplineonthereferencebankstoensureconsistency and reliability of their submissions, and enhance the transparencyandcontroloftheHIBORfixingprocess.1.8 WhilethedifferentconstructofLIBORfixingandHIBORfixingmeanssomeoftherecommendations intheWheatleyReviewarenotapplicable intheHongKongcontext, italsocontainsarangeofrecommendationsthataimsto improvethe governance and controls of the LIBOR fixing process that may be worthconsideringforenhancingtherobustnessofHIBORfixing.ThereisthusaneedtotakeintoaccountsuitablerecommendationsintheWheatleyReview,inparticularthoserelatingtoimprovingthegovernanceandcontrolsattheadministratorandindividual referencebank level to seewhether similar improvements shouldbeintroducedinHongKong.1.9 Having considered Hong Kongs own circumstances and the WheatleyReviews recommendations, theWG has proposed a fivepronged approach toimprovetherobustnessoftheHIBORfixingmechanismby:

(a) providingclearguidanceforreferencebanksonratesubmission;(b) developingaCodeofConductcoveringbothratesubmissionguidance

and soundpracticeson systemsof control for the fixingprocess forobservancebyreferencebanks;

(c) enhancing the independence and governance of the HIBORcompilationprocessattheadministratorlevel;

(d) confiningthescopeofHIBORfixingtotenorsthathavestrongmarketdemand;and

(e) reviewingandenhancingprovisionsincontractsthatreferenceHIBOR.AfiveprongedapproachtorefineHIBORI. Clearguidanceforreferencebanksonratesubmission

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1.10 TheWGrecommendsthataRateSubmissionGuidancebedevelopedasapriority,whichshouldclearlydefineguidelinesfortheexplicituseoftransactiondatatodeterminesubmissions. TheWGconsidersthatratesubmissionsshouldbetransparentlysupportedbydirectlyrelevanttransactionswhereobservable,orby indirectlyrelevanttransactiondatawithappropriateadjustmentsbaseduponthefollowinghierarchyoftransactiontypes:

(a) Top priority should be given to transactions undertaken by thereferencebankitselfintheinterbankunsecuredlendingmarket:(i) Where the referencebank isaprimebank1,both itsborrowing

fromanybankand its lending tootherprimebanksaredirectlyrelevant;and

(ii) Where the reference bank is a nonprime bank, its lending toprime banks is directly relevant. However, its borrowing fromprimebanksisindirectlyrelevant.

(b) Wheredirectlyrelevanttransactionsarenotobservableorconsiderednotsufficient(e.g.transactionsizetoosmalltobeofreferencevalue),rate submissions should make reference to indirectly relevanttransactiondata,includingthefollowing:(i) USD/HKD swaps which is one of the most actively used

instrumentforseekingHKDfundsinourmarket; (ii) Otherderivative instruments including forward rateagreements

andHIBORfutures,ifthereareactivetrades;and(iii) Other relatedmarkets, including but not limited to, repurchase

agreementsandExchangeFundBills. (c) Quotes bymoney brokers offered to prime banks can be used as a

reference.

1.11 While reference banks should adhere to the above hierarchy as far aspracticable, expert judgment is needed to determine whether and howadjustment should be made to transaction data to ensure the submission isrepresentativeof theHIBORdefinition. The rationalebehind the adjustmentsshouldbeclearlydocumented.

1 Primebankisaconceptualreferencetoagroupoffinanciallystrongbankswhichareabletocommandtheminimallevelofcreditriskpremium,ascomparedtootherfinancialinstitutions. Theyareusuallycharacterisedbygoodcreditrating,broadfundingbase,goodreputation,astrongbalancesheet,andreadyaccesstocentralbankliquidityfacilitythroughahighlevelofeligiblesecurities. Referencebanksshouldmakereferencetotheabovefactorsandexercisejudgementwhendecidingwhetherabankisaprimebankornot. 6

II. DevelopingaCodeofConduct1.12 TheWGrecommendsthataCodeofConductbedevelopedinconsultationwith the industry, which should set out clearly the rate submission guidancementioned above aswell as the soundpracticeson systemsof control for thefixing process at individual bank level. In this regard, the WG considers itimportantforeffectivecontrolstoinclude:

(a) mattersrelatingtotheHIBORsubmissionprocess;(b) regularreviewbyseniormanagement(e.g.TreasurerorRiskManager)

toensure that submissionsweremadeprofessionallywithadequatedatasupport;

(c) developing commensurate compliance check and independent auditprogram;

(d) establishing detailed policies and procedures on determination ofHIBORsubmissions,whichshould(i)ensurecompliancewiththeRateSubmissionGuidanceand(ii)includesubmitterapprovercontrol;

(e) puttinginplacenecessarycontrolswithproperaudittrailtofacilitatecompliancecheck,internalauditreview,andexaminationbyHKMA;

(f) appropriate segregation of duties to ensure that the ratedetermination process will not be influenced by any business lineswithinthebank;and

(g) settingout internaldisciplinaryactionsthatmaybe imposedonstaffinbreachofinternalpolicesandprocedures.

1.13 The WG further recommends that this important Code of Conduct besubmittedtotheHKMAforitsendorsement. Thisarrangementwouldprovideahandle for theHKMA toexercise supervisoryoversighton the referencebanks. Thiswouldbeakin to the current supervisoryarrangement formonitoringandensuringbankscompliancewiththeCodeofBankingPracticewhichhasprovedeffective. As the HKMA in its role as bank regulator already has the powersunder theBankingOrdinance toexerciseoversightoverHIBOR fixingactivities,theredoesnotappeartobeastrongcaseforcreatingaseparatestatutoryregimefortheregulationofthefixing.III. EnhancingtheindependentadministrationoftheHIBORfixingprocess1.14 Sameastheinterbankofferedrateinmajorfinancialmarkets,theHIBORisadministeredbyanindustrybodyofbanks. There istheconcernof insufficient

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independence as banks as contributors for the fixing process administerthemselves. TheWGconsidersthatthere ismerit inconsideringarrangementsthatcouldenhancetheindependenceoftheadministrationofHIBORfixing. 1.15 A good administrator should be credible and it should be able to fairlyrepresent a broad range of stakeholderswhen scrutinising the performance ofHIBOR. Besides,itshouldbeattheforefrontoffinancialmarketssoastoensureHIBOR evolves to meet the demands of the market. The WG thereforerecommends that the HKAB should entrust its responsibility for theadministration ofHIBOR to a separate organisation. TMA could be one of thepotentialcandidates. Inanycase,theHKABshouldseektheendorsementoftheHKMAbeforeenlistinganorganisationtotakeuptheroleofanadministrator.ThenewadministratorshouldbetaskedtodeveloptheRateSubmissionGuidanceinparagraph1.10andtheCodeofConductsetoutinparagraph1.12. Howeveritis important toensure thatHKAB remains theownerof theHIBOR fixingunderthisarrangementtoavoidanyunduedisruptiontothe largenumberofexistinglegalcontractswithreferencetoHIBOR.IV. Confining the scopeofHIBOR fixing to tenors thathave strongmarket

demand1.16 HIBOR is currently published for fifteen maturities. According tofeedback frommarketparticipants, therearevery few financialcontractswhichreferenceHIBORwithmaturitiesfallingonoddperiods(e.g.11month).Similarly,unsecured interbanktransactionswithmaturitiesfallingonoddperiodsarerareand it would be very difficult for reference banks to submit rates for thesematurities with the support of transaction data. Weighing the difficulties ofsubmitting these ratesagainst themarginalbenefitofpublishing them, theWGrecommendsthatthenumberofmaturitiestobesubmittedandpublishedshouldbe reduced toseven (overnight,1week,1month,2month,3month,6month,12month),whileHIBORfortheothereightmaturitiesshouldbephasedoutafteroneyear.V. ReviewingandenhancingprovisionsincontractsthatreferenceHIBOR 1.17 TheWG reviewed selected contracts thatmake reference toHIBOR andnotedroomforimprovementinsomeofthem. Forinstance,somecontractsarenotadequatelyclearastohowcontingencyeventssuchasHIBORunavailabilityshouldbehandled. Someothercontracts,(e.g.HKDForwardRateAgreement)havedetailsof theHIBOR fixingmechanismwritten in their terms, allow littleflexibility for future refinements in the HIBOR fixing mechanism, rendering it 8

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difficult to introduce refinements even if circumstances warrant. Theseobservations suggest that industry efforts can be made to promotestandardisation in terms thewayHIBOR ismade reference toand thebackstoparrangement if HIBOR is for some reasons unavailable. The WG thereforeproposesthattheHKAB,withtheassistanceoftheTMAifnecessary,shouldtakethe lead in encouraging market participants to review the terms in existingcontracts and identify provisions that could be clarified to mitigate possibledisputes and hurdles to improvement in the HIBOR fixing mechanism in thefuture.

