Sterling LIBOR Transition: Focus on Term SONIA

• United Kingdom

• Banking and finance
• Financial services and markets regulation

23-01-2020

New LIBOR transition publications

On 16 January 2020, the Bank of England, Financial Conduct Authority and Working Group on Sterling Risk-Free Reference Rates published a set of documents outlining priorities and milestones for sterling LIBOR transition in the UK in 2020. You can access the press release here. For the purposes of this briefing, we are focusing on the information provided about ‘Term SONIA’ along with an update on interest rate swaps.

What documents were published?

• 2020 Roadmap

• Working Group Paper (The Use Cases of Benchmark Rates: Compounded in Arrears, Term Rate and Further Alternatives)

• Progress on the Transition of LIBOR-Referencing Legacy Bonds to SONIA By Way Of Consent Solicitation

• Factsheet: Calling time on LIBOR: Why you need to act now

• Joint letter from PRA and FCA (to senior managers of UK banks and insurers with regards to LIBOR transition)

• FCA and Bank of England encourage switch from LIBOR to SONIA for sterling interest rate swaps from Spring 2020

5 things we learned about ‘Term SONIA’ from the latest publications

1. What is Term SONIA?

SONIA is an overnight interest rate. To calculate interest for, for example, a 3 month interest period, the current practice is to use SONIA compounded in arrears (“Compounded SONIA”) over a period that starts before the interest period and finishes before the end of the interest period. Term SONIA refers to a forward-looking term reference rate based on overnight SONIA. There has been significant interest in the development of Term SONIA in the loan market, in the hope that it will be a lower risk equivalent to LIBOR (LIBOR also being a forward-looking term reference rate). From both an operational and a drafting perspective Term SONIA feels like a more straightforward replacement to LIBOR than Compounded SONIA.

2. Who is working on Term SONIA?

Four administrators (FTSE Russell, ICE Benchmark Administration, Refinitiv and IHS Markit) are working on the development of Term SONIA, based on actual overnight indexed swap (“OIS”) data, tradable quotes provided by market makers and OIS futures data.

3. When will it be available?

The intention set out in the 2020 Roadmap is to publish a test rate in Q1 2020 with the aim that Term SONIA will then be available in the first half of Q3 2020 (in time to meet the FCA’s target date for no new LIBOR loans to be issued after the end of Q3 2020). These dates are provisional.

4. The regulators prefer Compounded SONIA, why?

Several reasons are given in the Working Group Paper, including:

• Compounded SONIA is viewed as being more robust that Term SONIA as it is based on more transactions on an average day.

• If a loan has the same reference rate as a derivative used to hedge the loan it will ensure that the loan is hedged effectively and cost efficiently.

• Compounded SONIA can be used across multiple markets – derivatives, bonds and securitisation.

• For each currency where there is a risk-free rate it is possible to calculate that rate compounded in arrears. The equivalent to Term SONIA may not be available for all currencies, which could be a key factor for a multi-currency borrower to ensure a consistent approach.

• There is concern about reintroducing structural vulnerabilities if Term SONIA use is widespread.

5. If Compounded SONIA is the preferred LIBOR replacement, why is Term SONIA needed?

The regulators recognise that Compounded SONIA may not work for certain limited types of borrower and transaction. For example:

• Borrowers with straightforward lending requirements (ie no hedging and not multi-currency) who don’t have the treasury function / technology to switch to Compounded SONIA.

• Trade and working capital where a look-forward term rate may be required to calculated forward discounted cash flows.

• Export finance / emerging markets where borrowers may need more time to make payments of interest and principal and so need certainty of interest payments at the start of an interest period.

• Islamic finance, where the variable rate of return needs to be pre-determined.

• Certain legacy LIBOR transactions where a change to Compounded SONIA would be too complicated or, given the remaining term, not cost effective.

The expectation is that the significant majority of UK lending will be based on Compounded SONIA and that will be the market norm. Other options, such as a fixed rate or using Bank of England base rate, will continue to be available.

Conclusion

Based on the latest publications, it looks like the UK loan market will need to quickly get to grips with both Compounded SONIA and Term SONIA. Compounded SONIA can be calculated now and the regulators are strongly encouraging market participants (who don’t fall into one of the limited categories that require Term SONIA or another alternative) to start using it where possible or, at the very least, include robust fallback clauses in cash products which continue to reference LIBOR^{1 2}. The headline message from the latest publications and from the Loan Market Association is that “the time to act is now”. Market conventions in respect of Compounded SONIA won’t develop unless market participants start working through the issues in transactions and engaging in discussions. Term SONIA, although in development, is not going to be the loan market standard.

A note on interest rate swaps

In contrast to the loan market, transactions referencing Compounded SONIA have been a feature of the derivatives market for some time.

The FCA and the Bank of England in their joint statement targeted at market makers have identified 2 March 2020 as the date on which the market convention for interest rate swaps should change from LIBOR to Compounded SONIA.

Current trading in derivatives referencing Compounded SONIA is now broadly at the same notional value as for LIBOR. The joint statement is likely to have the effect of tipping the balance so trading volumes in transactions referencing Compounded SONIA increasingly eclipse those referencing LIBOR.

The decline in the liquidity of LIBOR referencing derivatives may mean that the costs of hedging LIBOR referencing loans increases.

How can Eversheds Sutherland help?

Eversheds Sutherland can support you on the full spectrum of LIBOR transition-related issues ranging from large-scale re-papering projects for global banks and financial institutions to individual queries from borrower clients on the impact of LIBOR transition. Eversheds Sutherland is able to draw on the expertise of Konexo (its technology-driven alternative legal services arm) and a market-leading team of partners and other legal experts in finance, regulatory, derivatives and other relevant areas, both in the UK and across the globe.

1. We note that we are waiting for the results of the ongoing Consultation on credit adjustment spread methodologies for fallbacks in cash products referencing sterling LIBOR, which is due to close on 6 February 2020, which considers how to minimise the economic impact of moving from LIBOR to a risk free rate.

2. In a webinar on 23 January 2020 the Loan Market Association confirmed that they are reopening discussions on whether fallback to SONIA (and other risk-free rates) should be hardwired in the LMA recommended drafting rather than continuing with the current amendment approach.