LIBOR to SONIA – the final stretch of the transition
On the 9th February 2022, the Financial Conduct Authority (FCA) published a press release regarding the finalisation of the transition from the London Inter-Bank Offered Rate (LIBOR) to the Sterling Overnight Indexed Average (SONIA). Following the final publication of the one, three and six-month sterling and Japanese yen LIBOR (the ‘Applicable Rates’) on a panel bank basis on the 31st December 2021, the FCA reiterated that they as well as the the Bank of England (BoE) and the Bank of England (BoE) working group ought to continue to encourage firms that are contractually exposed to LIBOR to try and transition permanently to Risk Free Rates (RFR’s) such as SONIA. The FCA further reiterated that during 2022 they will seek views on the cessation of one month and six-month synthetic sterling LIBOR by the end of 2022 and on when to end the three-month sterling synthetic LIBOR.
This article will look overall at the transition from LIBOR to SONIA as well as the amendments to existing legislation allowing for the LIBOR to SONIA transition to occur and what firms need to do to minimise exposure to any legacy LIBOR contracts.
What is LIBOR?
LIBOR is an interest rate benchmark that is used by lending banks which outlines the average rate at which banks are willing to borrow wholesale unsecured funds on the London interbank market. The rate is calculated based on the submissions from selected panel banks in five currencies and a range of tenors.
LIBOR has been used by lenders and other financial institutions for decades as a reference point in the determination of the interest rate charged on various debt instruments whether this be in the form of loans, bonds or derivatives. LIBOR is significant because of its widespread adoption and understanding; it is estimated that over 100 million financial contracts have adopted LIBOR which total up to an estimated value of $300tn ($30tn in GBP markets).
The problems with LIBOR
The underlying market which LIBOR based on is no longer liquid nor the principal way for banks to borrow. In recent years banks have found alternative avenues to the interbank market to borrow sums. This reduction in liquidity of the interbank market has meant that LIBOR is no longer a reliable rate when measuring the real cost of borrowing.
Another issue is that LIBOR contains a term bank credit risk component in its calculation which is designed to provide lenders with compensation for adopting the risk of lending over a term period. This exposes borrowers to fluctuations in bank credit risk which makes LIBOR an unsuitable reference point to hedge the general level of interest rate (discussed further below). LIBOR also includes a liquidity premium related to the length of the interest period in its calculation.
LIBOR is a forward-looking estimate, it is calculated using estimates provided by the panel banks that carry out a forecast based on their current loan portfolios, which outlines the rate they estimate they could borrow funds in each of the maturity periods in the relevant currency on the interbank market. The problem with this was that each panel bank calculated their rate based on a different set of assumptions and adopted their own calculation methodologies which in turn meant that LIBOR was prone to manipulation. This vulnerability was exposed in the LIBOR scandal in 2008 when banks had submitted borrowing cost estimates that were far lower than the costs actually incurred in borrowing those funds on the interbank market.
As of 31st December 2021, the Applicable Rates are no longer calculated on a panel bank basis, instead it is now calculated using synthetic estimations so that it can be used by contracts which have LIBOR written into them akin to the Applicable Rates and are not able to transition to alternative rates (see further in the Tough legacy contracts, the Critical Benchmarks (References and Administrators’ Liability) Act 2021 (CBA) and the FCA’s tough legacy regime section below).
SONIA and the reasons for transitioning to RFR’s
In contrast to LIBOR, SONIA is a Risk-Free Rate (RFR); it measures the overnight lending rate paid by banks calculated and administered by the BoE. The BoE calculates SONIA based on actual and eligible transactions reported to it which reflect the trimmed mean of interest rates actually paid by banks to financial institutions and investors when borrowing unsecured wholesale funds overnight.
