As mentioned in our recent Law-Now, one of the documents published in January by the Bank of England, the FCA and the Working Group on Sterling Risk-Free Reference Rates (Sterling Working Group) is a paper (the Working Paper) from the Sterling Working Group firmly setting out its view that overnight SONIA compounded in arrear (SONIA CIA) should be the primary vehicle for LIBOR transition, ahead of any prospective Term Sonia Reference Rate (TSRR). On Wednesday last week, the Bank of England published a discussion paper: Supporting Risk-Free Rate transition through the provision of compounded SONIA (the Discussion Paper) in which the Bank seeks views on the publishing of various SONIA calculations to ease the transition from LIBOR to SONIA referenced products. In this Law-Now we discuss the current state of play in the loan markets and the proposals in both the Working Paper and the Discussion Paper.
Since July 2018, the FCA has been encouraging market participants to actively transition from LIBOR to risk free reference rates (RFRs) as alternative benchmarks, rather than pursuing its previous proposals to reform LIBOR. RFRs measure secured or unsecured overnight borrowing costs in the financial markets. SONIA (Sterling Overnight Index Average) is described as (near) risk-free because the overnight transactions that make up the underlying data reflect nominal or minimal credit risk.
The Sterling Working Group has chosen SONIA as its recommended RFR and aims to facilitate a transition to SONIA by the end of 2021 across the Sterling derivative, bond and loan markets.
In the derivatives market, the Sterling Working Group predicts SONIA will soon become the most common benchmark and this is supported by the joint statement from the Bank of England and FCA in January encouraging market makers to switch to SONIA imminently on 2 March 2020. As regards the bond market, the Sterling Working Group notes that SONIA CIA “has become the market norm for floating rate Sterling bonds and there is strong liquidity developing for securitisations that reference [it].”
The Working Paper notes there has been slower progress in the loan markets, but nonetheless the Sterling Working Group has set a target for the markets to cease issuing GBP LIBOR-based cash products maturing beyond end 2021 by the end of Q3 2020. The Working Paper positively comments on the barriers and the work currently underway to address these such as updating of IT and treasury management systems, the LMA’s work on standardising documentation (see below further), and the gradual establishment of market conventions as new SONIA CIA loans are being executed in the market, albeit in limited pilot schemes and specific circumstances.
SONIA CIA v TSSR
SONIA is an overnight rate and calculated on a backward looking basis.In order to use SONIA CIA to calculate interest over a longer period, the current preferred approach is to use SONIA CIA over a period that starts before the interest period and finishes before the interest payment date (the so called “lag approach”). The reason for the lag is to allow interest to be calculated prior to the end of the interest period, giving the borrower time to arrange payment due at the end of that period.A TSRR would be a forward-looking reference rate based on overnight SONIA, which would work operationally and in documentation in a similar way to LIBOR. The Working Paper notes that FTSE Russell, ICE Benchmark Administration, Refinitiv and IHS Markit are each working on developing a TSRR, and the Sterling Working Group expects a TSRR will be published this Q1 for observation with an agreed TSRR available for use later this year.
However, the Sterling Working Group supports the UK authorities’ preference for a broad-based transition to SONIA CIA and advises that the use of a TSRR will only be appropriate for borrowers which cannot operate with an in arrear rate or where they have very simple needs.The Working Paper states confidently that use of SONIA CIA is “appropriate and is likely operationally achievable for approximately 90% by value of the Sterling LIBOR loan market”. The Working Paper outlines the arguments for SONIA CIA as follows:
- it is more robust than a prospective TSRR;
- it will work more consistently with the derivatives markets and enable more effective and cost- efficient hedging;
- it will work more consistently and reliably across multiple markets; and
- term rates may not be available in all currencies, and SONIA CIA will work across multi-currency facilities.
As regards the remaining 10%, the Sterling Working Group expects these transactions would require fixed rates, Bank of England’s Bank Rate or a TSRR, but that these alternative rates will need be required for specific circumstances only, and notes that further consideration is necessary for trade and working capital facilities using discounted cash flows, Islamic finance, and project and real estate finance transactions.
Call for Action
In line with the appeals by the FCA and Bank of England in January (see our previous Law-Now), the Working Paper calls for firms to engage urgently on LIBOR transition to SONIA CIA, and assures the market that a further task force will be working hard to overcome the remaining obstacles in the loans market and to address the specific considerations for the more complicated transactions in the remaining 10%.
The LMA is also looking to drive further engagement on the transition from LIBOR to SONIA, specifically looking at the various conventions and consideration of credit spread methodology which the market needs to establish in order to progress the transition to SONIA CIA operationally with finalised methodology and systems. In further support of the Sterling Working Group, the LMA urges market participants to progress with SONIA CIA rather than wait for the TSRR, and is seeking responses on its exposure drafts of (a) the term and revolving facilities agreements, based on SONIA CIA and SOFR (see our Law-Now in September) and (2) its reference rate selection agreement for legacy transactions.
To further focus attention, on 20th February the LMA issued a note outlining the outstanding requirements for finalising its exposure drafts, namely:
- the formula for calculating the Fallback Compounded Rate; and
- agreement on key conventions, including whether to compound the rate or the balance, and whether or not to use an observation shift, application of floors and rounding.
Bank of England Discussion Paper
In effectively an acknowledgment that the market infrastructure to support SONIA CIA as the main alternative to LIBOR was not yet ready, the Bank of England published its Discussion Paper to assist in the acceleration of the adoption of SONIA as a reference rate in Sterling markets.It is seeking views on the publication of two indexes, a SONIA Compounded Index and a SONIA Period Average.
The Discussion Paper notes that although compounded SONIA is already established for use in the Overnight Index Swaps market and in the sterling floating rate bond market (see also above), it requires a number of data points to calculate that may not be easily available to corporate borrowers.As such, following a range of feedback given to the Bank, it was clear that market participants wanted a trusted calculation source against which rates published by other providers could be checked.
A SONIA Compounded Index would, in the Bank’s view, simplify the calculation of compounded interest rates by:
- making it easier to calculate compounded interest rates with only 2 data points required (compared to the 60 (one for each business day) needed to calculate SONIA CIA for a three month interest period);
- creating a set of conventions that would reduce uncertainty and confusion amongst users around calculation methodologies; and
- providing flexibility to calculate SONIA CIA for any combination of start and end dates to a period.
The other proposal by the Bank is that it publishes a simple set of compounded SONIA Period Averages in order to give market participants access to a SONIA interest rates compounded over a range of set time periods (e.g. 30 days or three months).
The SONIA Period Averages would provide further simplicity by publishing compounded rates that could be directly referenced in contracts.They would not cover every reference period used by market participants but in the interests of simplicity and utility, only be a limited set of periods of time.
Through the Discussion Paper, the Bank is seeking market consensus on the conventions to be applied for these period averages.Those conventions would require reaching consensus on an unambiguous start date for each day a period average was published and the annex to the Discussion Paper sets out three alternatives that the Bank is proposing could apply:
- reference periods of exactly 30, 90 and 180 days;
- reference periods of exactly 1, 3 and 6 months; or
- reference periods of exactly 1, 3 and 6 months adjusted to start on a business day using the “modifying following” convention.
The Bank is encouraging market participants to answer a series of questions on their Discussion Paper by the 9th of April.
Responding to the Bank of England and the LMA
If market participants and other users would like to respond to the issues raised in the Discussion Paper and/or the LMA’s exposure drafts, CMS is well placed to assist you in considering the issues and providing a response.Please contact your usual CMS contact or any of the people below.