Market transition from LIBOR to SONIA
Following the various travails of LIBOR over the last few years, the Bank of England set up the “Working Group on Sterling Risk-Free Reference Rates” that recommended, in April 2017, the Sterling Overnight Index Average (or “SONIA”) as their preferred risk-free rate for Sterling. Since this recommendation, the Working Group has focused on how to migrate from LIBOR to SONIA across Sterling markets.
From the end of 2021, Sterling LIBOR will no longer be available as the Financial Conduct Authority (“FCA”) considers that it will no longer be necessary “to persuade, or compel, banks to submit to LIBOR”.
The move away from LIBOR is inevitable and will impact a large variety of transactions such as debt capital markets securities, bank loans, hedging arrangements, and bank deposits among others. There will be a range of connected changes over the next few years and there are a number of areas in which we do not yet know the details.
But there are some natural areas for analysis and potential action in the short term such as the review of existing loan and hedging documentation, for the prevalence of LIBOR language and for the purpose of gaining a clear view around the vulnerability to changes imposed by counterparties without due process or fair consideration of corporates’ requirements. There as a risk that banks or other counterparties seek to impose outcomes on borrowers which are not fair and we have already seen examples of that and supported clients in negotiations on these points.
Since the picture will change over time it is important to follow developments as matters progress. There are some areas such as the adaptation of the payment basis for loans, where it seems possible that it may be left more to commercial negotiation between the parties.
Corporates should consider this transition as part of their treasury priorities. It is important to analyse the portfolio of affected (existing or anticipated) debt and hedging transactions, consider economic, accounting and operational aspects of the transition and monitor ongoing regulatory developments.
Where there are genuine commercial issues around changes to existing documentation, it is important to identify that and establish a strategy for achieving a reasonable outcome.
Centrus offers expertise in the technical issues and significant experience in supporting effective commercial negotiations. As independent corporate finance advisors we are expecting to increase the level of engagement with clients – which has grown over the course of 2019 – on this issue during the remainder of the year and into 2020.
The early 1980s saw a rise in the trading activity of a variety of new market instruments, notably interest rate swaps, foreign currency options and forward rate agreements. This movement led to the need for a uniform, standard benchmark to price this array of financial products. In October 1984, the British Bankers’ Association, working alongside the Bank of England and other interested parties, began work on a new rate. The “BBAIRS” term (British Banker’s Association Interest Rate Swap) was created, setting a standard for interest rate swaps, and in January 1986 the first London Interbank Offer Rate (“LIBOR”) was released.
LIBOR is constructed by taking quotes from a range of banks on how much they would be charged in interest to borrow money on a short-term basis from another bank. The outliers are excluded and an average is taken, which is published at 11 am (London time). LIBOR is calculated by the Intercontinental Exchange (“ICE”) and published by Thomson Reuters. It is published across five currencies and in a range of tenors.
LIBOR and other “IBOR” rates have historically underpinned a huge range and volume of financial transactions and they have been entrenched within the global financial system.
This paper focusses just on the UK and Sterling, where GBP LIBOR is used by borrowers and lenders, including banks and financial institutions, as the reference rate for various corporate debt instruments. IBORs are also used as a benchmark for mortgages, government bonds, credit cards and student loans in various countries, along with various other “non-financial documentation” uses such as insurance valuations and late payment clauses in commercial contracts. Apart from debt instruments, LIBOR is also used for other financial products such as derivatives including the mainstay vanilla products of interest-rate swaps and cross-currency swaps.
Causes for the transition away from LIBOR
Most of these uses would logically have started with a risk-free rate but of course in the real world there is no such thing as a completely risk-free rate (even overnight). LIBOR was understood not to be truly risk-free but was seen as a robust benchmark and with a relevant grounding in the extensive market of inter-bank lending, which of course prior to the financial crisis was in any event seen as pretty low risk. However, the financial crisis and subsequent ongoing changes to the financial system over the last decade have left it looking a great deal less robust.
