The discontinuation of LIBOR and phasing in of SONIA in the Sterling Markets, what do we know so far?

26 April 2021

Global financial markets are preparing to transition away from the use of the London Interbank Offered Rate (“LIBOR”) and adopt an appropriate alternative risk free rate (“RFR”) by the end of 2021, and banks and borrowers alike will need to ensure they are ready for the switch.

This blog provides a short summary of the reasons for the move away from LIBOR, the progress to date in terms of identifying the Sterling Overnight Index Average (“SONIA”) as the most appropriate alternative rate in the Sterling markets, and the steps still required to be taken to ensure such markets are ready for the phasing out of LIBOR by the end of the year, particularly in light of the on-going COVID-19 pandemic.   

Why are we losing LIBOR?

The announcement that steps would be taken to phase out LIBOR was made by Andrew Bailey (then Chief Executive of the UK Financial Conduct Authority (the “FCA”), now Governor of the Bank of England) in July 2017. By the time of the announcement, the use of LIBOR had long been the subject of high-profile allegations of manipulation, particularly around the time of the global financial crisis, but the key reason cited for ending the use of the benchmark was due to the declining rate of actual unsecured inter-bank term lending taking place. In the absence of such transactions, setting the rate ultimately becomes a matter of judgement and this has led to a common view that LIBOR is not sustainable and is not therefore the most appropriate benchmark to which hundreds of trillions of dollars should be linked.

As such, by the end of 2021, the 20 panel banks which currently submit LIBOR rates to the ICE Benchmark Administration (“ICE”) each day will no longer be required to do so, and firms should not therefore rely on LIBOR being published after that time.

 

What is SONIA?

SONIA has been identified by the Working Group on Sterling Risk-Free Reference Rates (the “Working Group”) as the most appropriate risk free rate (“RFR”) to replace LIBOR in the sterling markets.

SONIA is a backward looking rate which is published at 9am (GMT) on each day in relation to previous business day in London. It measures the rate of interest paid on minimal risk, short term wholesale funds (such as between large financial institutions), and is calculated on the basis of actual interest paid on overnight, unsecured sterling deposits. It has historically been lower than LIBOR as it does not contain a bank credit risk element or cost of funds.

 

Areas of Focus

The market’s first SONIA loan in July 2019 was a new bilateral facility between Natwest and National Express Group Plc. Following this transaction there have been a number of other SONIA transactions in the sterling markets, some more high profile than others, with the Loan Market Association (“LMA”) keeping track of the details of those deals that are publicly available. Such transactions have helped to set some precedents, however, there are a number of areas where work remains in progress in order to ready the whole market for the phasing out of LIBOR, including in relation to the following key areas of focus:

Calculation Convention Guidance

Conventions as to the way in which SONIA should be calculated and used in lending transactions will ultimately be driven by market adoption but, whilst principles have begun to become established through the execution of SONIA loans, there is now more formal consensus in respect of a number of important areas. In September 2020 the Working Group published its convention recommendations following their period of consultation . This included a recommendation that ‘SONIA compounded in arrears’ is the most appropriate rate to adopt in term contracts (at least until a forward looking SONIA rate can be made available). (This was as expected and follows what the market was seeing). From 3 August 2020, the Bank of England began to publish a SONIA Compounded Index (going back to 23 April 2018) in order to assist with providing a simple, standardised way to calculate compound interest rates.

The recommendations of the Working Group also concluded that the adoption of a ‘five banking days lookback without observation shift’ approach (which is also known as an ‘observation lag’ approach) is the most suitable in terms of calculating SONIA over the course of an interest period. The recommendations do however also suggest that if lenders are able to offer ‘lookback with an observation shift’, this remains a viable option.

Under the ‘five banking days lookback without observation shift’ methodology which the Working Group recommends, for every day of the interest period the rate from the 5 banking days prior, is used. The LMA has provided a useful work-through by way of an example: “For a one month interest period of 1 March to 1 April with a 5 London business day lookback, the rate for 1 March would be taken from 22 February (the day falling 5 London business days’ prior) and so on. On 25 March, the agent would know the full month’s interest amount and would be able to invoice the borrower for payment at the end of the interest period.”  

The Working Group has also now drawn conclusions in relation to the treatment of bank holidays and weekends, so that interest should be compounded on London banking days only.  In terms of rounding, the Working Group recommends that SONIA be rounded to four decimal points and Sterling amounts to be rounded to two decimal points.