Chapter2:ImplicationsoftheglobalfinancialcrisisforHIBOR

Background2.1 HIBOR is a term commonly used to refer to a series of interestsettlement rateswhichareownedbyHKABandhavebeen inplace forover20years. These rates are fixed each business day (excluding Saturdays) byreference tomarketrates forHKDdeposits in theHongKong interbankmarket. Foreachfixing,20banksdesignatedbyHKABasreferencebankswillprovidetheirestimatedofferratesatwhichdepositsinHKDarequotedtoprimebanksintheHongKonginterbankmarketat11.00a.m2.2.2 Individual reference banks are selected by HKAB on therecommendationofTMAonthebasisofreputation,scaleofactivity intheHKDmarketandcreditstanding. ThepanelisreviewedeverytwoyearsandthelastreviewwasconductedinAugust2012.2.3 Daily fixings are available for fifteen HKD deposit maturities fromovernight deposits, 1 and 2 weeks deposits and 1 to 12 months deposits. IncalculatingHIBOR,atrimmedmeanmethodisusedbyaveragingthemiddle14of the quotations from the 20 reference banks,with the result rounded up, ifnecessary,tothefifthdecimalplace.2.4 The set of daily fixings are published on HKABs website, while thefixings and rates contributed by individual banks are available from fourinformation vendors,namely,Bloomberg,ThomsonReuters,TullettPrebonandQuick, as soon as the fixings arepublished. ThomsonReutersused tobe thecalculatingagentforthefixings,but inordertoensurethesimultaneousreleaseofinformationtothefourinformationvendors,theHongKongInterbankClearingLimited (HKICL),aprivate company jointlyownedby theHKMAand theHKAB,tookoverthecalculatingagentrolesince2008. FunctionofHIBORininterestrateriskmanagement2.5 Similar to the benchmark reference interest rates in other markets,HIBOR is essentially amarketdriven product initiated by the banking industrythrough the industryassociation, i.e.HKAB inthecaseofHongKong. Todate,therateisreferencedinanumberoffinancialcontracts,includingsyndicatedloan 2 ExtractedfromthedefinitionofHKABInterestSettlementRatesintheHKABHKDforwardrateagreements. 10

contracts,residentialmortgageloancontracts,HKDforwardrateagreement(FRA),interest rate swaps and other interest rate derivatives products. The strongmarket demand for HIBOR stems from its important role in interest rate riskmanagement. 2.6 Depending on their expectations of future interest rates, marketparticipantswant the flexibility to choosebetween fixed rate and floating ratefinancial instruments in order to manage their interest rate risk exposures. Marketparticipantsalsousederivatives(e.g.FRA,interestrateswapcontract,etc.)tohedgetheirinterestrateriskexposures. However,aprerequisitefordifferentfloating rate instruments to gainmarket acceptance and liquidity is a crediblefloating interest ratebenchmark that can fairly representmarket interest rates. Similarly,acrediblebenchmark isneededfordeterminingthesettlementdetailsof these floating rate contracts. Such market demand gave rise to differentinterest rate benchmarks in different markets, including HIBOR in the case ofHongKong. RobustnessofHIBOR2.7 Beforetheglobalfinancialcrisis,referencebanksthatenjoygoodcreditratingandreputationwereregardedasahomogenousclassofcounterparties intheunsecuredHKDwholesalefundingmarket. Thecreditriskpremiumchargedon them were generally small and included as part of HIBOR. In economicsubstance, most reference banks were also prime banks. This pool of primebanksfunctionedasanunsecuredwholesalefundingmarketforHKD(Box2.1setsout thedynamicsof thismarket)as theywillingly lent tooneanotherand themarketwasefficientintransmittingHKDfundstopartiesinneed. Asreferencebankswereveryoftenalsoprimebanks,theycanusetheirowntransactionstosupportsubmissions.

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Box 2.1: Prime bank in unsecured wholesale funding market

Prime bank is a general description for financially strong banks, which are usually characterised by good credit rating, broad funding base, good reputation, and a strong balance sheet with a high level of eligible securities for obtaining central bank liquidity facility. As compared to other banks, a prime bank typically commands the minimal level of credit risk premium. Prime banks in Hong Kong, as a pool of HKD suppliers, play the role of market makers for the unsecured wholesale funding market. Market players sitting on surplus funds can place the funds with prime banks at a term to maturity they desire. Since they are price takers, in most cases they have to accept the bid rates quoted by prime banks. On the other hand, institutions in need of funds can borrow from prime banks for a term to maturity they need. Similarly, these institutions being price takers will normally accept the offer rates. Before the global financial crisis when the market was fairly liquid, the spread between bid and offer rates were small, typically only a couple of basis points. As depicted in the following diagram, the pool of prime banks perform the financial intermediary function of matching players sitting on surplus funds with those having funding needs.

For a non-prime bank, the offered rate basically represents the minimum funding cost of tapping funds from the unsecured wholesale funding market. The offered rate does not yet take into account the additional credit risk premium that could be charged on a weaker bank. Before the global financial crisis, there were infrequent but not rare situations where the funding cost of some financially weaker banks went above HIBOR (e.g. A premium was usually charged on Japanese banks, the so-called Japanese premium, during the Japanese banking crisis in the 1990s). In the aftermath of the global financial crisis, however, many foreign bank branches in Hong Kong could no longer maintain a prime status because of credit concerns stemming from problems in their home countries. Consequently, their funding costs have since risen above HIBOR.

Pool of Prime banks

Banks with surplus funds to be deposited to the unsecured wholesale funding market

Banks tap funds from the unsecured wholesale funding market

Sourceoffunds,e.g.retaildeposits

Prime banks offer rate

Prime banks bid rate

Applicationoffundssourcedfromunsecuredwholesalefundingmarket,e.g.syndicatedloans

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2.8 Since the global financial crisis, the unsecured wholesale fundingmarkethasbeenseverelydisrupted. Toavoidbankcreditrisksandtoconserveliquidity, bankswith excess funds become unwilling to lend to those in need. Even if they arewilling to do so, the interest rates they demand varywidely,depending on their assessment of the counterpartys credit risk. Due to thedrastically increased credit differentiation among banks, the range of creditspreads charged on banks in themarket haswidened to unprecedented level. Asaconsequence,whiletherearestillprimebankswhichcontinuetocommandatightcreditspread,thenumberofprimebankshasreducedsignificantly. 2.9 Besides, banks that continue to maintain the prime bank status areinvariably supported by a strong retail funding base. They sparsely need toborrowHKD from the interbankmarket. While theymay lendoutHKD, theircounterpartiesarelikelynonprimebanksandassuchthetransactedpricecannotbe directly used to support HIBOR submissions. In tackling this challenge,reference banks have to make use of indirect transaction data and makeadjustmentswhenestimatingtheratesthattheybelieveshouldbequotedbyoneprimebanktoanotherprimebank. 2.10 ThemethodsreferencebanksuseinarrivingatthesubmissionratesareconsistentinprinciplewiththerecommendationsmadeintheWheatleyReview. AccordingtoasurveyoftheexistingreferencebanksconductedbytheHKMA,inthe absence of directly relevant transaction data, reference banks commonlydraw reference fromother transactiondata includingUSD/HKD swap,FRA,andExchangeFundBills (EFB). Since these instrumentsarenotdirectlyrelevanttounsecured interbank term borrowing, reference banks have to apply bothmathematical techniques and expert judgment to adjust for the differences,includingbutnot limited tocredit risk, liquidity risk,andmarketspecificsupplyanddemandfactorsprevailingatthetimeofsubmission. Itisworthmentioningthatmarket ratesof repoagreementsand certificateofdeposit (CD)were lesscommonlyadoptedinHongKongbecauseinterbanktradingoftheseinstrumentsare inactive. This highlights the importance of taking into account factorsspecifictothelocalfinancialmarketwhenformulatingproposalsforHIBOR. TheglobalfinancialcrisisimpactLIBORandHIBORdifferently2.11 TheimpactoftheglobalfinancialcrisisonLIBORandHIBORplayedoutdifferentlyinsomekeyaspects. Mostnotably,LIBORsubmissionscarryastronglabeling effect because the submitted rates refer to contributing banks ownfundingcost. OneofthefindingsofauthoritiesintheUKandtheUSisthatsuchlabelingeffectcouldhave incentivisedacontributingbanktoreport lowerrates 13

during the global financial crisis. In contrast, reference banks for HIBOR areasked to estimate prime banks funding cost rather than theirown, hence theconcernsaboutlabelingeffectareless. 2.12 Moreover,HongKongwasnotattheepicenterofthecrisis.AccordingtodatapublishedbytheHKMA,theaverageHKDfundingcostoflocalbanksrosebrieflybetweenAugustandOctober2008,butdroppedbackquicklyinNovember2008 and declined steadily since then to nearly zero by December 2009,suggestingthatduringtheepisodeprimebankswerenotunderseverefundingorliquiditypressure. Assuch,theydidnotappeartohavesignificant incentivetounderreport.2.13 Another concern arising from the LIBOR incident is the conflicts ofinterestissue,whichariseswhentradersattempttoinfluencethesubmissionsinordertobenefittheirownpositions. Whileitcannotberuledoutthatreferencebanks inHong Kongmay similarly face the conflicts of interest issue, theWGbelievesthattheriskofthishappeninginHongKongisrelativelylow. Generallyspeaking, banks in Hong Kong do not maintain significant HKD interest ratetradingpositions. Asan illustration,onecommon instrumentforthetradingofLIBORisEurodollarfuturescontracts,whichhadanoutstandingopenpositionofoverUS$8trillionasatendSeptember2012. InHongKong,however,tradingofHIBOR futurescontractshasso farbeenvery inactive,withanopenpositionofHK$25millionasatthesamedate. Backtesting2.14 The WG reviewed the past results of HIBOR fixing with a view toassessingwhethertheresultscanappropriatelyreflectthefundingcostofprimebanksatthematerialtime. Basedontheobservationssetout inthefollowingparagraphs, theWG concludes that HIBOR fixing has been performing well inreflectingthefundingcostofprimebanks.2.15 InHongKong, it iscommon formarketplayerstoobtainHKD fundingthroughUSD/HKDswapinsteadofdirectlyborrowingHKDfundsintheunsecuredwholesalemarket. The ruleof interest rateparity suggests that inanefficientmarket the cost of borrowing HKD funds directly should closely track thecombinedcostofborrowingUSDandentering intoaUSD/HKDswap(seefigure2.2 for an illustration). Backtesting results show that, prior to the globalfinancialcrisis, theHKD fundingcostas implied from theuseofUSD/HKDswapdidcloselytracktheresultsofHIBORfixing,reflectingasmoothfunctioningoftheHKDwholesalefundingmarketduringthatperiod. 14

If S, F and L are observable, one can infer H using the above formula. H so derived is normally referred to as swap-implied rates. For this exercise, the WG uses USD HIBOR fixing as a proxy of L. In practice, banks make their own estimation of prime banks USD f di t

In a perfectly efficient market, path 1 and path 2 (comprising a,b,c) should achieve the same result. That is, S*(1+H)/F = 1+L

USD 1 (1) 1-year deposit at L% p.a.

(2a) Convert USD to HKD @ spot rate S

HKD S (2b) 1-year deposit at H% p.a.