There are two main causes, apart from greater awareness that banks are not risk-free institutions:
- firstly, the reduction in the scale of inter-bank lending;
- secondly the challenge presented to the credibility of LIBOR from the realisation that a number of participating banks were manipulating it for their own benefit.
In 2012, following substantial fines being imposed on various international banks, the UK government conducted the Wheatley Review which called for reform of LIBOR. Across the globe, similar changes are being made to the other IBOR rates.
In 2015, the Bank of England set up the “Working Group on Sterling Risk-Free Reference Rates” tasked to develop alternative benchmark risk-free rates (“RFRs”) for use instead of LIBOR.
In April 2017, this group recommended the Sterling Overnight Index Average (or “SONIA”) as their preferred RFR for Sterling. The main perceived benefit of SONIA, which itself has been around for a while too, is that it is based on daily transactional data rather than quotes from participants as to what they claim they would be charged. Since this recommendation, the Working Group has focused on how to migrate from LIBOR to SONIA across Sterling markets.
From the end of 2021, Sterling LIBOR will no longer be available as the Financial Conduct Authority (“FCA”) considers that it will no longer be necessary
to persuade, or compel, banks to submit to LIBOR” or “to sustain the benchmark through our influence or legal powers.
Andrew Bailey, Chief Executive of the FCA, summarised the real-world issues with LIBOR neatly in a speech he gave in July 2018, observing that:
[SONIA] is now supported by an average of 370 transactions per day… the average daily count of deposit transactions that would potentially qualify as inputs to six month LIBOR – the most commonly used of the sterling LIBOR rates – was just 2 in the past 6 months. LIBOR could not achieve the same robustness as SONIA even if the LIBOR panels included all banks in the market. SONIA, unlike LIBOR, does not use, and has no reliance on submissions based on expert judgement.
The following chart summarises the timeline:
The FCA is concerned that preparations are not as advanced as they would like but appear to be holding fast to their intention to move away from LIBOR. The Centrus view is that this is going to happen. Even if the Bank of England does not use regulatory action to stop or discredit any attempt to keep publishing LIBOR, it will be discredited and no one will be required to make submissions after 2021. Banks will not want to provide this legacy data and to take the unnecessary reputational and legal risks involved.
There are two clear strands to effecting a change-over: firstly, transitioning away from LIBOR in new contracts, and secondly dealing with LIBOR in legacy contracts including potentially some challenging negotiations with investors and hedge counterparties.
The following table summarises the key issues for corporates:
SONIA is administered by the Bank of England and was recommended in April 2017 as the RFR replacement for LIBOR by the Working Group referred to above. SONIA is a rate paid on wholesale unsecured overnight loans. It has been in existence since 1997 and has recently been reformed to include a wider pool of transactions in preparation for its use as the Sterling RFR. Other countries have made similar choices although, for example, the US is using a rate based on repos (the “Secured Overnight Funding Rate”).
SONIA is calculated as the weighted average of the interest rates charged for all unsecured loans reported by market participants in the London overnight market. Only deals of £25m or more are considered as part of the average. It is a daily rate and has no term structure. SONIA-based financial instruments at present accrue interest using the daily rate which is then compounded over the relevant time period and of necessity calculated in arrears.
SONIA is constructed from actual transactions rather than quotes provided by banks (as with LIBOR). Using this methodology should, in theory, reduce the possibilities of market manipulation. SONIA is already used as the reference rate for Sterling Overnight Indexed Swaps (“OIS”) a simple interest-rate derivative swapping a fixed-rate leg against the SONIA floating rate over a set period.
Some Centrus clients may be familiar with SONIA from our daily market data sheet where we provide the spread between 3-month OIS swaps, based on SONIA, and 3-month LIBOR, as a measure of perceived risk in the banking system. In a credit-risk-free world they would be very close.
Lending a bank money at (say) three-month LIBOR involves taking credit risk for a fixed three-month period on the principal lent, unlike a swap, and therefore a larger spread between the two is seen as indicative of greater concern over bank credit quality.
The chart below illustrates the spread between SONIA and LIBOR over the past 10 years. It can be seen that the spread differs between LIBOR tenors – the six-month rate captures more risk than the one-month, so the spread is different and the adjustment one would apply on transition should reflect this.
