LIBOR discontinuation in the loan markets: Is compounding SONIA the answer?

Tim Rennie and Darren Phelan, respectively a partner and senior associate at Ashurst LLP, recently represented National Westminster Bank plc on the first SONIA-based loan, which was made available to National Express Group plc.

In this article they provide the background to (i) the issues that have faced LIBOR; (ii) introduce SONIA; (iii) contrast the differences between LIBOR and SONIA; (iv) consider how SONIA can be used in the loan markets; and (v) finally examine the issues that need to be overcome with a SONIA-based loan.

KEY POINTS

• LIBOR is a benchmark interest rate that is currently used in c.$300 trillion of financial contracts. The Financial Conduct Authority has advised that LIBOR may not be supported after 31 December 2021.
• In the absence of a SONIA term rate, compounding SONIA calculated with a lag is becoming the likely alternative to LIBOR.
• Due to the structural differences between the basis on which each of LIBOR and SONIA is produced, there are a number of factors that loan market participants should consider when adopting compounding SONIA.

What is LIBOR?

The London Interbank Offered Rate ("LIBOR") is one of a number of Interbank Offered Rates ("IBORs") that are widely used in the global financial markets. LIBOR is a forward-looking benchmark based around anticipated unsecured wholesale borrowing costs published for specified tenors. LIBOR provides an indication of the average rate at which each LIBOR contributor can borrow unsecured funds in the London interbank market for a given period, in a given currency. LIBOR is based on submissions by a panel of banks using available transaction data and their expert judgement.

Where is it used?

LIBOR is an interest rate benchmark used throughout the global financial markets and is integral to a number of financial products including bonds, derivatives and loans. LIBOR is used in approximately $300 trillion worth of financial contracts (including $30 trillion equivalent in GBP markets). For the purpose of this article, we are focusing on the replacement of LIBOR in the loan market.

WHAT IS WRONG WITH LIBOR?

What are the identified issues with LIBOR?

The legitimacy of LIBOR has been questioned ever since the global financial crisis, when rates spiked to sky-high levels in 2008 and 2009 as banks appeared to be on the edge of collapse. LIBOR was subject to further scrutiny and public attention in 2012 when it was revealed that it had been artificially manipulated by a number of the panel banks that formed the basis of calculating the rate.

In recent years, a key concern of regulators is that the underlying transactions that LIBOR seeks to measure are no longer liquid. As noted by Andrew Bailey, Chief Executive of the UK Financial Conduct Authority ("FCA") in a speech delivered on 27 July 2017, "There are relatively few eligible term borrowing transactions by any large banks which can be used as the basis for calculating LIBOR – i.e. these banks receive few loans or deposits of a twelve-, six- or even three-month term from other banks or eligible corporate depositors.". To put this in context, the panel banks executed just fifteen transactions of potentially qualifying size in a particular currency and tenor in the whole of 2016 between them.

Consequently, LIBOR is currently sustained by the use of 'expert judgement', and not transactions, by the LIBOR panel banks to form many of their submissions. In the absence of an active market, LIBOR cannot possibly accurately measure that market. The FCA, which has regulated LIBOR since April 2013, considers that this lack of liquidity raises a serious question about the sustainability of LIBOR. Furthermore, panel banks between them are increasingly uncomfortable with providing submissions based on judgements with so little actual borrowing activity on which to base those judgements.

Given the issues with LIBOR highlighted above, on 27 July 2017 the FCA concluded that: (i) it does not consider that LIBOR is sustainable; (ii) the market should work to transition to alternative rates by the end of 2021; and (iii) firms should not rely on LIBOR being available after the end of 2021.

LIBOR replacement: a loan market solution is required

LIBOR reform is an issue that impacts a variety of financial products. However, the loan market is currently behind in its transition away from LIBOR.

In the first six months of 2019, SONIA accounted for a little over 45% of notional swaps trading in sterling. However, as at 18 September 2019, only the NatWest/National Express loan on which Ashurst LLP acted has been entered into with its interest rate based on SONIA.

In Andrew Bailey's speech in July 2019, he stressed to loan market participants that they should assume that LIBOR will not be published after 31 December 2021 noting "This is not a low-probability tail event.".

In light of Andrew Bailey's comments, it is crucial that banks accelerate the transition away from LIBOR.

WHAT IS SONIA?

