EXIT LIBOR, ENTER SONIA (and others) Major Changes in Interest Rate Calculations
LIBOR is going
The London Interbank Offered Rate (LIBOR) has been a mainstay of financial contracts. It is central to derivatives, securitisations, bonds, loan notes and syndicated loans. But it is going in its current form. It is due to be phased out in 2021. The end of LIBOR will have significant implications, both for existing contracts linked to LIBOR, and for future contracts.
The Financial Conduct Authority (FCA) wrote to the CEO of each major bank and insurer in September 2018 asking them to provide, by 14 December 2018:
- A board approved summary of risks related to LIBOR discontinuation;
- Details of actions planned to mitigate those risks; and
- The identity of managers responsible for implementing those plans.
Businesses which utilise LIBOR, even those which have not been lucky enough to have received one of those letters, need to consider how they will deal with its ending.
How did we get here?
Commencing almost fifty years ago, LIBOR became the standard metric for the setting of benchmark interest rates in financial markets. It is difficult to overstate its importance. As of 1 August the total notional value of contracts referencing LIBOR was over $240 trillion.
LIBOR was formerly managed by the British Bankers Association. The BBA used a panel of major banks to establish, daily, the market rate in the London inter-bank market for deposits of varying periods (from overnight to twelve months) in the principal internationally traded currencies.
What went wrong ?
As banks came to rely less on wholesale interbank deposits the panel banks, which may not actually have been offered any deposits, increasingly used “expert judgment” to determine the rate at which they would notionally have been offered deposits. This “expert judgement” came increasingly to be used in setting LIBOR rather than actual offered rates. The artificiality of the question banks ask themselves has been articulated by one supervisor as: “Were I to borrow, which I am not, what might the interest rate be?” The answer to such a question is full of uncertainty, and so of risk. Following the 2008 financial crisis it became apparent that some, at least, of the panel banks had been manipulating the rate to benefit their own book. The upshot was that the BBA was stripped of responsibility for managing the process, which is now run by Intercontinental Exchange Benchmark Administration Limited.
That did not resolve all the issues. There remains the problem of lack of liquidity in the market, which undermines the reliability of LIBOR as a benchmark rate. It is not just that LIBOR is unreliable for market participants. The FCA, like other supervisors, concluded that the lack of liquidity, and related unreliability, posed a systemic risk to the whole financial system. These flaws, combined with the scandal surrounding LIBOR manipulation, resulted in the FCA announcing that it intends to phase out LIBOR by 2021. Regulators throughout the world’s principal financial markets have taken the same approach.
What is to be done?
It has not proved easy to establish a replacement for LIBOR. Indeed, despite the stated intention of the FCA to dispense with LIBOR, the value of LIBOR linked transactions has continued to grow. A great deal of effort has been put into analysing the problems and attempting to develop solutions, but there has not been much end product to show for it, and market participants became relaxed, with some sceptical about if and when the end of LIBOR would fully occur.
A series of coordinated developments this summer showed that there is no room for complacency, that change is going to happen, that it is accelerating and that it will continue to accelerate.
Bailey burns the Libor Bridges
First, Andrew Bailey, CEO of the FCA, delivered a well trailed speech on Interest Rate Benchmark Reform: Transition to a World without LIBOR. He reiterated that the discontinuation of LIBOR will happen and that firms must prepare for it. Even if LIBOR continues after 2021 it will undoubtedly become much less used. There are many reasons why this will happen and why businesses will have to transition away from it:
- Currently the FCA supports the LIBOR setting arrangements and encourages panel banks to submit rates. That will not continue after 2021.
- Primarily for risk reasons, panel banks are increasingly unwilling to quote rates on the basis of “expert judgment.” As more banks cease to quote, LIBOR will become increasingly unreliable and, as that happens, the reluctance of remaining panel banks to quote will only be enhanced.
- Bailey said that firms selling LIBOR-related instruments will have to disclose the risk to investors.
- If LIBOR becomes insufficiently representative, Bailey said that the FCA, as supervisor, may conclude that it no longer satisfies the requirements of the EU Benchmark Regulation.
Bailey’s speech was followed in quick succession by three further papers
- Interest Rate Benchmark Reform: Overnight Risk Free Reference Rates (RFRs) from the (International) Financial Stability Board;
- Consultation on Certain Aspects of Fallbacks for Derivatives Referencing LIBOR, CHF LIBOR, JPY LIBOR, TIBOR, Euroyen TIBOR, and BBSW from the International Swaps and Derivatives Association (ISDA); and
- Consultation Paper on Term SONIA Reference Rates (TSSRs) from the Bank of England Working Group on Sterling RFRs.
It is important to note that, although the regulators are very clear in their aim to end the use of LIBOR they are not being prescriptive about how it will be replaced. Their strong desire is for market participants to develop alternatives, with guidance and assistance from the regulators.
If not LIBOR, what?
In the UK the emerging alternative to LIBOR is the Sterling Overnight Index Average which goes by the more attractive acronym of SONIA. It is determined by reference to unsecured overnight sterling transactions negotiated bilaterally and brokered in London through the Wholesale Market Brokers Association. In 2016 the Bank of England itself took over the administration of SONIA, helping to enhance its credibility as an interest rate benchmark.
Whilst LIBOR has been set by a single body, future benchmarks will be more diverse. Alternative benchmarks, similar to SONIA, are being developed in the other four LIBOR currency jurisdictions. These are, in Switzerland, SARON, in Japan, TONAR and in the US, SOFR. The ECB and ESMA have set up a working group to develop an alternative index rate for Euros.
