Transition from Libor to Sonia

16 July, 2019

Borrowers and Lenders take note – the FCA has advised that LIBOR (the London Interbank Offered Rate) will end in 2021 and are encouraging the adoption of SONIA (the Sterling Overnight Index Average) as the alternative interest rate benchmark.

 

By some estimates, LIBOR determines rates on $350 trillion of financial products worldwide, so moving away from it is clearly a big change. Key businesses and functions that will be affected include commercial lending, retail banking and wealth management. 

 

What is LIBOR?

LIBOR has been the UK’s standard benchmark interest rate for corporate lending, leasing and residential loans since the mid1980s, and has been adopted globally; set by a panel of international member banks, many financial institutions, mortgage lenders and credit card agencies set their own rates relative to it.

LIBOR is currently determined by the ICE Benchmark Administration (IBA), which consults with a panel of banks to obtain estimates of the current costs of borrowing. Using this information, the IBA is able to provide a forward looking rate which is used to calculate interest rates on loans.

 

Why are we moving away from LIBOR?

Confidence in LIBOR has dropped due to the reliance on panel banks setting fair and accurate estimates of the cost of lending, which may not reflect the true market position and could be at risk of manipulation (the 2012 LIBOR rigging scandal often being quoted).

 

Despite recent reforms to LIBOR, the FCA considers that the lack of underlying transaction data means that the validity of the opinion based submissions of panel banks remains questionable. In June 2019, the Bank of England (BOE) and the FCA jointly hosted a panel-based titled “Last Orders: Calling Time on LIBOR.” LIBOR isn’t being eliminated however, and technically could still be available after 2021, but regulators will no longer force or encourage banks to continue supporting the benchmark after that date.  The FCA has asked banks to voluntarily sustain LIBOR until 2021.

 

What is the alternative to LIBOR?

Whereas LIBOR was adopted globally, market developments suggest the transition is now towards different countries applying their own local reference rate. In the U.S., there is SOFR (Secured Overnight Financing Rate), Japan has TONA (Tokyo Overnight Average) and the European Bank has developed the Euro Short-Term Rate (ESTER).  In April 2017, the Bank of England’s Working Group on Sterling Risk-Free Reference Rates adopted the SONIA benchmark as their preferred RFR and since then has been working with the FCA on how to transition to using SONIA across British Sterling markets, with a mandate to encourage a broad-based transition to using SONIA in bond, loan and derivatives markets.

 

SONIA, the Sterling Overnight Index Average, is the effective interest rate paid by banks for unsecured transactions taking place “overnight” (in off-market hours) in the British Sterling market. It is “risk free” or “nearly risk-free” and doesn’t factor in any credit risk taken by lenders.  The advantage of SONIA is that it does not rely on submissions made by panel banks but is instead based on a weighted average of actual overnight funding on the wholesale money markets. SONIA is therefore much more in tune with actual market conditions. Regulators anticipate that the switch from LIBOR to SONIA will create more predictability in the UK debt market. 

 

Challenges for Borrowers / Lenders

The main challenge with SONIA is that it is a “backward looking” screen rate (as are SOFRA,  TONA and the others). Interest calculated using SONIA is only known once the rate has been applied. Furthermore, because it is an overnight rate this means it changes on a daily basis. Loan agreements using SONIA cannot set a fixed interest rate across the term of the loan (e.g. 3, 6 or 12 months). The loss of cash flow visibility will be a challenge for Borrowers.  Also, using SONIA it may be more difficult for borrowers to prepay principal or refinance mid period, since calculations cannot be carried out in advance of the prepayment being made. Lenders will also need to factor in their credit risk if using SONIA.   

 

In an attempt to resolve the above the Bank of England Working Group has held public consultations  on the possibility of introducing a Term SONIA Reference Rate (TSRR) which could potentially be tested in 2019. If TSRR is adopted it will go a long way to maintaining the structure of the current drafting in current contracts and allow the final rate to be known in advance of repayment dates from the outset of each interest accrual period.  However, its introduction is not a certainty at this juncture.

 

Action Points for Borrowers and Lenders

Whilst we anticipate LIBOR is unlikely to be widely used as a reference rate from the end of 2021, exactly how this will play out in the market is still uncertain, and we will continue to monitor the situation. 

 

To best prepare for the transition we would advise Borrowers and Lenders to review their existing lending documentation. Well drafted contracts should include fall-back provisions specifying an alternative rate for when LIBOR becomes unavailable. Such provisions might say, for example, that if LIBOR is unavailable, the rate last used will continue unchanged. Whilst this may be acceptable in the short term, a party losing out on an unfavourable interest rate may seek to re-negotiate whilst the gaining party will want to retain existing terms. Borrowers should liaise with their bank relationship managers to discuss further.

 

Banks and other corporates with significant LIBOR exposure should start preparing for the change if they haven’t already done so, including contract analysis.  It might also be reasonable to assume that month end processing and reconciliation will be more time consuming and complicated for Lenders and Borrowers alike, so this should be factored in to planning, as well as the potential for tax implications. 

 

For further information on the changes and how they may affect your business, please contact Aleks Wulff on 01892 506 127 or email at aleksander.wulff@crippspg.co.uk