HKD S * (1+H)

(2c) Convert HKD to USD @ forward rate F

USD 1+L

Figure 2.2: An illustration of interest rate parity

2.16 Post global financial crisis however, although the two sets of datacontinue to track one another, there are periods when HIBOR stayed slightlyabovetheswapimpliedrates. Havingconsideredthefollowingfactors,theWGconcludesthatthedegreeofdeviationisreasonable:

USDfundingcostForthisreviewtheWGproxiedUSDfundingcostbyboth USD LIBOR. In practice, banks make their own estimation ofprimebanksUSD funding cost,which couldbedifferent from thesefixing results. It follows that the swapimplied rates as calculated byreferencebankscouldbedifferentfromthoseestimatedbytheWGinthisexercise.

SupplydemandfactorInflowsoffundstoHongKongsince2009hasresulted inampleHKD liquidity.Tomanagetheirbalancesheet,banksmaybe keen to switch their surplusHKD funds intoUSdollars suchthatthelattercanbeusedforsaymakingUSDloans.ThisincreasesthesupplyofHKD in theUSD/HKDswapmarket, thuspushingdown theswapimplied rates. In short, the difference between HIBOR fixingresultsandswapimpliedratesreflectedastrongpreferencebybanksinswitchingHKDintoUSDusingUSD/HKDswap.

Market illiquidity Since the global financial crisis the unsecuredwholesale fundingmarkethasbecomevery illiquid,asmanifestedby

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the significantlywider spreads between the bid and the offer rates.SinceHIBORreferstotheofferedrate, itmayattimesstayabovetheratederivedfromactualUSD/HKDswaptransactions.

2.17 TheWG also reviewed the relationship betweenHIBOR fixing resultsand the rates on overnight index swaps (OIS), aswell as the yields of EFB ofsimilarmaturity. TheWG noted thatmost of the timeHIBORwas fixed at aspreadovertheothertworates. Thespreadrepresentsthecreditriskpremiumchargedonprimebanks,ascomparedwith the riskfree rate. TheWG furthernotes thatat timesof severe liquidity shock (e.g. late2007and late2008), thespread of HIBOR over the other two increased drastically. This is reasonablebecauseduring liquiditysqueezemarketplayers (i)hoard liquiditybypiling intoshort termgovernmentpaperand (ii) refrain fromoffering interbank lendingasthiswill consume their liquidity. The conclusion is consistentwithananalysisconducted by theHKMA shortly after the global financial crisis3. Overall, theWG considers that HIBOR fixing has been effectively reflecting the liquidityconditionsofthemarket.

2.18 HKD FRA is a derivative contract through which contracting partiesexpresstheirexpectationsonthelevelofHKDinterestratesonaspecificdateinthe future. For instance, the market price of a 1x4 FRA reflects marketexpectations on the level of 3monthHIBOR to be fixed onemonth from thetradedate. Assumingaperfectlyefficientmarket, the same forward rate (i.e.3month rateonemonth from the tradedate) canbederived from theHIBORfixingresults4onthetradedate. Withmoreeasilyobservabletransactions,FRApricesprovide a reliable referenceof themarket viewon forward rates. SinceHIBOR fixing results should alsobe reflecting themarket levelofHKD interestrates, the forward rate as derived from the HIBOR fixing results should trackcloselywiththecorrespondingFRAprices. Tothisend,abacktestingexercisewasconductedandtheWG issatisfiedthatthetwosetsofdata (i.e.1x4FRApricesandthesameforwardratederivedfromHIBORfixingresults)dotrackeachothercloselyundernormalmarketconditions. 2.19 TheWGalsocompared theHIBOR fixing resultswith the localbanksHKDcompositeinterestrateaspublishedbytheHKMA(Chart2.1). Duringbriefperiodsofacuteliquidityshock(e.g.late2008),theresultsofHIBORfixingsurgednoticeablyabovebanksoverallHKD fundingcosts,suggesting that liquidity riskpremiumhasbeenincludedtoreflectthemarketconditions. Itisinterestingto

3 AnindicativedecompositionoftheHIBOROISspreads,HKMAHalfyearlyMonetaryandFinancialStabilityReport,December20084 TheoreticallyabankcanborrowHKDforatermof4monthsat4monthHIBORanddepositthefundsfor1monthat1monthHIBOR.Thenetborrowingcostrepresentstheforwardinterestrateforthe3monthperiodfromthesecondtothefourthmonth. 16

note that after the global financial crisis the spread betweenHIBOR and localbanksHKDcomposite interestratehadcomedownsignificantlyand forabriefperiodtothenegativeterritory. Thereareseveralreasonsbehindtheapparentstructuralchange.

Increased credit differentiation Due to significant creditdifferentiation after the global financial crisis, the funding cost ofprimebankshasbecomesubstantiallylowerthantheaveragefundingcost of local banks. As such, the spread between HIBOR (thewholesale funding cost of prime banks) andHKD composite interestrates(theaveragefundingcostofalllocalbanks)shouldcomedown.

Low interest rate environment A key reason behind the spreadbetweenHIBORandHKDcomposite interest rates is that localbankshold a significant portion of noninterest bearing funds (e.g. currentaccountdeposits),whichcangreatlydragdownbanksaveragefundingcost as compared to their wholesale funding cost. However, wheninterestratescomedowntonearzerointerestlevel,theimpactwillbesignificantlylower.

Structural shift toward stable funding sources Since the globalfinancial crisis,banks see theneed to reduce relianceon less stablewholesalefundingsourcesandseekmorestablefundingsourcessuchas retail deposits. This structural shift is likely to result in lessdemand for wholesale funding and greater appetite for growingcustomer deposits. As interest expense for customer depositsrepresents a significant portion of HKD composite interest rates,increase in customer deposit rates as a result of keen competitionwould push up HKD composite interest rate, hence, the spreadbetweenHIBORandHKDcompositeinterestratesshouldreduce.

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Chart 2.1: HIBOR vs composite interest rate

0

1

2

3

4

5

6

7

Dec-2005 Dec-2006 Dec-2007 Dec-2008 Dec-2009 Dec-2010 Dec-2011

(%)

3-Month HIBOR Composite Interest Rate

2.20 AnotherobservationoftheWGisthatthestandarddeviationofHIBORsubmissionsbyindividualreferencebanksissignificantlylowerthanthatforUSDLIBOR. This is considered reasonable. As the HIBOR reference banks areessentially reporting thesame thing, i.e. theirestimationof the fundingcostofprimebanks,whiletheLIBORcontributingbanksarereportingtheestimationoftheirownfundingcosts,whicharelikelytobemoredispersedespeciallyaftertheglobalfinancialcrisis. 2.21 TheWGalsoobservesthatthenonbankusersofHIBOR,e.g.corporateborrowersofHKDloans,havealsobeenadaptingtochangingmarketconditions. Specifically, corporate borrowers understand that HIBOR represents only thefundingcostofprimebankswhichcommandsasmallcreditpremium,theyhavethereforebeenwillingtoacceptloantermswithasignificantlywiderspreadoverHIBOR (e.g.HIBOR +150 bps as compared toHIBOR+50 bps before the globalfinancialcrisis). In this regard,onekeyconcernof thecorporatesector is thatsincecreditspreadsarefixedfortheentiretermofaloancontract,anymaterialchange in the HIBOR fixing process could pose significant financial impact onthem. For instance, if the definition of HIBOR is to be changed such thatreferencebanksreporttheirownfundingcosts,thefixingresultswouldriseandtheloanpaymentstheypaywouldincrease.

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Conclusion2.22 TheWGconcludesthattherehasbeennonoticeableanomalyinHIBORfixing. Marketparticipantsdonot seem tohave significant concernsover thequalityof the fixingprocess. Most importantly,bothbanksandotherusersofHIBOR have adapted to the changing market conditions based on the HIBORdefinition. 2.23 Inviewoftheabove,theWGconcludesthatthecurrentdefinitionofHIBOR shouldbe retained. TheWG seesno tangiblebenefitsof changing thedefinition or replacing it with an alternative benchmark noting that suchfundamentalchanges to thecurrent regimewillcause significantdisruptions tothe large number of existing contracts with reference to HIBOR and result inhigherborrowingcoststosomeexistingbankcustomers. Roomforrefinement2.24 Despite theWGsconclusionabove, theWGsees room forenhancingtherobustnessoftheHIBORfixingmechanism. Inparticular,asexplainedinthesection under robustness of HIBOR above, the significant reduction inunsecured interbank transactions (especially between prime banks) since theoutbreakoftheglobalfinancialcrisishasincreasedtheneedforreferencebanksto exercise judgment in estimating the funding cost of prime banks. Amorestructured governance and control framework is therefore desirable to ensurethatjudgmentsaremadediligently,independently,andconsistently.2.25 In formulating a comprehensive proposal to refine the HIBOR fixingmechanism,theWGhascarefullyconsideredtherecommendationsmade intheWheatley Review. The WG is of the view that due to different construct ofLIBORfixingandHIBORfixing,someoftherecommendationsarenotapplicableinHongKongscontext.Forinstance,WheatleyReviewrecommendsdeferringthepublicationofquotationsbyreferencebanksinordertoreducethebanksworryabout the associated labelling effect on them,which, as explained above, is alesserconcernunderthedefinitionofHIBOR. TheWGalsoconsidersthattheremaynotbeaneed to introducea separate statutory regime for regulating theadministrationof,andsubmissionto,HIBOR,asproposedbyWheatleyReviewinthecontextofLIBORbecause:

Reference banks in Hong Kong do not have significant incentives tomisreportHIBOR;

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BacktestingofHIBORfixingresultsshownonoticeableanomaly; Bothbanksandcorporationshavealreadymadenecessaryadaptations

basedonthecurrentdefinitionofHIBOR; Thusfarthere isnosignificantpublicconcernabouttheriskofHIBOR

beingmanipulated;and The HKMA have sufficient powers under the Banking Ordinance to

ensureeffectivesupervisionofHIBORfixingactivities.

