Out with LIBOR, in with SONIA
A seismic shift across the financial services sector is looming. LIBOR (the London Interbank Offered Rate), a benchmark interest rate used by financial service providers across the world, is set to be replaced by the end of 2021.
It is estimated that LIBOR is the benchmark for over £30tn in financial contracts globally. Accordingly, the transition is going to have far reaching effects which is likely to have a significant impact on (amongst others) those in the retail banking and commercial lending sectors.
Why is it changing?
Since the LIBOR scandal in 2012, the legitimacy and credibility of LIBOR has been constantly called into question and it’s replacement almost inevitable. After a series of governance changes to LIBOR over the years following the scandal, the decision to finally replace LIBOR was announced in 2017 with a move to a new benchmark rate in the UK, known as the Sterling Overnight Index Average (“SONIA”), starting from 01 January 2022.
The transition has become necessary since the Financial Conduct Authority (FCA) reported in 2017 that the way LIBOR is calculated in essence meant that it no longer had benchmark interest rates which are calculated in compliance with internationally acceptable principles for robust interest rate benchmarks. The FCA has secured panel bank support to continue submitting to LIBOR but only until the end of 2021. Beyond that, it considers that it will no longer be necessary “to persuade, or compel, banks to submit to LIBOR”.
LIBOR vs SONIA – what’s the difference?
LIBOR is a “term rate”. This means it is published for different periods of time (typically 3 months or 6 months) and is “forward looking” (i.e. it is published at the beginning of the borrowing period). Due to LIBOR being “forward looking”, it incorporates a premium to compensate for the risk of default over the term for which it is calculated.
SONIA is a “backward-looking” near risk-free overnight rate based on actual historic transactions. It is published at the end of the overnight borrowing period and does not incorporate any premium due to lending to another bank on a longer-term basis. Accordingly, SONIA is expected to be lower than the LIBOR equivalent the vast majority of time.
SONIA measures the rates paid by banks on overnight funds and has been administered and published by the Bank of England since 2018. It reflects the average of the interest rates paid by banks to borrow sterling overnight.
There are many reasons why SONIA is deemed to be the best alternative to LIBOR:
- it is more sustainable given the volume of transactions reinforcing it;
- it is created by real transactions as opposed to quotes provided by banks (reducing instances of market manipulation); and
- risk is minimised because it does not include any term bank credit risk.
The transition to SONIA has already begun and the FCA has already confirmed that the end of 2021 transition deadline has not changed despite the COVID-19 pandemic. If not already done, lenders and borrowers should be reviewing and assessing their existing lending/borrowing arrangements to check LIBOR migration – is it required or catered for in existing agreements? If not, do agreements need to be updated to accommodate for the change and will there be any significant impacts? For example, it is anticipated a number of debt service covenants may need to be reviewed and amended as a result of the LIBOR transition.
"Any such changes to a facility arrangement may ultimately lead to the amount payable under the relevant facility being increased, which clearly needs to be communicated by lenders to their clients as soon as possible."
The FCA and Bank of England are actively encouraging lenders to make non-LIBOR linked products available to their clients by the end of December 2020. Accordingly, commercial lenders and retail bankers should now be looking to phase out and actively reduce reliance on LIBOR in the next 12 months (i.e. future-proofing documents by utilising SONIA now). The transition is going to be complex and no doubt a risk-based approach to the transition will prevail, but this needs to be actively managed and actioned as soon as possible given LIBOR’s approaching expiry deadline
Get in touch
For more information on this update, or any finance related matters, please contact Sean Halliwell.