Call for SONIA guidance before LIBOR deadline

Lauren McCarthy of Pinsent Masons, the law firm behind Out-Law, was commenting in light of recent developments in the market which has seen SONIA emerge as a preferred alternative to London Interbank Offered Rate (LIBOR), a measure of the average rate at which banks are willing to borrow wholesale, unsecured funds and the reference rate that is commonly used in many financial contracts currently.

Financial services regulators and central banks around the world have been pushing for a transition away from the use of interbank offered rates (IBORs), given the previous attempted market manipulation, false reporting and the decline in liquidity in interbank unsecured funding markets. The panel banks whose submissions inform LIBOR have agreed to support the rate until the end of 2021. Firms are therefore expected to adopt suitable alternatives in this timescale.

Earlier this year a Bank of England working group on sterling risk-free reference rates (RFRs) identified SONIA as its preferred alternative to LIBOR, and last month the FCA released guidance that encourages firms to stop issuing new LIBOR cash contracts that mature beyond 2021 by September 2020. The regulator has said it will be monitoring firms' progress towards this deadline over the course of 2020.

In a recent speech in London, Edwin Schooling Latter, director of markets and wholesale policy at the FCA, warned that panel banks' move away from supporting LIBOR could mean that LIBOR "no longer passes the key regulatory test of being capable of measuring the underlying market or economic reality". This means the benchmark would no longer be 'representative', meaning among other things that banks relying on it post-2021 banks could face enforcement action.

However, Schooling Latter said that it is possible that "an unrepresentative LIBOR" could continue to be published by a reduced number of panel banks for "a period" beyond 2021. He warned banks against relying on this scenario as a "safe alternative to transition", though. Schooling Latter said that contractual fall backs might offer banks a "safety net" if they are not yet ready to transition away from LIBOR altogether to SONIA or other reference rates.

The implications of a unrepresentative LIBOR, and the implementation of pre-cessation fall  backs was also addressed in a letter addressed to the FCA and the Federal Reserve Bank of New York from the International Swaps and Derivatives Association (ISDA), dated 4 December.

McCarthy said: "The speech from Schooling Latter provides a useful update on how firms might approach LIBOR becoming 'unrepresentative' at the end of 2021. What this speech does not address is what firms should do where contractual fall backs were written without the cessation of LIBOR in mind, so that firms are unable to base a transition from LIBOR on the basis of 'unrepresentativeness' and FCA announcements alone."

"It also proceeds on the assumption that SONIA will eventually work across all product books and for all firms, without necessarily contemplating how those products might be funded, or how the underlying systems are built. Firms, particularly those in the regulated space, would no doubt welcome further guidance from the FCA on how these issues should be dealt with," she said.

In his speech, Schooling Latter explained that the FCA will encourage the use of SONIA as standard in the sterling interest rate swaps market from early 2020. He also suggested banks should not delay in transitioning away from using LIBOR in the variable-rate SME lending market either, despite acknowledging that this will involve "significant infrastructure and documentation preparation, customer communication and staff training exercises for some banks".

"One message we have been keen to communicate is that delaying transition of new business away from LIBOR until the production of forward-looking term rates based on SONIA may not be the best approach," Schooling Latter said. "The loan market, like some others, has become accustomed to the forward-looking LIBOR benchmark. In those other markets, notably bonds and securitisations, we have also in the past heard arguments that forward-looking term rates are needed. But those arguments have largely evaporated in those markets, in the face of decisive shifts to overnight rates compounded in arrears. For similar reasons, including hedging costs and effectiveness, many expect to see this happen in large parts of lending markets too, particularly the wholesale end of those markets."

"The often-heard argument that borrowers who value certainty of payments need forward-looking term rates often doesn’t hold much water. For those whose priority is payment certainty, fixed rates may be best. Other variable rate options, for example SONIA observed over an earlier period, can also provide payment certainty before the end of the interest period. Moreover, the benefit of compounding may mean such rates are less volatile than a forward-looking term rate polled from market transactions on a single day may prove to be," he said.

SONIA, which is published by the Bank of England and based on an average of over £40 billion worth of transactions each day, is what is known as a 'risk-free rate' (RFR). However, RFRs are not an exact replacement for interbank offered rates, particularly forward-looking rates such as three-month and six-month LIBOR.