2.26 Nevertheless, the Wheatley Review contains a range ofrecommendationsthataimstoimprovethegovernanceandcontrolsoftheLIBORfixing process thatmay beworth considering for enhancing the robustness ofHIBORfixing.2.27 Having consideredHongKongsown circumstancesand theWheatleyReviewsrecommendations,theWGproposesafiveprongedapproachtorefinetheHIBORfixingmechanism,thedetailsofwhicharesetoutinChapters3to7.

Chapter3:Clearguidanceforreferencebanksonratesubmission

3.1 Chapter 2 reviews the implications of the global financial crisis for theHIBORfixingprocessesthemain impactbeingthedrasticreductionofdirectlyrelevant transaction data to support submissions, rendering it inevitable forreferencebankstoincreasinglyrelyonindirectlyrelevantdataandjudgment.3.2 While theapproachadoptedby referencebanks indetermining rates forHIBORsubmissionpurpose isconsideredreasonablegiventheprevailingmarketconditionsof theHKD interest ratesmarkets, theWG recommends that,as thefirstpronganda cornerstoneof the fiveprongedapproach,aRate SubmissionGuidance (RSG) be developed as a priority. Industrys comments should besought indeveloping theguidance. ThisRSG shouldalsobe submitted to theHKMAforcommentsandendorsement. ThischaptersetsoutthekeyelementsthattheWGrecommendstobeincludedintheRSG.KeyelementsoftheRSG3.3 The WG concludes that HIBOR submissions should be explicitly andtransparentlysupportedbytransactiondata.3.4 Toensureconsistencyand transparency in theuseof transactiondata,aclearhierarchyoftransactiontypesshouldbedevelopedinthespecificcontextoftheHKDinterestratemarket. Aclearhierarchyservestwomainpurposes:

(a) Submittingstaffandtheirmanagersatreferencebankswillhaveaclearroadmap to guide their judgment in prioritising the reference oftransaction data. This will help ensure that all relevant factors areconsistentlyconsideredwithappropriateweights.

(b) A clear hierarchy imposes discipline on the reference banks to gothroughadueprocess indeterminingtheratestobesubmitted. Ifasubmitterconsidersthattheprespecifiedhierarchycannotbeadheredto because of specific circumstances prevailing at the time ofsubmission,documentedjustificationsshouldbemaintainedforreviewby the manager overseeing the submission as well as by otherindependentreviewerssuchastheinternalauditors.

3.5 TheWGrecommendsthefollowinghierarchyoftransactiontypes:

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(a) Top priority should be given to transactions undertaken by thereferencebankitselfintheinterbankunsecuredlendingmarket:(i) Wherethereferencebankisaprimebank,bothitsborrowingfrom

anybankanditslendingtootherprimebanksaredirectlyrelevant;and

(ii) Wherethereferencebankisanonprimebank,itslendingtoprimebanks is directly relevant. However, its borrowing from primebanksisindirectlyrelevant.

(b) Wheredirectlyrelevanttransactionsarenotobservableorconsiderednotsufficient(e.g.transactionsizetoosmalltobeofreferencevalue),rate submissions should make reference to indirectly relevanttransactiondata,includingthefollowing:(i) USD/HKD swaps which is one of the most actively traded

instrumentforseekingHKDfundsinourmarket; (ii) OtherderivativeinstrumentsincludingHKDFRAandHIBORfutures,

ifthereareactivetrades;and(iii) Other related markets, including but not limited to, repurchase

agreementsandExchangeFundBills. (c) Quotes by money brokers offered to prime banks can be used as a

reference.

3.6 While reference banks should adhere to the above hierarchy as far aspracticable, expert judgment is needed to determine whether and howadjustment should be made to transaction data to ensure the submission isrepresentativeof theHIBORdefinition. The rationalebehind the adjustmentsshouldbeclearlydocumented. 3.7 UsersofHIBOR should recognise thatexpert judgment, ifexercisedwithdisciplineandunderstringentoversight,servesanimportantfunctioninensuringthe robustness of HIBOR. It avoids unnecessary volatility in the benchmarkinterest rate. To illustrate this point, it is useful to consider the hypotheticalscenario in Box 3.1. It is important to acknowledge the fact that there arenumerousother similar scenariosand it is impossible to setout ina rulebookhow each of the scenarios should be dealt with, rendering expert judgmentindispensibleintheratesubmissionprocess.

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Box 3.1: A hypothetical scenario

During the morning session of a trading day, market rumours disrupted the interbank market and led to a brief period of sharp rises in HKD interest rates at around 10:30am, with some trades done at elevated levels. The rumours were quickly confirmed to be unfounded and HKD interbank interest rates reverted to normal level, but very few trades were done during 10:30am to 11:00am. In this scenario, if reference banks stick rigidly to the transactions done around 10:30am and do not exercise any judgment on what they believe should be the right level of interest rates, HIBOR would be fixed at substantially higher levels and unnecessarily affect floating rate borrowers.

3.8 Tostrikeabalancebetweenadheringtoaclearhierarchyofdatasourcesandexercisingexpertjudgment,theWGrecommendsthefollowingguidelinesonwhenandwhatjudgmentshouldbemade:

(a) AssessmentofrelevanceDespitetheoverarchingprincipleofmakingsubmissionswith theexplicit and transparent supportof transactiondata,referencebankswillinevitablyneedtoexercisejudgmentontherelevance of transaction data. Typically, the following factorswill beconsidered: Proximity of time Transactions done just before the time of

making submissions should normally be givenmoreweight. Inthe absence of such trades, reference banks may need to lookfartherbackward in time for transactiondata. Inevaluating therelevance along the time dimension, reference banks shouldexplicitly assess whether there have been notable changes inmarket conditions during the time gap. For instance, ifmarketconditionshavebeenverystableallalong,transactionsdoneadaybeforemightbestillconsideredrelevant. Incontrast,ifamarketmoving event happens just before the time of submission, eventransactionsdone in themorningon the samedaymaybecomenotrelevant.

ReasonablenessoftransactionsizeAlthoughthis isnotexplicitlyspeltout, it iscommonlyunderstood that for transactiondata toberelevanttheyshouldbeofreasonablesizes. There isnohardand fast ruleas towhat is reasonableand judgment is thereforeneeded. Tofacilitateconsistentexercisingof judgmentalongthe

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sizedimension,referencebanksshouldregularlycompilestatisticsto support their judgment. If forexample statisticaldata suggestthat a ticket size ofHK$ 50million is not uncommon, referencebanks should accept transactions of this size as relevant unlesstherearestrongjustificationssuggestingotherwise.

Bidofferspread Inatransactionwhereanonprimebank lendsHKDtoaprimebank, it is likelythatthecontractratereflectsthebidpricequotedbytheprimebanktothenonprimebank,ratherthan theofferpricequotedby thenonprimebank to theprimebank. This is because nonprime banks are usually price takerswhileprimebankshavemorepower in setting theprice. SinceHIBOR refers to the offer rate, reference banks may makeadjustment for the bidoffer spread as necessary. Referencebanksshoulddocumentthereasoningoftheirjudgment includingthe market information used to support the size of adjustmentbeingmade.

(b) Inmakingreferencetoindirectlyrelevanttransactiondata,appropriateadjustments should be made to ensure the submission isrepresentativeof theHIBORdefinition. While referencebanksmaydevelopdifferenttechniquesforthispurpose,thesetechniquesshouldbedocumentedand reviewedby themanageroverseeing theHIBORfixing process as well as other independent reviewers. Theeffectivenessof these techniquesshouldbeassessedregularlywithaview to making necessary refinements. Amongst other things,adjustmentsarenormallymadeforoneormoreofthecomponentsofHIBORassetoutinparagraph3.11.

3.9 TheWGalsodiscussedwhether there shouldbea clearlydefined listofprime banks to facilitate submissions. Members however came to theconclusionthatitisnotfeasibletocomeupwithafixedlistofbanksasthelistofbanks changes as market conditions change. There is the risk of subjectingHIBORtounnecessaryvolatilitybysettingafixed listofprimebanks. Onemaysubject the list to frequent reviews and announce this change to all referencebanks. However, the news that a bank is being removed from the list couldunsettle the market and adversely affect the bank concerned. The idea ofdeveloping a fixed list of prime bankswas therefore considered not practical. Havingsaidthat,theWGalsonotedtheneedtoprovidemoreguidanceonthedefinitionofprimebankstothereferencebanksintheRSG. 3.10 Primebank isa conceptual reference toa groupof financially strongbankswhichareable to command theminimal levelof credit riskpremiumascomparedtootherfinancial institutions. Primebanksareusuallycharacterised

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by good credit rating, a broad funding base, good reputation, and a strongbalance sheet, and can readily access central bank liquidity facility throughpossessingahigh levelofeligible securities. Referencebanks should take intoaccount the above characteristicswhen judgingwhether aparticularbank is aprimebankornotat the timeofsubmission. Itshouldbenoted thatanotherfactortobeconsidered isthedegreeofcreditriskdifferentiationamongbanks. Thewiderthecreditriskdifferentiation,thesmallerthenumberofprimebankswillbe. ComponentsofHIBOR3.11 The WG proposes a modular approach in analysing HIBOR. Broadlyspeaking,HIBORcanberegardedascomprisingthefollowingcomponents:

(a) Interest rate This is also known as the riskfree rate, typicallyreferring to theratesonOISoryieldsof localcurrencydenominatedpaper issuedbythegovernment. TheyieldsofEFBscouldhoweverbeaffectedbysupplydemand factorsthatarenotdirectlyrelatedtothe interest rate component. In particular when the marketsentimentispanicky,flighttosafehavencouldpushtheyieldsofEFBtovery low levels. Historicaldatasuggestthat inextremecasestheyieldsofEFBcouldbepusheddowntothenegativeterritory.

(b) Credit riskpremium for primebanks This component isnot easilyobservable. Certain price information may help reference banks tojudgewhetherchangesshouldbemadetothiscomponent.Examplesofrelatedpriceinformationincludeobservedchangesincreditdefaultswap (CDS) spreads of prime banks and observed changes in themarket yields of senior unsecured debt they issued. As the termsandconditionsof these instrumentsareverydifferent from thoseofHIBOR,referencebanksshouldexercise judgmentas towhetherandhow theprice informationshouldbeused,bearing inmind that thiscomponentshouldnot include theadditional idiosyncraticcreditriskpremiumofnonprimebanks.