In addition to recommending the rate, the Working Group also made recommendations as to the preferred methodology for accounting for the difference between LIBOR and SONIA when switching from one rate to the other in existing contracts. As noted above, SONIA has historically been lower than LIBOR so to ensure a fair conversion an adjustment is needed so that neither party suffers an economic loss or receives an economic benefit solely as a result of the transition. The Working Group consultation identified a strong consensus in favour of the historical five-year median spread adjustment methodology as the preferred methodology for credit adjustment spread calculations, and in accordance with such expressed preference the Working Group recommended this methodology.

Legacy Loans

As LIBOR will no longer be available after the end of 2021, legacy loan contracts which provide for a LIBOR based interest rate will need to be amended to the extent they do not already include adequate language to deal with the discontinuation of LIBOR. 

Those LIBOR contracts which do not include appropriate fallback language and are not able to be amended (for example, due to difficulty obtaining necessary consents) have been termed ‘tough legacy’ contracts and the UK Government has now made provision in the new Financial Services Bill (introduced to Parliament on 21 October 2020) (the “FS Bill”), in an attempt to deal with the issues likely to arise with such contracts. Under the FS Bill, the UK Government has proposed amendments to the Benchmarks Regulation to give the FCA “new and enhanced powers” to assist with the transition away from LIBOR whilst also ensuring that customers and market integrity remain protected. Pursuant to these additional powers, the FCA will be able to direct a change in methodology of a critical benchmark and extend its publication for a limited time period for the benefit of tough legacy contracts, although will not be in a position to pre-determine or fix outcomes for parties to contracts. The UK Government’s policy paper on the amendments to be made to the Benchmark Regulations also advise that, before exercising certain new powers, the FCA will be required to issue statements of policy to inform the market of how it intends operationalise the legal framework.

On 5 March 2021, the FCA announced the dates for the cessation of all 35 LIBOR settings which are currently published. In terms of the Sterling settings, the FCA announced that the 1-week, 2-month and 12-month Sterling settings will permanently cease immediately after 31 December 2021. The FCA also announced that it would be consulting with ICE in relation to the continuation of the publication of a 1-month, 3-month and 6-month Sterling LIBOR on a non-representative, synthetic basis beyond the end of 2021 (pursuant to its new powers under the FS Bill), to assist with legacy contracts.

Documentation

In terms of revising the market standard loan documentation to incorporate SONIA, the LMA has produced drafts of multicurrency term and revolving facilities agreements incorporating rate switch provisions, draft multicurrency term and revolving facilities agreements incorporating backward looking compounded rates and forward looking interbank term rates (with one draft based on an observation shift approach and the other without observation shift) and drafts of single currency term and revolving facilities agreements incorporating backward-looking compounded rates. The drafts were all originally published as exposure drafts but were updated to LMA recommended forms in March 2021.

The LMA has confirmed that it is not at this stage working on facility agreements based on the forward-looking SONIA terms rates. However they have published a note of considerations in respect of the use of such rates.

 

COVID-19

The FCA issued a statement on 25 March 2020 confirming that, despite the on-going COVID-19 pandemic, the transition away from LIBOR should continue and the end of 2021 would remain the target date. On 1 July 2020, the Financial Stability Board echoed this message from an international perspective.

There has however been some movement in relation to certain milestones, including the date by which all firms should stop issuing LIBOR based products. Prior to the COVID-19 outbreak, this deadline was the end of Q3 2020 but due to the disruption caused by COVID-19, this was pushed back to the end of Q1 2021 (although banks were still expected to be offering SONIA based products by the end of Q3 2020). Given that the Q1 2021 deadline has passed, now is not the time for the market to slow its efforts to ensure a smooth transition away from LIBOR.

 

Further Information

For further information on issues raised within this blog, please contact Anna Shonfeld or a member of our Corporate and Commercial law team.

About the Author

Anna Shonfeld advises on a variety of financing transactions with a focus on real estate finance. She regularly advises borrowers on development finance, investment finance and refinances in respect of various property types including industrial units, hotels, science parks, offices, PRS and mixed use spaces. She often acts for high net worth individuals in connection with the acquisition financing or refinancing of prime and super-prime residential properties, and has experience of acting for both on-shore and off-shore structures.

 

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