In April 2017, The Working Group on Sterling Risk-Free Reference Rates recommended the Sterling Over Night Index Average ("SONIA") as the proposed alternative benchmark for sterling LIBOR interest rates. Introduced in 1997, SONIA has historically been used as a benchmark for overnight unsecured transactions denominated in sterling. SONIA is a measure of the rate at which interest is paid on eligible sterling-denominated deposit transactions. Since April 2016, SONIA has been administered and published by the Bank of England.

Why was it chosen?

SONIA was selected by the Working Group on Sterling Risk-Free Reference Rates as the replacement benchmark primarily because SONIA is considered a stronger interest rate benchmark due to it being based on an active, liquid, underlying market. The average value of transactions underpinning SONIA since April 2018 is c. £45bn per day.

In addition, SONIA tends to be predictable and tracks the Bank of England base rate very closely. This has the benefit of providing certainty to market participants.

How is it calculated?

As mentioned above, LIBOR is a forward-looking benchmark. In contrast, SONIA – like other Risk-Free Rates ("RFRs") – is backward-looking. SONIA is an overnight rate and is published at T+1. Since lending overnight in the wholesale markets is, very nearly, risk-free, there is no in-built term (liquidity) premium or credit premium.

Key differences between SONIA and LIBOR

SONIA is not a like-for-like replacement of LIBOR. There are a number of key structural differences between LIBOR and SONIA, which are set out in the table below:

There has been discussion about the possibility of producing a SONIA+ rate, which would be published on a forward-looking basis for specified tenors as is currently the case for LIBOR. The timing of its production is not certain, however, and Andrew Bailey has warned lenders that "delaying transition until term rates arrive is mistaken". In the absence of a SONIA term rate, market participants need to look to other solutions. In this regard, compounding SONIA has emerged as the front runner and its application in loan documents is explored in more detail below.

WHAT ISSUES FACE THE LOAN MARKET IN MOVING TO SONIA?

With banks having been set the challenge to find the solution to replace LIBOR, one should first consider the internal workings of a bank and how its systems currently operate.

With loans being either fixed or floating rates, and floating rate loans currently based either on Bank Rate or an IBOR rate, banks will have to create new operating systems for SONIA-based loans, as well as bonds and derivative products.
Loans can be provided on a term or revolving basis, either bilaterally or on a syndicated basis with each lender participating pro rata to the overall commitments in the facility. On a syndicated deal, the facility will have an agent acting in an administrative capacity, who acts as the intermediary through whom loan advances are made and interest and repayment proceeds are received.

Transitioning to a SONIA-based interest rate requires not only amendments to the underlying loan documentation but also to each lender's internal systems. By way of example, a lender will need to:

• create and use a SONIA-based model to price each new facility;
• establish a robust system internally to calculate the SONIA rate during the life of the facility;
• put in place new communication channels to inform each borrower of the interest it is due once the interest rate can be calculated;
• determine what level of information it will make available to its counterparts if they wish to challenge these calculations; and
• align its position across its different products, e.g. hedging, loans, ancillary facilities.

There is a huge volume of legacy loans that, if they mature in 2022 or beyond, will need to transition from being LIBOR-based. The expectation is that whilst some simple loans may transition onto Bank Rate, most will transition onto SONIA.

Since the announcement that LIBOR would be abolished, the market had anticipated that while the SONIA (overnight) rate was acceptable for the derivatives market, the loan market required a term rate solution, i.e. the SONIA+ rate referred to above, pricing in a premium for the tenor and counter-party risk. In the speech referenced above, Andrew Bailey further commented that even if such a rate is made available, it may not continue to be made available permanently, indicating that the loan market solution needs to be found elsewhere. We consider that if the term rate solution is made available, it should only be used for transitioning LIBOR-based loans with short remaining tenors, not for new longer tenor facilities. In the absence of a SONIA term rate, lenders have been considering using a compounded SONIA rate, pursuant to which a 'term' premium is built into the SONIA rate so that the cost of borrowing increases somewhat over time to reflect the riskier nature of lending money for longer periods of time.

One lender in the market has reached a position where it has now completed the first of its pilot programmes for SONIA loans, which was announced earlier this summer when NatWest Bank entered into a new loan with National Express Group plc.

This loan was put in place shortly after Associated British Ports issued notes in the floating rate notes market using a substantially similar calculation.