The reliability and risk-free nature of SONIA is derived from the fact that it is a rate which:
a. Is based on live transactions in liquid underlying markets as opposed to LIBOR which is derived from estimates provided by panel bank members and therefore vulnerable to manipulation;
b. minimises any credit risk component as it is backward-looking as opposed to LIBOR which is forward-looking and incorporates a credit risk component in its calculation; and
c. minimises any liquidity premium related to the length of the interest period.
SONIA has been published daily by the BoE since April 2018 and has tracked closely to the BoE base rate (see graph below). This further reiterates SONIA’s predictability and reliability as opposed to LIBOR which fluctuates (usually tracking higher due to the credit risk component in its calculation) when compared to the BoE base rate.
As SONIA is calculated on the basis of live transactions overnight, iIt is anticipated that SONIA in contrast to LIBOR is more flexible and adaptable to changing trends in the markets.
SONIA also unlike LIBOR does not incorporate a term bank credit risk component making it a more suitable and predictable rate to hedge the general level of interest rates.
Tough legacy contracts, the Critical Benchmarks (References and Administrators’ Liability) Act 2021 (CBA) and the FCA’s tough legacy regime (FTLR)
The term “tough legacy contracts” has been used to describe contracts which reference LIBOR but cannot be amended to transition to either SONIA or an alternative benchmark rate.
On the 15th December 2021 the CBA received royal assent and amended the UK Benchmarks Regulation (the UK BMR) to allow for the automatic transition of contracts referencing LIBOR after 2021 to the equivalent synthetic LIBOR rate. The CBA further includes protection provisions both for users of synthetic LIBOR as well as the ICE Benchmark Administration (IBA) (LIBOR’s administrator). Amalgamated with the FTLR the UK now has a dual pronged regime that deals with the use of synthetic LIBOR.
The first regime is demarcated by the CBA’s amendment to the UK BMR by inserting Articles 23FA, 23FB and 23FC into the latter legislation. The consequence of these amendments and the legislation itself is the following:
· In terms of scope the CBA applies to all contracts or ‘arrangements’ whenever formed, made under the laws of England and Wales, Scotland or Northern Ireland.
· If a contract incorporates a LIBOR rate which has been specified as ‘unrepresentative’ or ‘at risk’ by the FCA under Article 23A of the UK MBR then that rate shall be construed as referring to the synonymous synthetic rate regardless of its calculation methodology having been amended to being on a synthetic basis.
· The rates that have been selected to qualify for automatic transition are the Applicable Rates.
· Parties to a LIBOR referencing contract cannot argue that the automatic transition to the use of the synthetic rate constitutes a breach of contract, material change to the contract or frustration of the contract.
· Parties to a LIBOR referencing contract cannot sue the IBA for damages for any loss suffered due to any action or inaction it takes upon instruction by the FCA such as the amendment of its calculation methodology in the production of synthetic LIBOR.
· Parties can sue the IBA for damages on losses suffered due to any action or inaction attributable to the IBA which was done without instruction by the FCA or in response to a discretion provided to the IBA by the FCA.
· The effect of fallback provisions for loans and other LIBOR referencing agreements will depend on the type of fallback triggers implemented in the contract:
o Fallback trigger A – where the Screen Rate is ‘unavailable’ (as usually drafted in LMA facility agreements which have not been amended to include a ‘rate switch’ provision in anticipation of LIBOR cessation), the contract will transition automatically to the relevant synthetic LIBOR without the trigger being activated. A LIBOR referencing agreement that contains no fallback provisions would be treated in the same way.
o Fallback trigger B – where the LIBOR referencing agreement contains ‘rate switch’ provisions contingent on trigger events again usually seen in LMA facility agreements which allow for the use of an alternative rate once any of the events listed occurs. Under this circumstance the trigger should operate as drafted and an alternate rate may be used.
· The CBA will not apply if a contract or arrangement expressly provides that it does not apply.
· Any causes of action a party may have under a LIBOR referencing contract which exist before Article 23A designation will still be effective.
