An update on LIBOR reform and the transition to SONIA

LIBOR (London Interbank Offered Rate) will cease to be published from the end of 2021 and although SONIA has been agreed as the replacement rate (and is already being used for new transactions) there is still a lot work to be done on the transition, especially for legacy agreements. Matt Cooper, Tax and Treasury Director at Places for People, delves into the detail.

SONIA (Sterling Overnight Index Average – based on average interest rates banks pay to borrow sterling overnight from other banks and investors) is based on actual overnight transactions so there is no term structure and rates are not known in advance. The solution to this is to compound SONIA each day with a five-day lag. Operationally this gives some time to arrange payments but much less than before.

The other issue is that LIBOR and SONIA are not equivalent, so a credit spread adjustment is required. Over the last five years SONIA has averaged 0.12% lower than three-month LIBOR. This adjustment (i.e. SONIA plus 0.12%) has been agreed as the fallback position* and is being used by some as the default position for amendments to legacy loans.

Interestingly, SONIA is currently greater than LIBOR, so interest payments may increase. Using one-month interest periods reduces the adjustment, however this is operationally more burdensome.

Clearly dialogue with funders is key, but it is also time to consider operational issues:

  • Intercompany loans
  • Other references to LIBOR across the business
  • And don’t forget derivatives and hedge accounting...

There is lots of information available, including a set of resources from the Bank of England. It’s worth watching the webinar, ‘Is your business prepared for LIBOR transition?’ Spoiler alert – it probably isn’t!

* This difference has been adopted by ISDA (International Swaps and Derivatives Association) as a fallback for derivative transactions and has been recommended by the Working Group on Sterling Risk-Free Reference Rates that this fallback is used in cash products. Currently this difference is 0.04% for 1 month and 0.25% for 6 months.