The market has considered two methods to calculate a compounded SONIA rate (see box above). The above-mentioned deals both use the lag approach.

METHODOLOGY FOR COMPOUNDED SONIA-BASED CALCULATIONS

Lag approach

As demonstrated above, the rate used on a business day during the interest period is the SONIA rate published in respect of the business day falling on a specified number of business days prior to the relevant calculation date. The compounding is effected by adding the result for each daily calculation to the principal amount of the loan and using this figure to determine the accrued interest on the next business day. No compounding takes place on a non-business day, so a loan borrowed over a weekend has the applicable SONIA rate applied for three days to take into account the two non-business days. Using a five business day lag approach, the aggregate amount of interest due at the end of the interest period will be known five business days prior to the last day of the interest period.

Lock-out approach

In this approach, the rates used to determine the SONIA rates are those actually published for the applicable days in the interest period, again on a compounding basis. However, at the tail end of the interest period, the rate published on, say, the fifth business day before the end of the interest period is "locked out" and used in the calculations for the last five business days. As such, the final calculation can be done to ensure the aggregate interest is determined five business days before the end of the interest period.

TRANSITION PROCESS

The NatWest Bank bilateral loan is a very helpful development in the market, demonstrating that the applicable operational and legal technology is now in place to facilitate such a facility. With this, it has highlighted a number of challenges regarding what needs to happen next.

First, it would be a welcome sign in the market if a syndicated deal could be implemented. This would show a robust confidence by lenders in the agent's operating system and calculations of the compounded SONIA rate.

Second, and as highlighted above, every existing facility whose interest is determined by reference to LIBOR needs to transition to a new rate. As there is no statutory override this is expected to require specific implementation between the relevant lender(s) and their customer. It is also worth reminding the reader that on a historic basis the LIBOR rate and the compounded SONIA rate have not tracked each other, with LIBOR being the higher figure. It is expected that an "adjustment premium" will need to be added to the interest calculation in legacy deals to ensure the economic position between the lender and borrower remains constant, but clearly this will need to be agreed by those parties, where a failure to agree reverting to a pre-agreed fallback position. The scale of this task is not underestimated by the lenders we have been speaking to, but until each lender has confidence in a "tried and trusted" solution, they cannot commence these discussions with their customers.

The Loan Market Association is developing proposed wording for market participants to include in new facility agreements to cater for a SONIA-based facility. Standardising the legal wording will be a helpful development.
Similarly, having an accepted and robust SONIA calculator to determine the compounded rate based on either the lag or lock-out methodology will remove part of the operational risk of transitioning to a SONIA-based facility.

OTHER CHALLENGES

The above is specific to SONIA, which only relates to loans advanced in sterling. If there is a loan under a facility that can be borrowed in US dollars, euro, Swiss francs (the list goes on…), other RFRs will be applicable. The working groups are encouraging market participants to look to implement similar approaches and calculations across these RFRs to smooth the transition, but it is too early to tell if this will happen in practice.

One key difference between the RFRs is that whilst some, such as SONIA and €STR (the identified RFR for EUR), are determined by reference to unsecured overnight transactions, others such as SOFR and SARON (the identified RFRs for USD and CHF respectively) are determined by reference to secured overnight transactions. There are ongoing discussions whether this might result in different adjustment premia being applied for different currencies although we note the current LIBOR rates for different currencies vary significantly.

POSSIBLE BENEFITS FOR BORROWERS

One aspect of moving to a SONIA rate that will be of interest to borrowers is that lenders can no longer point to the limited LIBOR maturity periods when limiting available interest periods under a facility.

As the compounded SONIA rate can be determined for any interest period, starting and ending on any date, the only limiting factor is the lag period. Operationally, lenders will either want to limit the number of loans with short interest periods or limit the borrower's ability to terminate loans early; we may, however, see lenders starting to charge additional fees where a borrower requires additional operational flexibility.

Having a SONIA-based loan should simplify the refinancing process, reducing the notice periods for prepayments generally.

Finally, we note that the historic SONIA rate has been quite stable, with significant adjustments only occurring in line with changes to the Bank of England Base Rate, and importantly not with market events. So while the lag and lock-out methodologies described above leave the borrower with a short period in which to arrange its position to ensure it has sufficient cash to meet the relevant interest payment, in practice there should be limited difference between the actual amount due and the amount estimated in advance.

As published in Butterworths Journal of International Banking and Financial Law.