Some clients are monitoring the spread closely for market opportunities to lock in a beneficial difference now (rather than take the risk of the spread narrowing between now and 2021) and there is a case for taking action, should opportunities present themselves e.g. explicitly to restructure to SONIA-based positions.
SONIA – LIBOR Spread
The immediately obvious comment to note, looking at the chart, is that there is quite a lot of movement in the basis spread, as well as the differences depending on LIBOR tenor. It is sufficiently material and volatile that anyone with existing LIBOR-based positions (loans or derivatives) ought to care about the fact that the transition will not simply be to cross out “LIBOR” and replace with “SONIA”.
SONIA Funding – Lack of Term Structure
There is a key practical challenge with the abolition of LIBOR. The LIBOR index is published daily on various terms including one, three and six-month forward-looking periods, but SONIA is published daily first thing in the morning just as a (historic) overnight rate. A loan which simply references SONIA over a period would require daily compounding, taking the realised fixing for each day in the interest period and compounding it for a calculation at the end.
Alternatively, a “Term SONIA Reference Rate” could be used, for example with expected average SONIA used over a given period. It is important to realise that at present there is no such “term product” in existence and should one be created it will require a set of agreed practices around what market data is used and how.
For bank financing, and particularly for smaller corporates with limited operational resources, the lack of term structure is a key practical issue. The example below illustrates how the two basic concepts – daily calculation vs. a term product – might each work for a one-year facility with quarterly interest payments.
In our view a central question here is whether we really do need to have a term structure to the market RFR. Settlement on derivative transactions could simply work with a “backwards-looking” daily-compounded rate. There would then be a basis mismatch if loans used a forward curve set at the start of each roll period so there is an argument for everyone simply to move to the SONIA-referencing approach. That is not what many smaller corporates presently want, but it does seem possible that larger corporates (and banks) will prefer to align loans and derivatives and rely on a single benchmark, SONIA, and that the “term structure” concept may as a consequence fall by the wayside, at least for these larger businesses (another possibility for smaller borrowers is the Bank of England base rate, which regulators appear not to prefer).
Whilst not knowing one’s interest costs part-way through a roll period seems less than ideal, arguably the risk is not so different from not knowing the interest payment for the following period, assuming that at least some loans will continue to be drawn in that next period and there is limited planning that can be done around the costs (assuming they are not hedged).
The challenge around this level of change is partly just perception but in the financial world “perception” quickly of course becomes “trust” and if regulators want one thing they want
people to trust the system. Smaller corporates are perfectly happy being able to budget on the basis of interest rates which are known at the start of each roll period, and it requires less in
terms of a data and systems overhead and cost.
So we may end up in a world with some agreed basis for calculating a series of look-forward term rates, based presumably on OIS market data, or in a world with everyone using SONIA for loans. The latter represents the bigger change from a “common sense” perspective but the former is arguably more complicated and indeed we would then probably see a split of product types with some corporates preferring to stick to SONIA for loans as well as derivatives.
The following table summarises the current state of play for different markets:
SONIA in Debt Markets
There has been significant movement towards adoption of SONIA in debt capital markets. Financial institutions led the transition to SONIA-based instruments in relation to new floating-rate notes (“FRNs”), with SONIA used for all (around 50) public Sterling FRNs in 2019 to date and with some legacy transactions also moved over to SONIA.
Emerging practice appears to be to take a simple approach to one practical issue, the timing of interest calculations: interest payments are based on SONIA, compounded on a daily basis, for a “lagged” period ending five business days before the coupon payment. This means that there is in principle enough time to perform the calculations before initiating cash settlements and this is emerging as the standard approach. Margins tend not to be compounded; they are simply added to the compounded risk-free rate (and one expects any LIBOR/SONIA adjustment to be treated the same way).