(c) Market liquidity risk premium For a market with limited marketliquidity,marketmakerswouldneedtowidenthespreadbetweenthebidandofferratesinordertocompensatefortheadditionalriskstheyfaceasaresultofmarketilliquidity. Ifreferencebankshavereasonstobelieve thatmarket liquidity for theunsecuredwholesale fundingmarket has improved, they may exercise judgment to adjust theirsubmissionsdownward,andifviceversaadjustupward.

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(d) Funding liquidityriskpremiumDuetotheglobalfinancialcrisisandtheensuing regulatory initiatives, thebanking industryhasattachedgreaterimportancetoliquidityriskmanagement. Asaconsequence,banks are willing to pay a higher price to secure more stable andlongerterm funding,and theywillsimilarlychargeahigherprice forgiving up liquidity in the form of unsecured interbank lending.Referencebanksmayexercisejudgmentonwhethertherearenotablechangestothefundingliquidityriskpremiumchargedbyprimebanks.

3.12 ThestructuralcompositionofHIBORasproposedinparagraph3.11aboveisnotmeanttoberegardedasastandardmodel. Referencebanksmayapplyadifferent structureor includeother components in theiranalysis. Inany case,thestructureofanalysisshouldbecomprehensivelydocumentedandsubjecttoregularreview. 3.13 Asmentionedinparagraph3.8(b)above,whenmakingadjustmentsbasedon indirectly relevant transaction data, banks may adopt various techniques. Proprietary techniques are acceptable provided that they are supported bydiligentanalysisandsatisfactorybacktestingresults. Inaddition,thefollowingtechniques may also be considered provided that they are subject to regularreviewontheireffectiveness:

(a) Interpolationorextrapolationfromavailabledata;and(b) Drawing inference from the banks own transaction data and the

difference incredit riskpremiumbetween referencebanksandprimebanks. Forinstance,ifareferencebankjudgesthatitscreditstandingrelative to prime banks has remained stable, it may observe thechangesofitsownfundingcostandusethemtoinferthefundingcostofprimebanks.

3.14 Reasonableness check should be conducted to ensure that all apparentanomalies are looked into and explained for. Reference can be made to thesection on backtesting in Chapter 2 of this report,which covers some of thereasonablenesscheckstepsconductedbytheWGinthisreview.

Chapter4:DevelopingaCodeofConduct

Objectivesandscope4.1 TheWGrecommendsthataCodeofConduct(theCode)bedevelopedtoprovideahandleforoversightby(a)referencebanksinternally,(b)administratoratindustrylevel(seeChapter5),and(c)theHKMAatregulatorylevel. TheRSGasrecommendedinChapter3shouldalsobeenshrinedintheCode.4.2 InadditiontoRSG,theCodeshouldcoverthefollowingimportantaspectsinordertoensurethequalityoftheHIBORfixingprocessatreferencebanklevel:

(a) Effective governance structure to ensure adequate accountability ofseniormanagement;

(b) Effective systems of control to ensure prevention or detection ofanomaly,beitintentionalornot;and

(c) Ethical standards and best practices that personnel involved in ratesettingprocessshouldobserve.

4.3 Inorder to copewith changes inmarket conditions, theCode shouldberegularlyreviewedsuchthatenhancementscanbeintroducedwhereappropriateandnecessary. ItisenvisagedthattheCodewillcontinuetoevolvetotakeintoaccount newmarket developments, aswell as new international standards onindustrybestpracticestobeobservedinthesettingoffinancialbenchmarks. 4.4 TherecommendationsoftheWGonthekeyelementsoftheCodearesetoutbelow,whichhavetakennoteofproposalsintheWheatleyReview,aswellasthe Principles for Financial Benchmarks developed by the Global FinancialMarketsAssociation. IndustryparticipantsshouldcontributeandbeconsultedinfinalisingthedetailedprovisionsintheCode.Governancestructure4.5 There are two features of an effective governance structure at eachreference bank: (a) adequate senior management oversight and clearaccountability,and(b)presenceofindependentreviewfunction. 4.6 SeniormanagementoversightReferencebanksshouldensureadequate 27

seniormanagementoversight for the rate submissionprocessbydesignating aseniorexecutive tooversee,andbeaccountable for,allmatters relating to theHIBORsubmissionprocess,includingbutnotlimitedto:

Ensuring the reasonableness of rate submissions, and the use ofappropriatedataandjudgmentintheratecorroborationprocess;

Putting inplaceeffective systemsof control, includingwrittenpoliciesand procedures for such controls, to ensure integrity of the ratesubmissionprocesswithinthebank;

Ensuringappropriatesegregationofdutiestoaddresspossibleconflictsofinterestconcernswithinthebankarisingfromtheratefixingprocess;and

Takingallnecessarymeasurestoavoidexternal influenceovertheratesubmissionprocess.

4.8 The management responsibility for ensuring the integrity of the fixingprocessdoesnotonlystopatthedesignatedseniorexecutive. Referencebanksshould make clear that other relevant senior management members are alsoaccountabletothequalityoftheHIBORfixingprocess. For instance,theChiefRiskOfficerofareferencebankisultimatelyaccountablefortheindependentriskmanagementqualityofthebank.SincetheHIBORfixingprocessmaygiverisetoreputationor legalrisk (e.g.misreportingbehaviorswithin thebank),heorsheshallbeaccountable for theadequacyof internalcontrols for theprocess. Bythesametoken,sincetheChiefExecutiveOfficer(CEO)ofareferencebanktakesoverallresponsibility for theproperstandardsofconduct,aswellassoundandprudentbusinesspracticesofthebank,heorsheshouldalsobeaccountableforallissuesrelatingtothefixingprocess. 4.9 Independent review function Reference banks should assign riskmanagement staff independent of the front office and the designated seniorexecutivetoconductregularreview,focusing inparticularonassessingwhetherexpertjudgmenthasbeenexercisedinareasonableandconsistentfashion.Systemsofcontrol4.10 Submitterapprover process Reference banks should put in place asubmitterapprover process and assign the right personnel for these roles toensuretheprocessisconductedinanindependentandprofessionalmanner.

The role and responsibility of the designated submitter and approver,

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including their alternates, should be well defined and properlydocumented;theirauthorizationshouldbeclearlysetoutinwriting.

Theapproverand submitter shouldpossessexperience in the relevantmarkets and should possess the appropriate level of seniority in theinstitution.

The approver and submitter should be given sufficient training andguidanceon the ratedeterminationprocess,aswellas thisCode,andotherethicalstandardsthattheyareexpectedtomeetintheirroles.

The approver should possess sufficient expertise and seniority tochallengetheratesproposedbythesubmitter.

4.11 RatecorroborationprocessReferencebanksshouldputinplacedetailedpoliciesandproceduresondeterminationofHIBORsubmissions. Suchpoliciesandproceduresshouldinclude:

Collectionof transactiondataandotherprice information in linewiththeguidelinessetoutintheRSG;

Procedures for ratecorroboration inaccordancewith thehierarchysetoutintheRSG;

Approved techniques for making adjustment to indirectly relevanttransaction to ensure submissions are representative of HIBORdefinition;

Requirementtokeeprecordsofthedatausedintheratecorroborationanddocumentationofgroundsforapplyingexpertjudgment;and

Validation and approval procedures to be followed before makingsubmissions.

4.12 Segregation of duties Reference banks should ensure that there isappropriate segregation of duties to address the possible conflicts of interestarisingfromitsroleasbothcontributoranduserofthereferencerates,includingbutnotlimitedto:

Putting inplacenecessarysegregationofdutiesbetweenstaff involvedinratecorroborationprocessandstaffinvolvedinproprietarytradingofinterest rate derivatives, the degree of segregation should becommensuratewiththescaleandcomplexityoftherelevantoperationsofthereferencebank;

Putting in place necessary arrangement to ensure that only the

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necessary internal transaction data are passed on to the responsiblestaffforratecorroborationpurpose;and

Where the banks proprietary interest rate derivatives positions aresignificant, the submitters should not be given access to informationabouttheproprietarypositions.

4.13 Independent review Reference banks should develop commensurateindependent review processes. Typically, three levels of independent reviewshouldbeestablished, including: (a) regular reviewby theRiskManagementorFinancialControldepartment,(b)unscheduledcompliancecheck,and(c)annualaudit review. Some banks may also choose to engage external auditors toconductindepthqualityreview. Whilethescopeofreviewmayvaryfromtimetotime,thefollowingstepsshouldbetakenwherenecessary: Scopeofreview

Ascertaining the proper maintenance of records of the ratescorroboration and submission process, including data used andjustifications for any departure from the normal rate corroborationprocess;

Assessing reasonableness of rates contributed, by conductingbacktestinganalysisandotherreviewstatistics(e.g.frequencyofresultstrimmed,deviationofsubmissionsfromfixingresults);

Performing reviewon the sufficiencyof seniormanagementoversight,e.g. by checking whether the approver and the designated seniorexecutivehavebeeninquisitiveandcriticalwhenreviewingtheworkofsubmitters;

Evaluatingwhether issuesarising from the fixingprocess (e.g. inquiriesfrom the administrator of HIBOR) are thoroughly followed up andresolved;

Escalationprocedures Preparationof regular reports toseniormanagementon resultsof the

reviews, inparticularanyanomalies identified inthereviewprocess,sothat corrective actions could be taken in a timely manner andappropriatedisciplinaryactionscouldbetakenagainststaffinbreachoftheCodeorthereferencebanksinternalpolicies;and

Establishing procedures for the reporting of material breaches orunethical/abusivebehaviorsconcerning the rate submissionprocess to

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complianceor legalpersonnel,aswellastheescalationofthese issuesto the CEO and Board of Directors, as well as the owner andadministratorofthereferencerate,andtheHKMAandotherauthoritiesifappropriate.

