17 April 2020

The transition to SONIA goes marching on

The discussions regarding the replacement of the London Interbank Offered Rate (LIBOR) by the Sterling Overnight Index Average (SONIA) have been overshadowed somewhat by the COVID-19 pandemic, but despite the current challenging environment the Financial Conduct Authority (FCA) has emphasised that it is still focused on the change.

What is LIBOR?

LIBOR is a measure of the average rate at which banks are willing to borrow wholesale unsecured funds. It is a forward-looking rate, which is calculated and published daily in five currencies (GBP, EUR, USD, JPY and CHF) by the ICE Benchmark Administration, based on submissions from selected panel banks.

As LIBOR is forward-looking, it allows borrowers to know how much interest they owe and provides greater certainty for borrowers to know their future liabilities and be able to manage cash flows. The LIBOR rate for an interest period is determined at the start of the period and payment is due at the end.

In existence since the 1980s, LIBOR was initially a great success, but after the 2008 financial crisis there were various allegations of LIBOR manipulation in 2012 and several large banks faced numerous fines. The rigging of LIBOR, which also led to traders being convicted of manipulating the benchmark for profits, reduced public trust in financial institutions significantly. To restore public confidence, a number of reforms have been introduced, including the transferring of regulation to the FCA and criminal sanctions; however, such measures have been limited in restoring public confidence.

The Chief Executive of the FCA, Andrew Bailey, has also emphasised the need to move towards a model which is based on transactions and not expert judgment.

Why SONIA?

SONIA is a backward-looking overnight rate and is based on the average of interest rates paid by banks to borrow sterling from one another outside of market hours. SONIA itself is a risk-free rate, based on an active, underlying market, so is considered to be a stronger interest rate benchmark, and as it closely matches the rate set by the Bank of England, it also has the benefit of providing certainty to market participants. Based on actual transactions, SONIA is less vulnerable to the type of market manipulation that affected LIBOR where banks were able to submit their rates.

SONIA’s backward-looking term is one of the key reasons for the slow progress in the loan market to transition from LIBOR to SONIA, despite Andrew Bailey warning lenders that they need to end their reliance on LIBOR and start making the necessary preparations. The possibility of producing a SONIA forward-looking rate similar to LIBOR and introducing within loan agreements the possibility of a compounded average of SONIA has been discussed. However, whilst a consensus is being gained as to the best approach to producing a SONIA forward-thinking rate, some lenders have highlighted there is a danger that SONIA would simply be an updated version of LIBOR and carry the same risks which led to the PPI mis-selling scandal.

A further challenge is the administrative burden of amending finance documentation for loans that go beyond 2021.

When are we transitioning?

Despite the publication of various documents by the FCA, the Bank of England and others, outlining the priorities and milestones on LIBOR’s transition in 2020, there has been slow progress.

LIBOR has been established as a benchmark which is embedded in as much as $340 trillion financial contracts worldwide; its replacement is not going to be a simple process.

Another concern is cost. Replacing LIBOR is going to be expensive and if not handled effectively could create market confusion resulting in potential litigation.

Taking steps to make ready for the change is an easy piece of advice to give but with priorities having inevitably changed for a lot of financial institutions and borrowers as we continue to deal with the coronavirus pandemic, it could be argued that, for the present, we need flexibility to allow banks and borrowers to deal with the immediate challenges they face.

Mandeep is an Associate in our Banking and Finance team.

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