The banking market is materially behind. Most lenders are accepting the Loan Markets Association (“LMA”) broad-but-sensible drafting for replacement “screen rates” released on 17th October 2018, but some are insisting on full discretion. The work on transition of legacy loan agreements has so far made little progress although banks are increasingly indicating willingness to move forwards with engaged borrowers, and a relatively common talking point has been the approach to new revolving credit facilities (“RCFs”). LMA have also recently published an exposure draft of a compounded SONIA-based sterling term and RCF document.
SONIA in Derivatives Markets
LIBOR is of course used in the calculation of many derivatives’ cash flows and their mark-to- market (“MTM”) valuations. There is a “SONIA market”, which is significantly more progressed than SONIA funding, with SONIA derivatives – such as OIS swaps described above – being traded in the Over The Counter (“OTC”) market since the inception of SONIA in 1997. OTC contracts are traded directly between two parties without the supervision of an exchange so potentially present practical issues around data quality and consistency. But there is significant cleared volume now and London Clearing House now reports that while the notional of outstanding GBP OIS swaps is less than that of conventional swaps, the trading volume is higher in OIS.
The fact that SONIA is gaining traction in the hedging market means that the basis can be observed and inform a strategy for converting trades across.
Potentially liquidity will thin over time in the LIBOR swap market more materially. Whether or not that will happen before regulators take decisive action is not clear. Three-month SONIA futures also have now been launched and slowly grown in volume. Since market participants frequently use the very liquid futures market to construct discount curves at the short end, this is an important complement to the development of a swaps market.
The transition of legacy contracts to SONIA would be expected to be on the basis of a spread being added to the SONIA floating rate. The International Swaps and Derivatives Association (“ISDA”) has run several consultations looking at “fall backs” (in ISDA language i.e. fall-backs for when the relevant IBOR is no longer published) for the situation where LIBOR and other IBORs are permanently discontinued – see consultations here. The 2018 consultation showed that a majority of respondents favoured using the compounded setting in arrears methodology with the spread adjustment on the basis of the observed historical mean or median difference.
As noted above, for FRNs the emerging standard approach is a compounded RFR with a five-day lag. In the context of derivatives, sometimes a lag is used but they don’t tend to have the same five-day lag as cash products. This has a hedge accounting implication: for 100% effectiveness clearly one would want the same lag applied to both. An alternative is potentially to time transactions e.g. trade swaps five days before the relevant hedged loan, but there is a risk of unhelpful complexity here. It would make most sense for corporates who use derivatives only for hedging purposes to be able to avail themselves of the same market conventions in both cash and derivatives markets.
The areas under ongoing discussion include how to calculate the spread adjustment (as median or mean of historical data, and over how long in terms of the historic data and subject to what calculation conventions); whether there should be a transition period and how that should work, and whether one has a lag (like described above for cash products and if so how many days) or alternatively simply ‘repeats’ of the last calculation day several times to make the full period whilst giving knowledge of the calculation result in good time.
In terms of the spread adjustment the front runners appear to be using five years of historical data and a median of that, or 10 years and a “trimmed mean”. One important subtlety is that the adjustment will potentially vary by tenor e.g. 1 or 3-month LIBOR will have different spread adjustments because the difference from SONIA varies as shown above. ISDA have published some analysis of their own and also have announced that Bloomberg will produce and publish various data to support the transition and afterwards.
Application to SONIA to existing derivatives trtansactions
There is an obvious directional preference for “the rate” in terms of corporates vs. banks in many cases. However, there are important nuances in the treatment of historic swaps and other derivatives. The same issues largely apply to fixed rates within loans where the ‘break’ cost involves a cost indemnity similar to swap close-out language (indeed such provisions often use ISDA jargon although post-ringfencing the banks are tending to prefer language which does not explicitly use ‘derivatives language’ and gives them more flexibility).
- Firstly, “the rate” features in two parts of the calculation: the determination of the floating rate leg in, for example, an interest-rate swap and (ii) the determination of discount factors for discounting future payments.
- Secondly, MTM is used for various reporting reasons including in statutory accounts, with or without the overlay of hedge accounting, but alongside (i) financial reporting purposes it is used for (ii) calculating the economics of restructures including close-out payments and (iii) determining collateral requirements.