4.14 CompliancewiththeFirstConductRuleReferencebanksshouldensurethat they observe the Rule set out in Section 6 of the CompetitionOrdinancewhich prohibits agreement, concerted practice and decisions that distortcompetitionsinHongKong. Amongotherthings,referencebanksshouldnotactin concertbydivulging tooneanotherdetailed informationabout theirpricingpoliciessoastoinfluencethefixingresults. 4.15 Handling of complaints andwhistleblower reports Reference banksshouldestablishanddocumentprocedures forhandlingcomplaintsarising fromthebenchmarksettingprocessand reportsmadebysubmitters,approvers,andotherwhistleblowers,including:

Properrecordingofallsuchcomplaintsandreports; Timelyallocationofsufficientandindependentstaffresourcestoreview

andinvestigatethesecomplaintsandreports;and Procedures for timely reporting ofmaterial complaints and reports to

theCEOandBoardofDirectors,theownerandadministratorofHIBOR,andtheHKMA.

Ethicalstandards 4.16 Reference banks should develop a set of ethical standards specificallyaddressing the HIBOR fixing process. Staff training should be regularlyconducted to remind staffof theethical standardsexpectedof them. Amongotherthings,thefollowingshouldbeobserved:

The determination of rates should be based on the sole objective ofreflectingthedefinitionofHIBOR(forsubmittersandapprovers);

Refrain from attempting to influence the rate setting process of thereferencebankforstaffnotinvolvedintheHIBORfixingprocess;

Refrain fromattempting to influence the rate settingprocessofotherbanks(forallstaff);and

Report inatimelymanneranyobservedunethicalorabusivebehaviorsof staffwithin the referencebankoremployeesofotherbanks (e.g.a

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submitter should immediately report to the senior management ifhe/shewasapproachedbya colleague inanattempt to influence theratesettingprocess).

EndorsementbyHKMA4.17 TheWG further recommends that this importantCodebe submitted totheHKMA for itsendorsement. Thisarrangementwouldprovideahandle fortheHKMAtoexercisesupervisoryoversightonthereferencebanks. Thiswouldbe akin to the current supervisory arrangement for monitoring and ensuringbankscompliancewiththeCodeofBankingPracticewhichhasprovedeffective.

Chapter5:Enhancingtheindependentadministration

oftheHIBORfixingprocess5.1 Sameastheinterbankofferedrateinmajorfinancialmarkets,theHIBORisadministeredbyanindustrybodyofbanks. There istheconcernof insufficientindependence as banks as contributors for the fixing process administerthemselves. TheWGconsidersthatthere ismerit inconsideringarrangementsthatcouldenhancetheindependenceoftheadministrationofHIBORfixing. Keyattributesofacredibleadministrator5.2 TheWG considers itdesirable for theHKAB toentrust itsadministrativerole for HIBOR to a separate credible organisation. A credible administratorshouldpossessthreeattributesassetoutinparagraphs5.3to5.5below.5.3 Ability to keep pace with market changes and initiate necessaryenhancementsTheWGconcludesthatitisimportantforHIBOR,createdbythemarket for the market, to evolve with the market and continue to serve itsfunctions. The administrator should therefore be at the forefront of financialmarket development and possess firsthand information about the changingmarketdynamics.5.4 Free fromconflictsof interestThereareproblems ifbanks responsibleforcontributingratesaresolelyresponsibleforadministeringthe fixingprocess. Such arrangement puts to doubt the administrators ability to challenge thesubmissionsof referencebanks and take appropriate followup actions to lookintoanomaloussubmissions. Itfollowsthatthenewadministratorcannotbeanassociationmakingupofbanksonly.5.5 Balanced representation A credible administrator should be able tobalance the interests and needs of different stakeholders when dealing withmattersandcomplaintsarisingfromthefixingprocess,andproposingchangestothefixingmechanisminthelightofmarketdevelopments.5.6 TheWGrecommendsthattheHKABshouldseektheendorsementoftheHKMAbeforeenlisting anorganisation to takeup the roleof an administrator. TMAcanbeoneofthepotentialcandidates. 5.7 With the strong presence of treasury professionals, the TMA should beabletodetectpromptlychangingmarketconditionsandintroducerefinementsto 33

theHIBORfixingmechanisminatimelymanner. Ontheissueofindependence,whilethetreasuryprofessionalsusuallycomefrombanks,membershipinTMAisreasonablydiverseandincludesmoneymarketparticipants,representativesfromthe corporate sector, legal and accounting professions, as well as the HKMA. The more balanced representation ensures that it will take into account theinterestsofdifferentplayerswhenmanagingmatters relating to the fixingsandproposingchangesinthefuture. HKABshouldremaintheownerofHKDHIBOR5.8 TheWGconsidersitimportanttoensurethatHKABremainstheowneroftheHIBOR fixing toavoidanyunduedisruption to the largenumberofexistinglegal contracts with reference to HIBOR. Specifically, strong governance andoversightof theadministrationofHIBORcanbe readilyachievedbyhaving thisroleentrustedtoacredibleinstitutionwithoutachangeofownership. Nearterminitiativesofthenewadministrator5.9 TheWGrecommendsthatthenewadministrator,upontakinguptheroleoftheadministratorofHIBOR,shoulddeviseanactionplancoveringthefollowinginitiatives(paragraphs5.10to5.14setoutthedetails):

DiscusswiththeHKABonthemodeofcooperationbetweenthetwoparties. Theresponsibilitiesoftheadministratorshouldbesetoutclearlyinwriting;

DeveloptheCodesetoutinChapter4,theRSGsetoutinChapter3in consultation with market participants, and submit them forHKMAsendorsement;

Devisea timetable for timely implementationof theCodeandRSGbyallreferencebanks;

EstablishanefficientgovernancestructurecomprisingaSurveillanceand Governance Committee (SGC) responsible for scrutinising thequality of submissions by reference banks. The SGC should besupported by dedicated staff resources carrying out daytodaysurveillancework;

Liaisewiththecalculatingagent(seeBox5.1oncurrentarrangement)to identify work that can be done to strengthen the surveillancecapabilityofthenewadministrator;and

Establish a Benchmark Review Committee (BRC) responsible forreviewing the need to address issues relating to HIBOR fixing

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activities,withaviewtoensuringthesmooth functioningofHIBORasthefinancialmarketcontinuestoevolve.

Box 5.1: HKICLs role regarding HIBOR

In 2008, the HKAB changed its designation of HIBORs calculating agent from a newswire service company to the Hong Kong Interbank Clearing Limited (HKICL), a private company jointly owned by the HKMA and the HKAB. The main reason for the change is to ensure fair dissemination of HIBOR fixing results to all major newswire servicers. In addition, the calculating agent is responsible for preparing two regular statistical reports summarising the data of HIBOR submissions by reference banks. The reports are made available to the HKAB, all reference banks, and the TMA.

ModeofcooperationbetweentheadministratorandtheHKAB5.10 While the mode of cooperation should be agreed between theadministratorandtheHKAB,priorconsultationwiththeHKMAisrecommended. Amongstotherissues,thefollowingshouldbecovered:

The HKAB, by entrusting only the administrative role to theadministrator, retains full ownership and ultimate responsibility inrespectofallissuesrelatingtoHIBOR.

The administrator in carrying out its role will independently (a)conduct surveillance work to ensure the quality of HIBOR fixingprocess, (b) as an ongoing exercise, review the HIBOR fixingarrangement with a view to proposing further enhancements toimprovetherobustnessofHIBOR,(c)developeffectiveprocedurestohandle complaints and reportsbywhistlebloweronHIBOR relatedissues,and (d)establishclearprocedures forthetimelyreportingofsuspectedirregularitiestotheHKMA.

TheHKICLshouldremainasthecalculatingagentofHIBOR.TheHKABshouldauthorisetheadministratortodirectlyseekthesupportoftheHKICLincarryingoutitsduties.

The HKAB should provide explicit consent for the administrator toreportanyirregularitiesoranomaliesrelatingtoHIBORfixingdirectlytotheHKMAwithoutpriorconsultationwiththeHKAB.

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The administrator is responsible only for scrutinising the overallrobustness of HIBOR but not the daytoday compilation of HIBORfixings,whichshouldremainthedutyoftheHKICL.

Establishinganeffectivegovernancestructure5.11 Toensuresufficientoversightoftheratesettingprocess,theadministratorshould establish a SGC responsible for scrutiny of individual submissions andfixing results, aswell as other issues relevant to the administration ofHIBOR. Membership of the surveillance committee should be sufficiently broad, andshould include nonreference banks and corporations which are users of thereference rate. The committee should meet on a quarterly basis and thefollowingissuesshouldberegularlyreviewed. 5.12 General quality of submissions: As set out in Box 5.1, currently, tworeports are being prepared by the calculating agent. These reports enablereviewers toassess thegeneralqualityofsubmissionssuchas the timelinessofsubmissions and the degree of dispersion of the submitted rates. Theadministrator should initiate an exercise to enable more systematic andsophisticatedevaluationofthequalityofsubmissions. TogetherwiththeHKAB,the administrator should also establish policies and procedures for handlingconsistentlypoor inputs fromservingreferencebanks. Thedisciplinaryactionsto be introduced may include issuance of warning letters, as well as thesuspension or termination of the reference bank status in case of ongoingnegligence. 5.13 Scrutinyof individualbanks submissions: In addition to reviewing thegeneral quality of submissions, the administrator should assign dedicated staffresourcestoconductstatisticalanalysistodetectsignalsofpossibleanomaliesinthe rate submission process. Examples of warning signals include (a)submissionswithaparticularlyhighfrequencyofbeingtrimmedoutinthefixingprocess,(b)submissionsexhibitingapatterndeviatingsignificantlyfromthepeers,and (c)submissionsexhibitingasharply increaseddegreeofdispersionwithnonoticeable change in market conditions. The administrator should makenecessary inquiries to ensure that submissions by reference banks areprofessionally determined in accordancewith the RSG. Escalating proceduresshouldbeestablishedtoreporttoSGCcasesgivingrisetosuspicionsofcollusivebehaviouramong referencebanksorattempts tocompromise the fixing resultsby selected reference banks. For timesensitive cases potentially involvingseveremisconduct,procedures shouldbe laiddown soas toensure the timelyescalationtotheSGC,theCEOofthereferencebanksconcerned,aswellasthe

