General Near Risk-Free Rates Related Risk Factors

Global benchmark reform has replaced many IBOR settings with near risk-free rates (RFRs) such as SONIA, SOFR and €STR. RFRs are overnight rates published in arrears, typically based on wholesale market transactions, and may be unsecured (e.g., SONIA, €STR) or secured (e.g., SOFR).

Unlike IBOR, interest under RFR referencing transactions is only known at or near period end and does not embed a credit risk premium.

The following applies if near risk-free rate benchmarks (such as the Sterling Overnight Index Average (“SONIA”), the Secured Overnight Finance Rate (“SOFR”) and the euro short-term (“€STR”, previously “ESTER”)) and/or any other relevant benchmarks (together, “RFRs” and each, an “RFR”) are directly or indirectly used to determine certain amounts payable under a transaction and/or determine its value.

Various interest rate benchmarks globally have been the subject of regulatory guidance and reform. Over the last few years, regulators around the globe have engaged with the financial services industry to transition markets from interest calculations based on interbank offered rates (or “IBORs”) to RFRs. For example, as of 1 January 2022, Sterling, Euro, Swiss Franc and Japanese Yen LIBOR settings in all tenors, and USD LIBOR 1-week and 2-month settings have either ceased to be published or are no longer representative. USD LIBOR Overnight, 1-month, 3-month, 6-month and 12-month settings have either ceased to be published or become non-representative after 30 June 2023.

RFRs are overnight rates, published every business day in arrear and intended to be based on actual transactions in the wholesale market. RFRs may be calculated based on unsecured (e.g. SONIA and €STR) or secured (e.g. SOFR) transactions. For the purposes of calculating a rate for a particular period of time (e.g. monthly or quarterly) under a derivative transaction, a rate is calculated based on the overnight RFRs published for that period.

In contrast to transactions referencing IBOR term rates, where the interest rate is known at the beginning of the interest period, interest under an RFR-referencing transaction:

• will only become known at, or near the end of, the interest period; and
• does not itself contain an embedded premium which reflects credit risk.

RFRs are overnight rates that are subject to day-to-day fluctuations in market rates. The level of an RFR can change over time and depends on a number of factors including day-to-day changes in supply and demand. Taking an average of, or compounding, an RFR over a period of time may smooth the impact of any such fluctuations, with longer averaging/compounding periods generally having a greater smoothing effect versus shorter averaging/compounding periods.

The market in RFRs continues to develop. For example, market participants and working groups have considered alternative reference rates based on RFRs, including term RFRs which seek to measure the market’s forward expectation of an RFR rate over a certain term (see, for example, the paragraph on SOFR Term Rate). The International Swaps and Derivatives Association, Inc. (“ISDA”) has also published overnight RFR rate options, as well as provisions required to implement compounding and averaging approaches. In addition, there are RFR indices being published by various regulators and benchmark administrators, including for SOFR, SONIA and €STR. ISDA has also published certain floating rate options which relate to such RFR indices.

Please note however that the use of RFRs and term RFRs is still developing. The existence of a particular RFR or term RFR should not be taken to indicate that it will be available for use with all products, and the methodologies and applications of RFRs may change over time.

Liquidity for a number of RFR-referencing transactions in certain markets is developing. If, at the time of valuation, there are no or limited observable market parameters or standards for such RFR-referencing transactions, valuation would depend on certain assumptions proprietary to HSBC. Even if observable market parameters or standards for such RFR-referencing transactions do develop, HSBC may choose to deviate from, or otherwise not to incorporate, such standards in its proprietary models. Additionally, even if the majority of market participants do switch to using RFRs, there is no guarantee that a liquid market will continue to develop in relation to RFR-referencing transactions. This may give rise to issues with putting appropriate hedging in place and you may incur substantial costs if you were to amend, terminate or restructure an RFR-referencing transaction prior to its maturity.

