An update on the LIBOR-SONIA transition

LIBOR, the London Interbank Offered Rate, will be phased out at the end of 2010. Andy Gladwin, Director at DTP, provides an update on the latest situation and the transition to SONIA (Sterling Overnight Indexed Average).

The story so far

Following widespread market manipulation of the LIBOR benchmark rates during the height of the financial crisis, the independent Working Group on Sterling Risk-Free Reference Rates (RFRWG) was established in 2015 to implement the Bank of England Financial Stability Board’s recommendation to develop alternative risk-free rates. Supported by the Bank of England (BoE) and the Financial Conduct Authority (FCA), in April 2017 the RFRWG recommended SONIA as the preferred benchmark.

Since then, specialist sub-groups and market practitioners have focused on how to transition to the adoption of SONIA across sterling markets under three guiding principles – transparency, conformity to international standards (which was achieved in May 2018), and equitable treatment of all parties (‘no winners and losers’).

In January 2020, the Bank of England, the FCA and RFRWG published a series of guidance, highlighting the action that needs to be taken by all corporate borrowers.

Latest developments and next phase

As of 2 March 2020 the FCA and the Bank of England are encouraging all market participants that new derivatives should reference SONIA.

In the case of legacy loans, bonds, and interest rate contracts maturing beyond 2021, much of the recent focus has been on the mechanics and formulae for adapting SONIA – a risk-free, overnight rate – to serve as a market replacement for LIBOR – a forward-looking (term) rate that includes premia for term liquidity and bank credit risk.

In most cases, the risk-free reference is expected to be lower than LIBOR (up to 0.04% between 3-month LIBOR and 3-month compounded SONIA). To bridge this gap, a consensus is needed on how to calculate the rate to be applied and what the credit adjustment spread should be to achieve economic neutrality.

The International Swaps and Derivatives Association (ISDA) has been at the forefront of this research and consultation, and the most favoured mechanisms consist of a rate compounded in arrears for the term adjustment. For the credit adjustment spread, the favoured approach is the historical median approach over a five-year lookback (the methodology favoured by the NHF), avoiding the period when LIBOR was inflated by market manipulation.

There is also an ongoing debate about when the transition date can be triggered, ranging from the announcement by authorities that LIBOR is no longer ‘representative’ as a market rate, to the official cessation of rate publication.

A consultation on credit adjustment spread methodologies was launched by the RFRWG last December, with replies sought by 6 February. Results will be published in due course, but the RFRWG acknowledges that there may be some ‘tough’ legacy contracts that cannot easily be transitioned under such mechanisms as ‘consent-solicitation’. This is a market process that has already successfully been applied to eight floating rate bonds with a total nominal value of £4.2bn.

The RFRWG has published a roadmap of its intended communications and priority milestones for the remainder of 2020.

As an integral participant in this process, the Loan Market Association (LMA) has developed and published exposure drafts of wording for compounded SONIA-based sterling term and revolving facilities agreements. These are not yet considered to be in recommended form, and so are offered to lenders and borrowers to form their own view on whether the wording is appropriate for loan documentation. The LMA is inviting feedback from end-users and advisers.

The most recent developments aimed at 'turbo-charging' sterling transition were announced by the Bank of England on 26 February. Firstly, the Bank announced that in addition to the overnight SONIA rates it already publishes, it will publish a compounded SONIA index from July 2020.

That index will allow market participants to calculate a wide range of compounded SONIA rates in an easy and consistent way, supporting achievement of the 2020 Q3 target for new issuance.

In addition to publishing the index from October 2020, the Bank will be progressively increasing the discount on (or reducing the total percentage of) the sums it will lend against the amounts it accepts as LIBOR-linked collateral. This will give firms the time to replace that collateral with risk-free rate alternatives.

What you need to do now

The transition affects the entire corporate borrowing, deposit-taking, and interest rate management world, including housing associations.

A joint statement by the Bank of England, FCA, ACT and CBI, ‘Calling Time on LIBOR: Why you need to act now’, outlines a four-point plan for immediate action:

  • Identify all LIBOR exposures – in addition to loans, deposit facilities, and interest rate products, these may encompass ancillary contracts such as leasing and pensions.

  • Check contracts – loan wording may contain ‘fallback’ language, but may not often address the issue of LIBOR becoming permanently unavailable.

  • Business impact of SONIA – the new benchmark is not a like-for-like replacement for LIBOR, so some business system adaptations may be required.

  • Discuss with lenders / investors / advisors – banks and institutional investors themselves will be engaged in significant changes to internal and market trading systems, so an understanding of their preparations and timetables should be established, whilst also liaising with the borrowers’ own legal and treasury advisers to ensure adequate internal readiness.

Useful links and resources

Who to speak to

John Butler, Policy Leader