Update on the LIBOR-SONIA transition

The transition from LIBOR to SONIA will be complete by 2021. The Working Group on Sterling Risk-free Reference Rates has outlined a number of milestones to be met this year. DTP outlines the detail behind this.

15 March 2019

Under the direction of the Bank of England, the Working Group on Sterling Risk-free Reference Rates has achieved much since its establishment in early 2018. Consultation has broadened from 16 banks to more than 130 relevant firms, and while significant issues remain, the transition from LIBOR to SONIA will take place, in stages, up to 2021.

The Working Group has improved its communications efforts: publishing the minutes of its meetings, releasing a starter pack and monthly newsletters, and revising the wording of a ‘Replacement of Screen Rate’ clause for loan documentation, in conjunction with the Loan Market Association.

Key principles

A number of key principles have been of paramount importance to the Bank of England throughout the process, not least that the transition should not produce ‘winners and losers’, and that transparency is essential. This has been boosted by SONIA meeting international benchmark standards.

In consultation with, but independently from the Bank of England, the International Swap Dealers Association is developing its own methodology for the derivatives market, and appears further advanced. This is unsurprising, given the well-established market in trading different interest rate bases.

The main issue exercising the Working Group is the practicalities of publishing a forward-looking term reference rate based on SONIA. This is of particular relevance to social housing providers, which have substantial legacy funding.

The Working Group has established a series of milestones which should be met during 2019. These include:

  • the development of operational capability and systems for SONIA-referencing loans and other instruments
  • the production and availability of a term reference rate
  • agreement on sterling ‘fall-back’ language and implementation
  • evidence of significant adoption by new business across derivatives, bond and loan markets.

Transition and fall-back plans will evolve during 2020-21, with the intention that LIBOR publication will no longer be guaranteed by the Financial Conduct Authority after 2021. 

What we don’t know

For social housing borrowers, uncertainties remain, including when and how the transition will work in practice, and how to calculate the necessary spread adjustment to convert from LIBOR to SONIA.

In December, the Working Group discussed ‘compression auctions’ as a means of matching up and offsetting LIBOR/SONIA bids and offers as a means for the market to reduce the amount of long-dated legacy LIBOR swaps by converting to alternative reference rates. Further taskforces are planned, to look at identifying and removing barriers to transition, accounting challenges, and approaches to compounding SONIA.

In an international context, the Band of England and Working Group appear well advanced. The EU has agreed an extension to December 2021 of the transitional period for critical benchmarks, and the US and Swiss central banking authorities have reported a number difficulties in making progress.

What we do know

While the Working Group implementation plan has made progress, much of the detail remains unclear.

The planned new term rate to replace LIBOR, possibly based on SONIA-OIS, the Sonia overnight index swap rate, may ease the transition provided that it seamlessly replaces LIBOR.

However, the Working Group accepts that conversion to any new rate means every LIBOR contract will require a fair spread adjustment, so there is no transfer of value between the parties (i.e. no winners or losers). Whatever the new rate, a spread adjustment will mean a permanent adjustment to legacy loans.  Exactly what this will mean in practice remains uncertain.

How much will it cost?

If there are to be no winners or losers, nothing. The new term rate might roughly equate to a ‘synthetic’ LIBOR, but with transparency. 

Looking ahead to practicalities, in December 2018 DTP published its own thoughts on possible approaches to calculating a spread adjustment.