As regards the first point the easy part is the determination of the floating-rate leg: an adjustment will in due course be promulgated by ISDA, hopefully, informed by the above mentioned consultations. We will have to see how complex an approach they land on. A swap which was “LIBOR vs. x%” will become “(SONIA + y%) vs. x%”.
The discount rate – the second limb of the “the rate” bullet point above – is much more complicated. It is seen by banks, in the main, where there is the requirement to collateralise positions (regardless of any unsecured threshold) in cash or a reference in documentation to a price calculated on that basis, that the discount rate used should be based on the SONIA discount curve i.e. the OIS market. If you are “out of the money” naturally one might prefer to be using a heavier discount rate. The position where there is no collateralisation with cash is less clear-cut but in practice we frequently see banks stake out the same position. There is some logic to this: SONIA and OIS are the best approximation to a risk-free rate and a cash collateralised derivative is (nearly) free of counterparty risk and moreover any interest earned on collateral will be earned at SONIA.
For borrowers with large negative MTM positions the difference between this and LIBOR discounting can be material. A bank has recently made a case, for a restructure we were advising on involving an interest-rate fix embedded in a loan and with a life of around 50 years, that they were sufficiently wedded to using SONIA that even using the (slightly higher) gilt rate was unreasonable, let alone using the LIBOR swap curve to determine discount factors for the future cash flows. We observed that it was perhaps a coincidence that this served their commercial interests but in fairness the banks have been using this for both sides of their balance sheets for some time and the view has a modest amount of merit. But it is not clear cut. Arguably the more pertinent commercial point is that when the transaction was entered into the market standard was LIBOR with its implicit bank credit risk element and any closeout might reasonably reflect that original implicit agreement.
To conclude on this particular area: our view is that on voluntary early termination of hedging positions, corporate clients should review the documentation and if it makes explicit reference to “cash collateralised price” then the bank will likely propose use of a SONIA discount curve and this approach has some merit. But banks do not have 100% of the argument and the corporate may wish to take a view in the broader context of the relationship. Where there is no such clear nod to cash pricing, our view is that there is a rationale for LIBOR discounting with a view to sharing in the funding benefit of closing the position out and the reduction in counterparty risk for the bank.
Without wishing to explore every nuance in this short paper, there is a connection here to the application of valuation adjustments for credit risk and funding costs. To the extent that banks are required to provision against valuations for these reasons there ought also to be room for manoeuvre in the calculation of close-out prices and any lack of movement represents a rather one-sided outcome. While the commercial reality may be that the close-out is a request of the corporate, that does not need to set a precedent for others and any corporate finding itself on the losing side of these arguments involving a material sum may wish to consider the implications for future business. There may be merit in proposing a unified front across certain sectors or products but at the time of writing the consideration of these issues is at a relatively early stage. It is worth noting that these valuation adjustments do not apply to embedded fixes, common in some sectors e.g. housing associations.
Turning to the second bullet point above, the wide set of uses for derivatives MTMs, the basic principle is that they should all be the same. Accounting for derivatives is supposed to be about “fair value”, so is hedge accounting, so are actual transactions (witness the above commentary on debates over discount rates) and so of course are collateral requirements. Having said that, should a reporting entity find that its banks insist on SONIA discounting but there be no intention to restructure and a view that LIBOR-discounting, perhaps with an adjustment for credit risk, is more appropriate for financial reporting, then these in-principle identical numbers could easily diverge.
