Look out LIBOR here comes SONIA!

If you have, or are considering entering into loan arrangements that carry interest calculated by reference to LIBOR, and that has a term extending beyond December 2020, then this article will be of relevance to you.

In my article of July  2019 I explained that, the widespread manipulation of LIBOR after the financial crisis resulted in the establishment by the Bank of England of the Working Group on Sterling Risk Free reference Rates, to consider and propose risk free alternatives to LIBOR (Risk Free Rates or RFRs)  as a method of calculating interest rates for borrowers. Following this consideration and consultation, the Working Group have proposed that the Sterling Overnight Index Average (“SONIA”) should be the preferred alternative risk-free rate for Sterling.

In a number of Fact Sheets and consultation papers issued in January 2020, the Working Group has sought to consult on, and answer a number of questions.

1. How much longer is LIBOR going to be around?

The panel banks that currently provide the quotations used to calculate LIBOR have indicated that they will not continue to do this after the end of 2021. Anyone with a Loan or other financial products that depend on LIBOR will therefore need to transition to a new methodology by that date.

2. What will replace it?

The Working Group is seeking to enable a broad-based transition to SONIA by the end of 2021 across the sterling bond, loan and derivative markets.

3. What is SONIA, and why is it better?

SONIA is a historic overnight rate, which is derived from actual overnight rates used in the cash and Swap Markets for huge volumes of transactions – this means that it is based on factual data across a large sample – meaning it is more robust and less volatile than LIBOR. It is also (virtually) risk free as it does not incorporate any risk or liquidity premium which was inherent in the calculation of LIBOR.

4. How is a SONIA INTEREST Rate calculated?

SONIA is a daily overnight rate. In order to arrive at a rate for an agreed period, the historic SONIA for each day in the period is taken and compounded to give the rate for the whole period. The calculation is done by reference to a period that “lags” behind the corresponding interest period to give time for the rate and interest amount to be calculated and agreed by the relevant interest payment date.

5. What if I want or need to be able to fix my interest rate at the beginning of an interest period as I do with LIBOR?

In its working paper “Use Cases of Benchmark Rates: Compounded in Arrears, Term Rate and Further Alternatives”, issued in January 2020, the Working Group acknowledged that, while more sophisticated borrowers may have the capability to adopt historic SONIA, some groups of product, including Loans (particularly to SMEs and in the Mid Markets) may still want to operate by reference to a forward looking interest rate. The expected group is small as a percentage of the total volume of transactions (@10%) but represents a large number of transactions due to their smaller size.

Following an invitation for expressions of interest in December 2018, four administrators (FTSE Russell, ICE Benchmark Administration, Refinitiv and IHS Markit) have confirmed they are working on the development of a Term Sonia reference Rate (TSRR) and have presented their plans to the Working Group. It is expected that Term SONIA Reference Rates (TSRRs) will begin to be published early in 2020, to allow a period of observation before they are used in products.

The Working Group has made it clear that TSRR is not their preferred option and that use should be limited. Specifically they note that TSRR is unlikely to be appropriate for Loans with associated derivatives. Areas where they consider that a TSSR may be appropriate include:

• Smaller corporate, wealth and retail clients, who may lack the resources necessary to adapt to the necessary technological requirements.
• Trade and Working Capital products that require a term rate to calculate forward discounted cashflows.
• Export Market and Emerging Markets where the longer lead times typically required to make payments, makes historic SONIA impractical.
• Islamic Finance.

6. Will SONIA be cheaper than LIBOR?

Sort of but probably not. One of the issues that needs to be resolved is what to do with the credit and liquidity risk element that is priced into LIBOR (because it relates to the rate at which a Bank can borrow an specified amount for a specified term in the markets on an unsecured basis) which is not incorporated into the overnight rates that SONIA depends on. At first blush, this appears to mean that SONIA should be cheaper, but in fact, this has led to further consultation on how the risk factor should be priced back into the rate. In its consultation paper issued in December 2019, four options were suggested with option 1 being favoured by most respondents to earlier consultation by ISDA.