Depth of market and liquidity in the underlying market will be essential to the widespread acceptance of SONIA. There are clear indicators that this is now occurring at a pace.
- In April 2018 the Bank of England started publishing a reformed and strengthened SONIA. This resulted in an increase from 80 to 370 recorded transactions each day by the end of June. It is worth noting, by contrast, that, in the first six months of the year, there was an average of only two actual transactions per day that would qualify for inclusion in setting six-month sterling LIBOR.
- A major breakthrough was the £1bn SONIA linked floating rate note issued by the European Investment Bank in June 2018. There have been subsequent bond issues referencing SONIA by Lloyds Banking Group, Santander and Royal Bank of Canada.
- At the same time, both the ICE and LSE now offer trading in SONIA futures. The volume of SONIA cleared OTC derivatives has more than trebled over a year.
SONIA and LIBOR What’s the Difference?
SONIA is a genuine market rate. Unlike LIBOR, it does not use, and has no reliance on, rates reflecting “expert judgment.”
The fundamental difference is that LIBOR is a forward-looking rate for deposits of a variety of fixed periods. By contrast SONIA, as its name implies, is concerned solely with overnight transactions.
How do you solve a problem like SONIA?
Sonia works for Derivatives Traders
The biggest market which currently relies on LIBOR is the interest rate derivatives market. This market has no need for the term rates that are a well-recognised feature of LIBOR. It can operate with overnight RFRs, compounding them where that is appropriate. The FCA anticipates that liquidity in interest rate derivative markets will be grounded in Overnight Index Swaps (OIS), so directly linked to overnight RFRs, and that such liquidity will increase.
Sonia will not be a straightforward substitute in debt markets
The syndicated loan, securitisation and bond/note markets all rely heavily on LIBOR and some bilateral bank loans also reference LIBOR. Many participants in these markets require to know what precise interest rate will apply to determine payments at the end of the term, something which is provided by LIBOR. At the present, very limited progress has been made in developing RFR derived term rates.
Pending the arrival of such forward-looking term rates the FCA suggests using a backward looking compounded overnight RFR. That is to say interest is compounded daily by reference to overnight RFRs. The result is that the applicable interest rate is not known until the end of the period. That hardly seems an acceptable solution to parties requiring certainty at the inception of a loan arrangement.
The Bank of England Sterling RFR Working Group suggests that, over a period, as liquidity increases, it will be possible to develop a forward-looking term SONIA RFR, so allowing market participants to lock in a known rate at the start of a lending period. They suggest that such rates can be generated from the prices of derivatives which reference RFRs, such as OISs and futures. The logic for this is that these instruments provide information on market expectations of SONIA over a future period, i.e. equivalent to the term sought. The Working Group believe that, although there is sufficient liquidity in the SONIA OIS market to do this, that market is not yet sufficiently transparent to allow this method to be widely utilised with confidence.
It is clear that a good deal of further development work needs to be done before the debt markets can be confident that there is an acceptable substitute benchmark for term rates.
What will happen to existing contracts which extend beyond 2021?
Read the Contract
There will be many different arrangements. There are standard fall-back provisions in the template of the Loan Market Association (LMA). Historic fall-back arrangements are problematic in that they contemplate temporary unavailability of the LIBOR benchmark rather than permanent disappearance. They provide for a waterfall of substitute benchmark rates, ending with the individual lender’s cost of funds. This is pretty unsatisfactory for the borrower who loses the protection of an objective benchmark. But these fall-back provisions are often heavily negotiated: different consequences will flow from different agreements, even if both started from the LMA template.
Changing an existing contract to accommodate the new environment will not be easy. Necessary consents will be more difficult to obtain in some agreements than in others. This will be particularly true for bonds or notes which are widely held, perhaps by retail investors. A change to the basis of calculating interest is likely to require consent of a super majority, if not of all, bondholders. Where it is practical to change the agreement similar considerations will apply as where a new agreement is being entered into (see below).
The problems that may affect loans, bonds and securitisations are less acute in relation to derivatives but there are important issues. The ISDA Master Agreement has standard fall-back provisions for derivatives contracts and ISDA practice is to publish protocols providing for standard ways to implement necessary changes to contracts. The ISDA Consultation indicates that ISDA will publish a protocol to establish a LIBOR fall-back for existing swaps contracts governed by the Master Agreement. But a single protocol is unlikely to cover all situations. For instance, interest rate swaps are often used as hedging the rate under a linked lending transaction. At present both the loan and the swap will be linked to LIBOR but accommodating the end of LIBOR may produce different results in the two transactions.
What provisions should go in a contract being signed next week?
Market participants need to assume that LIBOR may not exist, and will certainly be highly problematic, after 2021. There does not currently exist a clear and agreed replacement for LIBOR. As mentioned earlier, regulators and market participants are gearing up to develop alternative solutions for contracts which commence after, or extend beyond, 2021. At this stage it is not possible to predict with any certainty what those alternatives might be.
The essential requirement therefore, where a reference interest rate is required, is to preserve flexibility so that, as market practice develops, any changes can be introduced with the minimum of complication. The LMA published its first guidance on the subject in “The Recommended Revised Form of Replacement Screen Rate Clause and User Guide”in May 2018. It provides slot-in drafting that allows changes to be made in a wider range of circumstances than at present, but it remains to be seen whether it will become accepted in the market.
ISDA has indicated that it will amend the Master Agreement to implement fall-back(s) for LIBOR. The fall-back is likely to be SONIA in relation to Sterling LIBOR.
What will happen after 2021 is an emerging picture. Readers should keep abreast of developments and consider carefully potential risks to their contracts in the light of those developments.
RW Blears LLP