Impact on clients
We have referred or alluded to the main issues arising from the abolition of LIBOR (and other IBORs) in the above analysis, but to summarise:
- Timing of changes for new contracts and existing contracts
A wide range of existing and new contracts will need references to SONIA. We can predict with a reasonable level of confidence that there is scope for real wrangling over aspects of this.Most financial instrument documents include provisions to guide how the interest rates would be set if LIBOR is no longer available, but these are not the solution as they are typically drafted just around temporary disruption.Fall-backs ought to be based on the relevant RFR, with an adjustment to minimise any value transfer at the point at which the fall-back is triggered. Both ISDA and LMA are now engaged but it is work in progress. One scenario is that we see ISDA arriving at reasonable conclusions on the adjustments for LIBOR legs in swaps which can then inform the approach to other products, but cash products such as loans are bilateral documents which any regulator or industry body will be reluctant to try and dictate changes to.Some clients have considered delaying the raising of new RCFs on the basis of waiting for their lenders to be able to document based on SONIA. This has some merit so long as liquidity is adequately protected but it could easily become a case of the ‘tail wagging the dog’.The timing of change-over to whatever is the new approach is itself quite complex. ISDA have recently run a consultation on “pre-cessation triggers” which yielded inconclusive results. The question is whether to transition (i) only when there is a permanent cessation of publication of LIBOR, (ii) at an earlier time when there may be an indication e.g. from the FCA that LIBOR is “no longer representative”, which for regulatory reasons FCA may be obliged to make and which may be clearly the case, even if LIBOR does continue to be published (this is the “pre-cessation trigger” concept), or (iii) on an even earlier date which is commercially agreed between the relevant parties albeit presumably using the technology then anticipated for cessation.Naturally FCA have a preference for people making their own arrangements rather than leave the entire responsibility to them as the regulator – they favour the last option. Edwin Schooling Latter of the FCA gave a speech in January where he said:
“We think that the best and smoothest transition from LIBOR will be one in which contracts that reference LIBOR are replaced or amended before fallback provisions are triggered. It will likely be in market participants’ best interests to have moved away from LIBOR contracts to ones based on the RFRs before liquidity in LIBOR-referencing contracts has significantly declined. In the early days of transition there was the question of who would have the boldness and agility to be among the first to move away from LIBOR to initially less liquid alternatives. When we approach the end of that transition, we may instead find reluctance to be the last to remain on LIBOR. Many, I hope, are therefore likely to close out or convert their LIBOR contracts before fallbacks are needed.”
Our view is that it makes sense to be pro-active subject to the following three prerequisites:
- An adequate level of management time and operational resource to enable success in preparation and implementation for whatever level of change is sought;
- Sufficient engagement at board level to enable decisions to be made, and
- Lenders / swap counterparties which are able to provide or agree the pricing data as well as agree something reasonable commercially, such that one can rationally conclude that one is not better off waiting.
In this situation it makes sense to look at the possibility of transitioning to SONIA for some loans and swaps, potentially with the same bank and ideally broadly offsetting each other in risk and accounting terms. Undertaking a modest-sized transaction on this basis can be seen as a sensible exercise in risk management. If it is more a matter of ‘proof of concept’ then equally it could be a new transaction, e.g. RCF.
- Term structure
We discuss above the potential outcomes regarding whether or not there is to be a “Term SONIA”. Either outcome may affect treasury policies and commercial strategies as well as accounting presentation and operational matters such as budgeting and systems. Several commercial data providers have indicated that they are working on a Term SONIA but there does appear to be a risk that this product, should it be produced, will lack market acceptance or liquidity.Our view is that larger businesses and particularly those using derivatives for risk management should assume that they will not use a Term SONIA product even if it becomes available.
- Operational Risk
Changes to legal documentation, treasury systems, data sources, internal models and pricing curves used throughout an organisation introduce significant operational risk. It will be important not just to leave this to a couple of individuals in isolation and organisations should consider putting appropriate governance arrangements in place to manage the process and ensure that appropriate resource is available. The systems aspect affects many areas from cash management to financial reporting.Changes in the benchmark being used and calculating the relevant spread applied to existing LIBOR contracts introduces an element of conduct risk, perhaps more so for banks and investors but also for borrowers e.g. in relation to risk reporting in prospectuses.