36

regulatorforfollowupactionsorfurtherinvestigations. 5.14 Asnotedinparagraph5.3,theadministratorshouldkeepunderreviewthefunctioningof thebenchmark interestrateandensure itcontinues tomeet theneedsofthemarketandservethefunctionsitwascreatedfor. Tothisend,theadministratorshouldestablishaBRCtoberesponsible forreviewing theproperfunctioningofHIBORinthechangingfinancialmarkets. Onatleastahalfyearlybasis, and more frequently if market situations or changes in the supervisorylandscape demand, the BRC should meet to discuss and review the followingissues:

(a) Whether thedefinition, calculationmethodology and fixingmechanismcontinuestobeappropriate;

(b) WhetherthescopeofbenchmarkcontinuestoservetheusersofHIBORandrelevantcontracts;

(c) WhetherthereisaneedtoupdatetheRSGorprovisionsintheCode;and (d) Other issues relevant to the administration of the benchmark interest

rate. Ensuringcontinuous,accurateandtimelypublication5.15 HKABmay continue to designate theHKICL as the calculating agent forcompilingthefixings. Assuch,existingtechnicalandoperationalproceduresforsubmitting rates (e.g. towhom submissions should bemade, submission timewindow,etc.)canremainunchanged. 5.16 The administrator should make all reasonable efforts to promote theconsistent, accurate and timely publication of the reference rate. It shouldengageindiscussionwiththeHKICLtoreviewandrefineproceduresforhandlingcontingentevents(e.g.technicalproblems,weather,etc.)thatcouldinterruptthenormal rate collectionorpublicationprocess, aswell as thehandlingoferrorsidentifiedbyreferencebanksafterpublicationofthefixings. Goingforward,therelevant procedures should also be laid down and made available to allcontributorsandendusers. 5.17 To ensureunfettered access toHIBORbymarket participants, theHKABmaywanttocontinueengagingtheexistingdatavendors forthedistributionofthe fixings. Thenew administrator should review theestablishedpoliciesandproceduresforsafeguardingconfidentialinformationandcontrolstopreventthepremature,unauthorizedorpreferentialdisclosureofinformationconcerningthe

37

38

referencerate.Puttinginplacecomplaintshandlingprocedures5.18 TheWGrecommendsthatcomplaintsarisingfromtheratesettingprocessshould inthefuturebereferredtotheadministrator,whichshoulddrawuptheprocedures for handling complaints. Among other things, it will establishprocedures for recording those complaints. The followupactions tobe takenfor complaints of different naturewill also be developed. Therewill also bewritten procedures for handling substantiated complaints. Depending on thematerialityofthosecomplaints,thefollowupactionscouldincludenotificationtoHKAB as rate owner or escalation to the regulator for supervisory review orinvestigations.

Chapter6:ConfiningthescopeofHIBORfixingtotenors

thathavestrongmarketdemand6.1 TheWGalsoexploredproposalsforimprovingthedifferentaspectsofthefixingmechanism. Theseproposalsinclude:

(a) Whether it is desirable to confine submissions to tenors that havestrongmarketdemand;

(b) Whetherthetrimmedmeanapproachshouldberetained; (c) Ifthetrimmedmeanapproachshouldberetained,whetherthelevelof

trimmingshouldbeincreased;and (d) Whetherthere isaneedtochangethenumberofreferencebanksfor

thefixingprocess.

6.2 Aftercarefulconsideration,theWGconcludedthatonlythefirstproposalshouldbepursuedatleastforthetimebeing. Theparagraphsbelowsetoutthereasonsandargumentsleadingtothisproposition. Confiningsubmissionstofrequentlyusedtenors6.3 HIBORiscurrentlypublishedforfifteenmaturities. Accordingtofeedbackfrommarketparticipants,someofthematuritiesforHIBORarerarelyreferencedin financial contracts. At the same time, transactions for these maturitiesseldom take place in the unsecured interbank market. As it is difficult forreferencebanks to support the rates contributedwithactual transactionsdata,reference banks are relying on interpolation and extrapolation techniques toderivetheratestobecontributedforthesematurities. Inviewofthemarginalbenefitofpublishingtheseoddtenors,theWGrecommendsthatthenumberofmaturitiestobesubmittedandpublishedforHIBORbereducedfromfifteento7. Hence, it is proposed that HIBOR should continue to be published for tenorsincluding overnight, 1week, 1month, 2month, 3month, 6month, and12month,butHIBORshouldceasetobeavailablefor2week,4month,5month,7month,8month,9month,10month,and11month. 6.4 The WG is mindful of the possible impact this change could have onexisting contracts that are referenced to the maturities to be dropped. Wethereforeproposea12monthphaseoutperiod toallow the lapsingofexistingcontracts or necessary adaptations by contracting parties if the contracts run

39

beyondthedateforsuspendingthesetenors. 6.5 Apart from putting in a relatively long phaseout period, the WG alsoconsidersitimportanttoensurewidepublicationofthischangesoastoensureasmooth transition. For this purpose, HKAB and TMA should prominentlyannouncethischangeontheirwebsites,alongsidethedailyfixings. Inaddition,theyshouldconsulttheirmembersandmakesuretheyreviewexistingcontractsandtheproposed12monthtransitionperiod isfeasibletomarketparticipants;. Besides, they should also ensure the new financial contracts will not makereferencetothephasingouttenors. AssumingthisproposalisadoptedbyHKAB,theinfrequenttenorsidentifiedshouldbephasedoutin2014. Changingthetrimmedmeanapproach6.6 The WG considered whether the trimmedmean approach should beretainedforcompilingthefixings. ReferencebanksarerequiredtoestimatetheofferratesatwhichHKDdepositsarequotedtoprimebanksat11.00a.m. Thefixingresultsandindividualbankssubmissionsarepublishedafter11.15a.m.onadailybasis. ThefrequencyandtimelinessofthefixingsarethemajorreasonsbehindthepopularityofchoosingHIBORinthepricingandsettlementofcertainfinancialcontracts. 6.7 Ideally, thoroughcheckingshouldbeperformedonalldatasubmittedbyreferencebanksbeforecalculationisperformedtoderivethefixingratesandthefixingcanbecalculatedusingthesimpleaverage. However,thetimeanddataconstraintmeans it is not feasible to perform indepth checking on individualsubmissionsbyreferencingallrelevanttransactionsexecutedaround11.00a.m.before thedailypublications. As such,we see theneed to continueadoptingthetrimmedmeanapproachwhichcontainsanautomaticbuiltinmechanismforhandlingoutliersinthedatasetreceivedfromreferencebanks. Thecalculatingagent should however continue to perform reasonable checking on datasubmitted to make quick enquiries with the reference banks with the aim ofidentifyingobviouslyunreasonablesubmissions(e.g.thefatfingererrors). Changingtheleveloftrimming 6.8 While the trimmedmean approach is proposed to be retained, theWGalsoconductedanalysisandexploredtheneedforchangingtheleveloftrimmingemployed in calculating the fixings. With 20 submissions received daily, thecurrentpractice istotakeoutthetop15%andbottom15%ofsubmissionsandthentakeaverageoftheratesthatremain. 40

6.9 Theoretically,thehigherthe leveloftrimming,the lowerthe influenceofoutliers in the rate fixing process. Taken to the extreme, one may use themediantocalculatethefixingbytrimmingthetop45%andbottom45%ofratescontributed. However, if only the middle two observations are used incompilingthe fixings,onesacrificesthebenefitof lookingatratessubmittedbythe majority of the group. We therefore considered increasing the level oftrimming from 30% to 50% by excluding the top 25% and bottom 25% incalculatingthemean. Thecharts in figure6.1comparethe fixingresultswhenthe levelof trimming isat30%andat50%. Thechartssuggest that the fixingresultsfromeitherapproach isnotsignificantlydifferentbasedonpastavailablehistoricaldata.

41

Figure 6.1: Trimming at 30% versus 50%

HIBOR O/N

0

1

2

3

4

Feb-08 Aug-08 Feb-09 Aug-09 Feb-10 Aug-10 Feb-11 Aug-11 Feb-12 Aug-12

(%)

Middle 14 Middle 10

HIBOR 1 Week

0

1

2

3

4

5

6

Feb-08 Aug-08 Feb-09 Aug-09 Feb-10 Aug-10 Feb-11 Aug-11 Feb-12 Aug-12

(%)

Middle 14 Middle 10

HIBOR 1 Month

0

1

2

3

4

5

6

Feb-08 Aug-08 Feb-09 Aug-09 Feb-10 Aug-10 Feb-11 Aug-11 Feb-12 Aug-12

(%)

Middle 14 Middle 10

HIBOR 2 Months

0

1

2

3

4

5

Feb-08 Aug-08 Feb-09 Aug-09 Feb-10 Aug-10 Feb-11 Aug-11 Feb-12 Aug-12

(%)

Middle 14 Middle 10

HIBOR 3 Months

0

1

2

3

4

5

Feb-08 Aug-08 Feb-09 Aug-09 Feb-10 Aug-10 Feb-11 Aug-11 Feb-12 Aug-12

(%)

Middle 14 Middle 10

HIBOR 6 Months

0

1

2

3

4

5

Feb-08 Aug-08 Feb-09 Aug-09 Feb-10 Aug-10 Feb-11 Aug-11 Feb-12 Aug-12

(%)

Middle 14 Middle 10

HIBOR 12 Months

0

1

2

3

4

5

Feb-08 Aug-08 Feb-09 Aug-09 Feb-10 Aug-10 Feb-11 Aug-11 Feb-12 Aug-12

(%)

Middle 14 Middle 10

NOTE:Middle14(trimmingat30%) Amongratesquotedby20referencebanks,thethreehighestandthethreelowestareeliminated. Theremaining14ratesarethenaveraged. The leveloftrimming isthereforeat30%as70%of the20 ratescollectedareused tocalculate theaverage. Middle10(trimmingat50%) Amongratesquotedby20referencebanks,thefivehighestand the five lowestareeliminated. The remaining10rates are then averaged. The levelof trimming is therefore at50%as50%of the20 ratescollectedareused tocalculate theaverage.