The second regime is encapsulated by the FTLR. The scope of the FTLR is applicable to ‘use’ as defined under the UK BMR and is applicable to all products other than cleared derivatives. Under this regime any institution or entity that falls within the definition of a ‘supervised entity’ under the UK BMR are not permitted to use the Applicable Rates after 31 st December 2021. The FCA have granted an exemption for tough legacy contracts and stated that supervised entities may continue to use synthetic LIBOR in all contracts that fall within the scope of the UK BMR except for cleared derivatives up to the 31st December 2022 (the date on which synthetic Japanese yen LIBOR will cease and the use of synthetic sterling LIBOR will be restricted although its use may continue for up to ten years under the UK BMR).
What does this mean for firms and mitigation of risks associated with LIBOR exposure
If not done already UK firms will need to start transitioning their existing LIBOR referencing contracts towards SONIA. Below is a simple two-step process for firms to follow to mitigate LIBOR exposure:
1 REVIEW OF EXPOSURE AND RISK ANALYSIS
- Review the LIBOR referencing debt instrument and any related agreements and assess LIBOR setting used.
- Perform a preliminary financial and legal risk assessment and assess benefits and risks of LIBOR migration to SONIA.
- Review fallback provisions in the agreement and check if the there is an automatic transition to synthetic LIBOR. Perform a further risk assessment of any automatic transition to synthetic LIBOR.
- Consideration of regulatory obligations.
2 ACTIVE REDUCTION OF LIBOR EXPOSURE
- Consider remediation/amendments of any LIBOR referencing debt instrument or related agreement with a maturity beyond 31 December 2021.
- Ensure any new debt instruments or agreements entered into reference SONIA as the interest rate benchmark.
- Set up an internal transition programme within your current corporate governance structure and make all stakeholders aware of the transition to SONIA.
The cost of transitioning to SONIA
The burden of costs associated with any amendment for the purposes of SONIA transition will be dependent on the terms of the loan/debt documentation. However, it is common for costs clauses to place the burden of costs on any amendments to the agreement requested by the borrower on the borrower. Under these circumstances one can argue that there is scope for a borrower to ask a lender to pay either in part or in full for the costs of amending any LIBOR referencing agreements they are a party to.
Another potential cost of transition that borrowers should bear in mind is the credit adjustment spread (CAS). The CAS is the term used for the adjustment that needs to be made to a lenders profit from interest payments when transitioning from LIBOR to SONIA. As stated earlier the former contained a credit premium element whereas the latter does not. Due to the lack of a credit premium element the rate of SONIA is lower than LIBOR, therefore, in order to ensure that the lender receives the amount in interest as initially agreed between the parties an adjustment needs to be made. The FCA has reiterated that the cessation of LIBOR should not be used by lenders as an excuse to increase interest rates, hence, CAS is used to enable fair economic value transfer for all parties. In respect of calculation of CAS the Sterling Risk Free Rates Working Group has recommended the use of a five year historical median for loans transitioning on LIBOR cessation based on the difference between sterling LIBOR and SONIA compounded in arrears over a five year lookback period. The International Swaps and Derivatives Association (ISDA) have also recommended a synonymous calculation for the derivatives market. In any event, the lender should provide a borrower with a basis of how they have calculated CAS when transitioning an agreement over to SONIA.
The transition from LIBOR to SONIA is now reaching its final stretch with Japanese yen LIBOR due to no longer be available post 31st December 2022 and with the future of sterling LIBOR very much uncertain, firms should now ensure that they review any exposure they have to contracts citing LIBOR with maturities beyond 31st December 2021 and put into effect a transition towards SONIA if not done so already. It is encouraged that firms endeavour to understand the risk and benefits of the transition to SONIA under their existing LIBOR referencing contracts and ensure that they have clarity on whether their contracts have automatically transitioned to synthetic LIBOR under the UK BMR and CBA. Lastly, it is further recommended that in order to protect themselves from unforeseen financial or legal risks firms should actively look to amend any current LIBOR referencing agreements and ensure that they have transitioned to SONIA as soon as possible.