LIBOR to SONIA - an update
2021 will prove to be a monumental year. LIBOR, which has been the reference rate for all types of debt from term loans to bonds since the ‘70’s, will be phased out. This will not be a sentimental passing as it has come to symbolise some of the worse excesses of bankers’ greed, epitomised in the LIBOR scandal which was detailed in an article in the FT in July 2012[i] where the author, a former trader, claimed that the rate had been regularly manipulated since 1991. This was in addition to multiple criminal settlements by Barclays Bank[ii] which revealed collusion between the member banks who were setting the rate. The expression ‘LIBOR fixing’ has taken a whole new meaning, or perhaps it was always there for all to see but no one had chosen to look too hard. The damage had been done and as a result reform was required.
Many steps have been taken since 2012, led by the Working Group on Sterling Risk-Free Reference Rates. The purpose of this article is not to review the winding road that has been travelled over the last 8+ years but, as we arrive at the finish line of the journey, to outline the implications for borrowers whose debt references LIBOR and also the considerations for any hedging instruments that may be in place. We will not be looking at the hedge accounting implications as they will be addressed elsewhere.
Our focus will be GBP LIBOR which will cease being published on 31st December 2021. In addition to this by the end of Q1 2021 banks will not be issuing loans (that expire beyond 2021) using LIBOR as a benchmark. This will also apply to derivative products such as interest rate swaps. Interest rate caps, as a non-linear product, have a longer lease of life, as will the ability to use LIBOR based derivatives for risk management purposes for existing positions.
The chosen replacement rate for LIBOR is SONIA (Sterling Overnight Index Average). SONIA is an overnight rate and the rate that banks use to lend to each other which ensures that it is a market traded rate. It does not rely on the returns from a panel of banks. This clearly fulfills one of the main requirements of the reform process. The disadvantage is that it is an overnight rate rather than having a term structure. The result of this is that a borrower will not know the amount they owe at the end of the month or quarter until the end of the period. This creates operational challenges. The solution that has been chosen by early adopters has been to use a 5 day look back to set the rate. This means that the full set of rates and hence the period end payment, will be known 5 days before payment is due.
The look-back period is a positive solution for loans, this however, is not matched by the standard ISDA fallback position which will, as a result, lead to a mismatch between a loan and hedging position if nothing is done about it.
As a borrower there are several steps that I believe should be taken in order to ensure that the transition to SONIA runs smoothly with minimum cost and value transfer:
1) Be clear on the loans and derivative positions that will be affected
2) Discuss the methodology for conversion that your lending bank is taking (Documents (lma.eu.com))
3) Ensure that the derivative position and loan position are matched
4) Ensure that the value of the new SONIA derivative is the same as the LIBOR derivative with no unreasonable cost of conversion.
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