Interest rate transactions that include a cap or a floor are more complicated to price than vanilla interest rate swaps. Pricing in these products is already subject to certain divergence in the market. The RFR-cap/floor market continues to develop and consequently, this divergence in pricing may be greater for caps and floors that reference an RFR due to the use of different models to price such transactions.

If a transaction is being used to hedge interest rate exposure, the following considerations may also be relevant:

• basis risks could arise as a result of differences between the terms of the cash product and the hedging transaction, such as differences in the interest calculation methodologies, payment dates and the fallback provisions in the event a benchmark ceases to exist;
• accounting, regulatory capital and tax issues may arise; and
• existing or new laws and regulations may materially impact upon any existing or new RFR transactions and such impact may be difficult to predict. Such laws and regulations may also have consequential effects on pricing and liquidity in the market.

In July 2021, the Alternative Reference Rates Committee (“ARRC”) announced recommended best practices¹ supporting the use of forward-looking SOFR term rates (“SOFR Term Rates”) for limited products in certain circumstances.

If you have a cash product referencing a SOFR Term Rate that is hedged with a product based on overnight or compounded/averaged SOFR, this could result in cashflow and/or valuation mismatches between the two products.

If you enter into any SOFR Term Rate derivative transaction with HSBC, you are responsible for complying with any and all applicable legal, regulatory, industry and/or market practice, guidance, standards and/or protocols (including, for example, any relevant ARRC recommendations). Please also note that the use of the CME Group’s forward-looking SOFR term rates is likely to require appropriate licensing – please contact the CME Group for more information and also refer to the CME Group’s FAQs².

Under the ARRC-endorsed methodology, SOFR Term Rates are derived from certain SOFR derivative transactions’ market data, so HSBC’s trading activities in such derivatives may impact on SOFR Term Rates. Please also note that SOFR Term Rates may not be equivalent to the rate for the identical term that is derived from the compounded/averaged SOFR for such period.

Given the ARRC recommendation that SOFR Term Rate derivatives be limited to end-user facing derivatives intended to hedge SOFR Term Rate cash products, there is very limited to no liquidity in the SOFR Term Rate derivative market and pricing may be unobservable. When entering into a SOFR Term Rate derivative transaction with HSBC, HSBC may include additional execution costs (“Additional Execution Costs”) in one leg of the derivative transaction to reflect HSBC’s risk management activities in connection with the transaction. Such Additional Execution Costs depend on HSBC’s view of prevailing and future market conditions, as well as HSBC’s related risk appetite. If you wish to early terminate, restructure, amend or novate the transaction, this may prove challenging depending on prevailing market conditions and you may incur potentially significant costs at the time of such early termination, restructure, amendment or novation. As a result, (i) the price of the transaction on the trade date; and (ii) the cost of terminating, restructuring, amending or novating the transaction prior to the termination date, in each case, is likely to be higher than that of a swap with the exact same terms but referencing overnight or compounded/averaged SOFR.

The above information is not a complete statement of risks and other considerations concerning its subject matter. This information is general and not intended to be, and should not be relied upon as, legal, regulatory, financial, tax, accounting or other advice. HSBC makes no representation as to the accuracy, completeness or timeliness of such information, which may also be subject to change. In particular, it has been prepared without taking account of any particular party's objectives, financial situation or needs.

You should seek independent advice, including if you are unclear about any potential implications in respect of the above, including legal, tax, accounting, regulatory, financial or other issues.

The value or price of a transaction (in relation to, for example, any mark-to-market determinations, or restructuring or unwind requests) may be calculated by reference to, or by discounting using, one or more benchmark or rate curves, as applicable. Such benchmarks or rates will or may be discontinued in the future or may over time no longer be appropriate, as determined by HSBC. As a result, HSBC may in the future apply a different discounting methodology, which may result in a different valuation or price.

Given that HSBC’s interest, involvement or role may vary depending on the transaction in question, HSBC may make decisions and act independently with respect to each transaction, without any obligation to treat all transactions alike, including, without limitation, agreeing or applying the same spreads or adjustments to alternative benchmarks for purposes of converting them into approximations of the original benchmark’s rates.