The London Interbank Offered Rate (“LIBOR”) is expected to cease after the end of 2021. In particular, LIBOR-linked loans may not be offered after Q3 2020. This will impact the variable rate in LIBOR-linked financial products.
Since the 1980s, LIBOR has been used widely as an interest rate benchmark to calculate the interest rate applicable to financial products. These rates are written into loans, derivatives agreements, and many other contracts. LIBOR is based on banks’ submissions of their interbank borrowing rates. The problem is that since the financial crisis in 2008, banks no longer fund themselves in this way. The absence of an underlying active market has meant that LIBOR is, and has been, sustained by the use of “expert judgement”. This cannot continue indefinitely, and 2021 is the last year that UK panel banks have agreed to provide their submissions to LIBOR.
Public authorities, in the UK and internationally, have been clear that LIBOR is expected to cease to exist after 2021. For loans, LIBOR products may not be offered beyond Q3 2020. All counterparties to a financial product or contract that references LIBOR will need to take action to remove any dependence on LIBOR that remains after 2021.
LIBOR is available in five currencies. Each relevant jurisdiction has established an alternative to LIBOR. This includes Sterling Overnight Indexed Average (“SONIA”) in the UK.
What is SONIA?
SONIA is an interest rate benchmark administered by the Bank of England. This means that only the Bank of England takes responsibility for its governance and publication every London business day.
SONIA is based on actual transactions and reflects the average of the interest rates that banks pay to borrow sterling overnight from other financial institutions. So, unlike LIBOR, which is fixed in advance for a set period (eg, three months), SONIA is an overnight rate, measured each day over the interest period to produce a final interest rate at the end (ie, SONIA is a backward looking rate). It is a (nearly) risk-free rate as it does not include any term bank credit risk or liquidity premium. These differences between SONIA and LIBOR impact how interest is calculated.
In April 2017, the Working Group on Sterling Risk Free Rates in the UK (the “Working Group”) recommended using the SONIA benchmark as their preferred risk-free rate. Since then, the Working Group has focused on facilitating the transition away from LIBOR across sterling markets.
The overall objective of the Working Group is to enable a broad-based transition of the sterling bond, loan and derivative markets to SONIA by the end of 2021. The objective is to reduce financial stability risks arising from widespread reliance on GBP LIBOR. As part of this work, the Working Group consulted on Term SONIA Reference Rates (“TSRR”) in 2018. Following this, the Working Group recommended the need for a forward-looking term rate for some participants in the cash markets and to support the transition of certain legacy contracts.
The prevailing view of the Working Group is that overnight SONIA, compounded in arrears, will become the norm in most derivatives, bonds, and bilateral and syndicated loan markets given the benefits of the consistent use of benchmarks across markets and the robust nature of overnight SONIA.
In this context, a new Term Rate Use Case Task Force was formed to identify where the usage of SONIA compounded in arrears is appropriate and to provide guidance where the usage of alternative approaches, such as a TSRR, may be necessary. Although a sterling TSRR does not yet formally exist, administrators are working on the development of an International Organization of Securities Commissions-compliant TSRR, and it is expected that TSRRs will be published in Q1 2020 for a period of observation.
What we need to know about SONIA’s implementation
One of the most significant UK financial documents published in recent times was a joint letter sent by the Bank of England and the UK Financial Conduct Authority (“FCA”) to senior managers of UK banks and insurers. The letter outlines a series of key targets for 2020 and makes clear that LIBOR transition plans should include these targets. The specified targets are to:
- enable a further shift of volumes from LIBOR to SONIA in derivative markets, supported by a statement from the Bank of England and FCA encouraging a switch in the convention for sterling interest rate swaps from 2 March 2020;
- cease issuance of cash products linked to sterling LIBOR by the end of Q3; and
- significantly reduce the use of LIBOR referencing contracts by Q1 2021.
What do you need to do now?
Establish where your LIBOR exposures are. Loans, deposit facilities, derivatives and floating rate notes may reference LIBOR. It is important to identify your exposure to LIBOR and to understand what will happen to these contracts if LIBOR is no longer available.
Check your contract terms. Your contracts may include “fall back” terms setting out what will happen when LIBOR is not available. However these terms often do not envisage that LIBOR could be permanently unavailable. Check the fall back terms, what they mean for your financial product and whether they need to be amended.
Familiarise yourself with SONIA, and what it means for you or your business. In sterling, the SONIA overnight rate is an alternative benchmark to LIBOR. SONIA is not a like-for-like replacement for LIBOR and cannot be directly substituted into existing contracts. Given the differences between the two rates, you or your business may need to make changes to systems in order to use SONIA.