This Consultation  considers the credit adjustment spread methodology to be used in respect of fallbacks from LIBOR to a SONIA-derived rate where the relevant adjustment is determined at the ‘fallback trigger date’ (e.g. the announcement of the cessation of GBP LIBOR) and applied at the ‘fallback activation date’ (e.g. the actual cessation date of GBP LIBOR).

In each of the alternatives outlined below, the credit adjustment spread, once calculated for a particular tenor, would be a set figure applicable for the remainder of the life of the transaction, i.e. the methodologies would produce spreads that are determined at the time of the fallback trigger date to apply for all future dates for that tenor from the fallback activation date.

• Option 1 – ISDA historical median approach.

The credit adjustment is based on the difference between GBP LIBOR and the SONIA derived rate that is calculated using a median over a five-year lookback period prior to the fallback activation date. This has the advantage of simplicity and robustness, as well as being less susceptible to manipulation because of the long periods of historical data that will be used.

• Option 2 – ISDA Forward approach.

This uses observed market forward prices for the difference between SONIA and LIBOR for loans of varying lengths. The credit adjustment would then be based on the relevant curve (which would specify the spread to be applied for every future date for Loan tenors of up to 20 -30 years and would be frozen at the fallback trigger date).  For future dates beyond the length of the curve, the adjustment rate would remain static at the rate for the last date on the curve. This method, while possibly having the benefit of smoothing transitional values, is more complex and data intensive, and may be limited by small transaction volumes from which to derive data.

• Option 3 – ISDA Spot-spread approach.

This would work similar to the Historical Median approach, and would use the daily spot differential between LIBOR and SONIA over a specified number of days leading up to the fallback trigger date (which may be as little as five business days). While simple, this method raised concerns around market volatility caused by prevailing market conditions at the time of the calculation, and the associated risk of manipulation.

• Option 4 – Modified forward approach.

This works similar to the ISDA Forward approach, but would simply calculate values as at a limited number of points after the fallback trigger date (rather than daily)  but would use data collected over a long observation period (1 year is proposed) and averaged to calculate the spreads as a means to address some of the concerns raised with the ISDA forward approach.

7. What now?

• New Loans: It is expected that most lenders will stop offering LIBOR based loans at the latest at the end of the year. Any Loans entered into between now and then should contain appropriate provisions to adopt an alternative approach when LIBOR is discontinued. If there is already a preference as to what should happen, then this should be negotiated in. SONIA Loans and derivatives are already available in the market and borrowers may wish to consider adopting this immediately.
• For existing Loans and other LIBOR dependent products, you should review your documentation urgently. Some will incorporate fallback provisions allowing agreement to be reached by the parties at the appropriate time (there is a form of LMA standard Clause for Loans and ISDA are working on a protocol for swaps). This may be a matter of commercial negotiation, but it is expected that a reasonably standard market approach will have been settled so that products and their associated derivatives will transition as seamlessly as possible.
• What about non Sterling Loans? Most of the financial markets in the EU and many beyond are moving to Risk Free Rates – you should speak to your Bank about its proposals for these as soon as possible.
• Is SONIA the only option? For some borrowers, rather than a SONIA rate, it may be preferable that Banks offer a base rate or fixed rate option to maintain the simplicity of administration. If TSSRs prove convincing then this may be developed as an option for the transaction types listed above.

For further information, please contact Kath Shimmin – Partner & Head of Banking & Finance.

Further reading:

Blake Morgan Client information sheet

Bank of England – UK Working Group on Sterling Risk-Free Reference Rates (RFR WG) 2020 Top Level Priorities

Bank of England – The Working Group on Sterling Risk-Free Reference Rates Factsheet

Bank of England – Consultation on credit adjustment spread methodologies for fallbacks in cash products referencing GBP LIBOR