Despite the disruption caused by the Covid-19 pandemic, the regulators of the financial sector continue to focus on phasing out LIBOR and the deadline of the end of 2021 has not changed. After this date firms cannot rely on LIBOR being published, and whilst it may seem far away, the far-reaching scope and scale of the transition cannot be underestimated. To support the Risk-Free Rate (RFR) transition in sterling markets the Bank of England began publishing the Sterling Overnight Index Average (SONIA) Compounded Index, a Risk-Free Rate that had been chosen to replace LIBOR in the sterling market, from 3 August 2020.
LIBOR is all-pervasive in many businesses. The LIBOR benchmark is used in a variety of commercial scenarios, including as a discount factor or reference rate in commercial contracts. LIBOR is also widely used as the reference rate for intra-group lending arrangements.
How do LIBOR and SONIA differ?
There are a number of significant differences between SONIA and LIBOR and the differences will impact the way firms manage their risk. LIBOR is a forward looking term rate, which means that the rate of interest is fixed at the beginning of each interest period and is quoted for a range of different maturities. This method provides borrowers with advance visibility as to their financing costs. SONIA measures the average rates paid on overnight unsecured wholesale funds, denominated in sterling. It is, therefore, a backward-looking overnight rate, based on real transactions, with the interest rate being determined and published after the period. Compounding is done in arrears, which means that the borrower only knows at the end of the interest period how much interest it has to pay.
Borrowers are likely to face operational challenges if they lack certainty as to what payments need to be lined up in advance of the interest payment date. Market participants are actively looking for a satisfactory solution to this challenge as there may now need to be a distinction between an interest period and a payment date, or period to allow time to arrange payment. In order to provide some forward visibility, the parties may choose to start the reference period for the interest rate calculations several business days before the beginning of, and end several business days before the end of, the relevant payment period. Alternatively, parties may fix the rate a few days before the end of the interest period. In addition, borrowers may need to hold additional cash to cover any potential interest rate movements during an interest period, impacting the internal cash management processes.
Key challenges for lenders and borrowers
Both lenders and borrowers are facing deadlines and challenges, the most important of which is the establishment of market conventions for calculating SONIA compounded in arrears. We have seen some development of tentative standardised documentation –a welcome step. Current recommendations from the Working Group on Sterling Risk-Free Reference Rates state that clear contractual arrangements should be included in all new and refinanced LIBOR-referencing loans to facilitate conversion, through agreed conversion mechanisms or an agreed process for renegotiation to SONIA, or other alternatives. Of course, both lenders and borrowers seek certainty in their arrangements, and the greatest certainty can be achieved by setting out in advance the terms of conversion at a future date.
As always it is essential to keep the lines of communication open between the counterparties, especially when any legacy contracts (existing contracts that do not mature until after the end of 2021) are dealt with.
The importance of due diligence
The process of transitioning for firms is likely to start with a large-scale due diligence exercise. All existing and new documents that include LIBOR provisions need to be reviewed in order to determine what fall-back language is used if a benchmark rate ceases to become available. The changeover from LIBOR to SONIA or to any other alternative rate is likely to impact a number of provisions in facility documents (and documents that are “grouped” with them, like ISDA master agreements or any intra-group funding arrangements), not just the interest calculation. Those include interest payment provisions, payment and repayment dates, break costs and others.
A SONIA loan (or any other RFR based loan) does not need any particular interest period selection. Selection of interest periods drives frequency of interest payments to be made and the duration of the compounding period: the longer the period, the more compounding there is.
The parties might want to revisit the prepayment and break costs clauses. Where the loan is not priced against a term benchmark, the arguments for break funding costs are more difficult to articulate. However, a bank receiving an unanticipated prepayment may still look to recover an amount reflecting its shortfall on redeployment of funds.
Looking to the future
There is a real possibility that financial markets will evolve significantly over the next few years and so firms may want to transition to another alternate benchmark as the new financial products and markets become established. Therefore “replacement of screen rate” clauses, in new and revised documentation should follow the market standard but allow for any flexibility required by the parties). Also consider the triggers for applying the new rate. For example, should a new rate apply only if LIBOR is discontinued or should it also apply if some form of LIBOR continues to be published but on a different basis?
Complex financings involve multitudes of different parties and interests so it is important to be aware well in advance what involvement and consents are required; intercreditor agreements often contain restrictions so that the consent of another group of creditors is required to any amendments relating to the interest calculation and payment provisions.
It is essential to be mindful that the transition may result in accounting and tax issues. These may arise because of the uncertainty in the period leading up to the replacement and from the replacement rates themselves. When amending existing facility documentation, lenders particularly must be mindful of their regulatory obligations.
In addition to legacy loans the working group identified a narrow pool of “tough legacy” contracts that cannot transition from LIBOR. The working group defines tough legacy contracts as those which do not have robust fallbacks for replacement of screen rates and are unable to be amended ahead of LIBOR discontinuation. It strongly suggests a legislative route for dealing with such contracts.
The regulator has also identified that certain type of borrowers will ultimately require a forward-looking rate. However, the current understanding between market participants is that such forward-looking term rates may not be available until relatively late in transition process, if at all.
As the end of 2021 is looming, firms must start to prepare to transition away from LIBOR as soon as possible. We recommend conducting a thorough due diligence exercise on all relevant documents to identify the scope of the project and then holding discussions and making a plan for transition with all relevant counterparties. Internally, organisations need to identify systems and processes that need changing and understand how the change will impact them economically and from an accounting and tax perspective. Implementation may be complicated and have far-reaching consequences and it would be sensible to start the process of transition in plenty of time.
This article originally appeared in Finance Monthly.