6.10 Separately, theWG noted that the level of trimming for calculating thefixings is specified in the HKAB FRA terms. As such, changing the level of 42

43

trimmingcouldriskbringdisruptionstoexistingHKABFRA. Weighingtheprosandcons,theWGconsidersitnotworthwhiletopursuethischange. Changingthenumberofreferencebanksinthefixingpanel6.11 As HIBOR reflects the funding cost of prime banks in the unsecuredwholesale funding market. Theoretically, the rate contribution process couldincludeonlybankswhichenjoy theprimebankstatus. However, ifonlya fewbanks are required to submit rates, the fixing process will become moresusceptible tocollusionandmanipulation. This isparticularly true if the fixingprocessemphasisesactual transactionsdataand transactions in theunderlyingmarket is thinandonly involvea fewplayers. It is thereforeessential for theratesubmissionprocesstoincludeareasonablenumberofbankstoaddressthepotentialproblemofprimebanks influencing the fixing results. Basedon therates they transactandobserve inother transactions, thenonprimebanksareabletoprovidechecksandbalances. Assuch,theinclusionofnonprimebanksisvaluableinthefixingprocessandassistindiscoveringthefundingcostofprimebanks. 6.12 TheWGconsideredwhetherthereisaneedtoexpandthesizeofexistingpanel for HIBOR. Having regard to the fact that there are not a significantnumberofactiveplayersintheunsecuredwholesalefundingmarket,thecurrentpanelsizeof20isconsideredreasonable forensuringthequalityofsubmissions. TheWGthereforeproposesnochangetothepanelsizeforthemoment. Havingsaidthat,theremaybeaneedtoadjustthepanelsizewhenmarketevolves. AsthepanelsizefordeterminingthefixingsisspecifiedincurrentHKABFRAterms,there is aneed tomodify the standard termsused in these contracts so as toallowflexibilityinmakingchangesinthefuture.

Chapter7:Reviewingandenhancingprovisionsincontracts

thatreferenceHIBOR

7.1 TheWGconsidersitadvisableforthebankingindustrytoexploremeansofpromoting more consistent application of HIBOR in financial contracts. In thisregard, theWG reviewed selected contracts thatmake reference toHIBORandnotedroomforimprovementinsomeofthem. Forinstance,somecontractsarenotadequatelyclearastohowcontingencyeventssuchasHIBORunavailabilityshould be handled. Some other contracts (e.g.HKD FRA) have details of theHIBOR fixingmechanismwritten in their terms,allow little flexibility for futurerefinementsintheHIBORfixingmechanismandrenderingitdifficulttointroducerefinements even if circumstances warrant. These observations suggest thatindustryeffortscanbemadetopromotestandardisationintermsthewayHIBORismadereferencetoandthebackstoparrangementifHIBORisforsomereasonsunavailable. Specifically, the WG envisages room for refinement for thefollowing:

(a) Backstop arrangement As part of business continuity planning,financial contracts should contain clear and welltested backstoparrangement for contingent scenarios when HIBOR is unavailable. Whilecertain typesof financialcontracts likeHKABFRAdohavesucharrangement in place, it is unclearwhether other contracts like loanagreementscontainsuchprovisions.Tothisend,effortsshouldbemadeto promote standardised and operationally feasible backstoparrangementforHIBORunavailability.

(b) Variantsof contractual language referencingHIBOR Similar to thebackstop arrangement, apparently there are no specific standards onthe exact language used in financial contracts referencing HIBOR. SomecontractsmayrefertothetradenameHIBORorHIBORHKAB,while some contracts may provide a fuller description. GreaterconsistencyinthelanguageusedtoreferenceHIBORwillmakeiteasierinthefuturetomanageanychangestotheHIBORfixingmechanism.

(c) Reference toHIBOR inHKAB FRA Aparticular case inpoint for (b)above isHKABFRAcontract,whosetermsprovideafulldescriptionoftheHKABInterestSettlementRates(seeBox7.1).TheWGbelievesthisformofreferencelacksflexibilityfortheindustrytodealwithchangingmarket conditions. As mentioned in Chapter 6, in theory, a higherlevelof trimming is somethingworthyexploring. However, since thecurrent levelof trimming (6outof20) iswritten in the termsof theHKABFRA,introducingchangesmaydisruptthissegmentofthemarket.

44

Similarly, the number of reference banks in the fixing panel is alsowritten in the HKAB FRA. While in this review the WG sees nomaterialadvantagesofchangingtheseparametersatleastforthetimebeing, it cannot be ruled out that in future such changes would bedesirable. Toallowmoreflexibilityinintroducingenhancementtothefixing mechanism in the long run, considerations should be given tochanging the standard terms of existing FRA. New contracts shouldincorporate the changes proposed, while existing contracts shallgraduallyphaseouttoallowasmoothtransition.

Box7.1ExtractfromHKABFRA

"HKABInterestSettlementRates"means,inrespectoftheContractPeriod,theratespublished,byHKAB. SuchratesshallbecalculatedbytakingtheratesquotedtoHKABby20HKABDesignatedBanksasbeingintheirviewtheofferedrateatwhichdepositsinHongKongdollarsfortheContractPeriodarebeingquotedtoprimebanksintheHongKonginterbankmarketat11.00a.m.ontherelevantBusinessDay(saveasprovidedinparagraphD7ofthesetermsandconditions)forSettlementDatevalueandeliminatingthethreehighest(or,intheeventofequality,threeofthehighest)andthethreelowest(or,intheeventofequality,threeofthelowest),takingtheaverageoftheremaining14ratesandthen(ifnecessary)roundingtheresultantfigureupwardsto5decimalplaces.7.2 TheWG recommends that theHKAB,with the assistance of the TMA ifnecessary,shouldtaketheleadinencouragingmarketparticipantstoreviewtheterms in existing contracts and identify provisions that could be clarified tomitigate possible disputes and hurdles to improvement in the HIBOR fixingmechanisminthefuture.

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Annex 1

WorkingGrouponHIBORReview

TermsofReference

1. Background In the lightofmarket concernsover the credibilityof theinterest settlement rate fixing mechanisms in a number of overseasmarkets, the Hong Kong Association of Banks (HKAB) has decided toconductareviewoftheHIBOR5fixingmechanism,inconsultationwiththeTreasuryMarketsAssociation(TMA).

2. ScopeForthepurposeofthisreviewexercise,HIBORfixingmechanism

shouldcoverfiveareas:(i) DefinitionofHIBOR;(ii) Methodologyadoptedindeterminingratestobesubmitted;(iii) FinancialproductsandinstrumentsthatarelinkedtoHIBOR;(iv) Statisticalfilteringofsubmittedrates;and(v) GovernanceandcontrolsatHKABandreferencebanklevel.

3. ObjectivesTheultimateobjective is toensure thereexist credibleand

representative benchmark(s) which could be used as (i) a basis forsettlement ofHKD interest rate derivative contracts and (ii) an index ofinterestrateforHKDfinancialcontracts including loans. Tothisend,thereviewexerciseshouldaimto:(i) assess whether reference banks have significant incentives to

misreport their HIBOR submissions, if so, what can be done tominimisesuchincentives;

(ii) identifypotentialareasofenhancementtothecurrentHIBORfixingmechanism and explore the different options for change byanalysingtheprosandconsofeachoftheoptions;

5 ThenameonHKABswebsiteshouldbeHKDInterestSettlementRate,butthisiscommonlyreferredto

asHIBORinthemarkets 46

(iii) identify and adopt the key principles for evaluating the trade offbetween the pros and cons of each of the explored options, anddecideonthebestoption(s)tobepursued;and

(iv) devise a comprehensive action plan with a clear and reasonabletimetablefortheimplementationofthechosenoption(s).

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Annex2WorkingGrouponHIBORReview

MembershipList

Convenor1. ChristopherChan,ManagingDirectorandChiefInvestmentOfficerAsia,

JPMorganChaseBank,N.A.Members2. HenryCheng

HeadofFinancialStabilitySurveillanceDivision,HKMA

3. AdrianFongHeadofRatesandBalanceSheet,GreaterChina,AustraliaandNewZealandBankingGroup

4. KennethHoYuKwan DeputyGeneralManager,HeadofMoneyMarket,BankofChina(HongKong)

5. JeffKwanTreasurer,MTRCorporationLimited

6. KinTingLiDeputyGeneralManager,GlobalMarkets,BankofCommunications

7. PeterLiPartner,BankingandCapitalMarketsLeader,AssuranceFinancialServicesPractice,PricewaterhouseCoopersHongKong

8. MunKiongLiewHeadofShortTermHKDInterestRateTrading,DeutscheBank

9. AndrewMalcolmPartner,Linklaters

10. KianHoeTanHeadofAssetandLiabilityManagement,StandardCharteredBank(HongKong)

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11. AndyWong

SeniorDealer,LiquidityManagementSection,CapitalMarkets&LiquidityManagementDepartment,TreasuryMarketsDivision,BankofEastAsia

12. BryanWong HeadofBalanceSheetManagement,HSBC

13. VinceWongHeadofG7&AsianCurrencyProducts,ICAP

14. VictorWuAssistantGeneralManager,HeadofLocalCurrencies,PortfolioManagementDepartment,GlobalMarketsDivisionfortheEastAsiaRegion,BankofTokyoMitsubishiUFJ

49

50

Abbreviations

BIS BankofInternationalSettlementsBRC BenchmarkReviewCommitteeBBA BritishBankersAssociationCD CertificateofDeposit CEO ChiefExecutiveOfficer Code CodeofConductCDS CreditDefaultSwap EFB ExchangeFundBills FRA ForwardRateAgreementHKAB HongKongAssociationofBanksHKICL HongKongInterbankClearingLimitedHKMA HongKongMonetaryAuthority IOSCO InternationalOrganisationofSecuritiesCommissions OIS OvernightIndexSwaps RSG RateSubmissionGuidance SGC SurveillanceandGovernanceCommittee TMA TreasuryMarketAssociationWG HIBORreviewWorkingGroupundertheTMAWheatleyReview TheWheatleyReviewofLIBOR:finalreport