In a speech on 12 July 2018, the Chief Executive of the FCA Andrew Bailey said that “…the discontinuation of LIBOR should not be considered a remote probability 'black swan' event. Firms should treat it is as something that will happen…”. While the current LIBOR panel banks have agreed with the FCA to continue submitting LIBOR rates until the end of 2021 to facilitate an orderly transition to alternative interest rate benchmarks across the market, the FCA has confirmed that, after 2021, it will not compel panel banks to continue to submit LIBOR rates to ICE Benchmark Administration (the LIBOR administrator).
Cross-sector working groups in various jurisdictions have been working on selecting risk-free rates to replace IBORs. The Bank of England’s Working Group on Sterling Risk-Free Reference Rates has set up bond and loan sub-groups to focus on the transition from LIBOR to SONIA (Sterling Overnight Index Average), the risk-free reference rate which has been selected for the Sterling markets. SONIA is a measure of the rate at which interest is paid on unsecured, overnight, Sterling wholesale funds. It is calculated based on executed transactions reported to the Bank of England and is published at 9am on the following business day. The Bank of England became its administrator in April 2016, and subsequently introduced a series of reforms to the SONIA benchmark in April 2018.
The use of SONIA (and other risk-free rates for other currencies) poses a number of structural complexities for market participants:
- SONIA is a backward looking overnight rate, whereas LIBOR is a forward looking term rate that is fixed for specified interest periods (1, 3, 6 months etc). Unless a term SONIA rate can be generated in advance, issuers/borrowers may only be able to confirm their floating interest cost at (or after) the end of an interest period (not before as is the case with LIBOR), affecting liquidity, cash flow management and investment decisions. Interest payment may need to be delayed for a few days after the end of the period to allow for calculation of interest. It remains to be seen whether forward looking SONIA term rates will be generated.
- LIBOR includes a bank credit risk element for the specified interest period (reflecting bank credit and liquidity risk over that period), whereas SONIA is a near risk-free rate, meaning that switching to SONIA rates in existing LIBOR transactions could be problematic in terms of maintaining economic equivalence for all parties. Some form of credit adjustment will need to be applied to the SONIA reference rate and it is unclear how this will be calculated.
- LIBOR is calculated on the same basis for each currency, whereas different risk-free rates and methodologies are being proposed for different currencies. This may lead to different spreads/margins being applied to different currencies, adding complexity for the application of risk-free rates to existing LIBOR transactions.
- For financial products maturing beyond 2021 that do not include fall-back rate provisions permitting a switchover to a replacement rate without obtaining the consent of the relevant banks or investors, there may be a need to negotiate with banks/investors to amend the existing contractual terms.
- In any event, the process of changing reference rates across a group’s financial products will need to be carefully co-ordinated. Given that it may not be feasible for a borrower/issuer to effect the change across all financial arrangements on a single day, borrowers may experience significant disruption and/or unhedged or mismatched exposure to interest rate risk.
In July 2018, the Working Group on Sterling Risk-Free Reference Rates published a paper outlining risks associated with issuing new Sterling LIBOR bonds and possible mitigants for bond market participants to consider. The working group is currently consulting the market on the possible development of forward-looking term SONIA reference rates, and a 30 September 2018 deadline for comments has been set. The International Swaps and Derivative Association is currently consulting the market on certain aspects of fallbacks for derivatives referencing certain IBORs. Responses to ISDA’s consultation are required by 12 October 2018.
In June, the European Investment Bank sold £1 billion of SONIA-linked bonds. A daily compounding SONIA rate was used for each 3 month interest period, but offset by 5 business days to allow payment of interest on the last day of the period. In September 2018, a number of financial institutions including Lloyds Bank plc and the Royal Bank of Canada followed the EIB’s lead by issuing SONIA-linked bonds. In the US, notable bond issuances referencing SOFR have come from Fannie Mae and the World Bank.
The transition from LIBOR to risk-free reference rates will have far-reaching effects across the financial industry. Market participants are encouraged to actively participate in the debate.