- Hedge Accounting
Moving hedging to a SONIA basis may create ineffectiveness in any hedging relationships with the basis risk introduced. The basis difference would arise if actual positions were more different to e.g. a cash flow hedge’s “hypothetical derivative” than they already are (many are identical but it is relatively common to run with a basis mismatch between loans and swaps). This area may entail changes in accounting standards but even if that is not necessary there will be an exercise in auditor engagement and ensuring that there is a clean narrative from documentation to calculation, particularly if there are material transition measurement issues. The IASB has indicated that there will be a period of a ‘relaxed attitude’ to this issue but that will presumably not last indefinitely.Changes to hedge relationships and measurement could have a material impact on P&L if efficiency of relationships is significantly impacted, although in practice it may be that the impact is not great compared to the levels of ineffectiveness which already exist in many portfolios.
- Liquidity in new underlying markets
Liquidity in SONIA products needs to develop over time and momentum is needed to drive the transition across the market. Given the clearer direction now on the RFRs, momentum is likely to continue to develop. For markets to develop properly they need participants who are informed and have clear objectives and this needs to involve corporate market participants as well as the banks.
Terminology in derivatives contracts determines the potential unwind costs for a derivative. Take for example a standalone swap: if the unwind clause is stated as “cash collateralised price” there is more rationale for an unwind value based on SONIA discounting, whereas if this is not included LIBOR discounting has merit. This is discussed in detail above along with related matters such as collateral calculations. Given SONIA is lower than LIBOR, for out-of-the-money positions (the common position for any older position given falls in rates over the last decade) this results in “less heavily discounted” discount factors and a greater break cost to the corporate.The position needs to be considered further once full clarity emerges with regards to the changes to the floating swap leg i.e. the spread adjustment.In the meantime, we are seeing an increase in client activity considering the appropriate format for their hedges and clients are beginning to consider moving derivative contracts to a SONIA basis or, when entering into new transactions, undertaking these on a SONIA basis.
Centrus can provide support for this whether in terms of analysing the commercial significance of the various scenarios or advising on strategy given existing relationships.
Conclusion and Next Steps
There will be a range of actions over the next few years to address this change. There are some natural areas for analysis and potential action in the short term:
- Establish an overall action plan and view around timing – a timeline for how the organisation anticipates implementing LIBOR reform may be useful as part of planning.
- Review existing documentation, both for the prevalence of LIBOR language (which should not come as a surprise hopefully) but also for the purpose of gaining a clear view – based on existing drafting – of the vulnerability to changes imposed by counterparties without due process or fair consideration of corporates’ requirements.
- Consider the adequacy of existing treasury systems, from spreadsheets and day-to-day procedures to systems and data provided by third parties. Businesses should expect insight and support from service providers in preparation. Particularly if there is an intention to adopt SONIA-based products “ahead of time” it will be important to have systems which are able to cope with that.
- Review of hedging strategies and documentation for the latitude in relation to this change and the potential impact in terms of hedge effectiveness.
- Derivatives valuation: there is a level of acceptance in the banking market for using SONIA for discounting (i.e. valuation), but room for debate and if corporates have concerns on this front they should raise promptly. This debate affects valuation for transactional and collateral purposes as well as financial reporting.
- Strategy for new transactions i.e. whether to move to using SONIA products; also whether or not to push for a forward term structure for loan rate re-sets.
- Strategy relating to existing positions i.e. whether to transact away from LIBOR before a solution is imposed or whether to make an informed decision to wait. In due course a consensus solution may be reached and (effectively) imposed. It is appropriate to document the reasons for either approach, even if the immediate action is “wait and see”.
- If looking to execute changes or SONIA-based new transactions, whether to work with other market participants or e.g. industry bodies, or to pursue bilateral discussions.
- The move away from LIBOR is a regulatory decision that will affect debt capital markets, bank markets and derivatives transactions. It will be fully in effect from 2021 but the picture will emerge over time and it is important to be on top of the stage of progress.
We recommend that treasury teams should:
- Prioritise this theme going forward and monitor developments
- Analyse the portfolio of affected (existing or anticipated) transactions
- Consider what approach to adopt in relation to existing and new loans (and FRNs where relevant)
- Consider, where relevant, what approach to adopt in relation to historic rate-fixing and derivatives positions, and new ones
- Consider economic, accounting and operational aspects of the transition
- Develop a clear plan and consider what level of reporting to boards and senior management is appropriate.