And Spring Heralds SONIA….and Alternative Rates

Client Alert
March 31, 2021

The end of March has welcomed Spring, and this year it marks a new era for the financial markets, particularly for loans and financial products which would usually use Sterling LIBOR as the benchmark for calculation of interest, default interest or to calculate a discount rate. After 31 March 2021, alternative rates or benchmarks should be used in place of Sterling LIBOR.

More than twelve years after the dramatic fall of Lehman Brothers  and the ensuing credit crisis [1], the Financial Conduct Authority recommends that there should be no new loans and financial products issued using Sterling LIBOR after the end of Q1 2021 which would last beyond 31 December 2021.

"It is now vital that all businesses take action to ensure they are ready to meet the next  major industry milestone – to cease use of GBP LIBOR in new loans, bonds, securitisations and linear derivatives that expire after the end of 2021, by 31 March 2021” (The Working Group on Sterling Risk-Free Reference Rates[2] March 2021).

What alternative rates are available?

There are a number of alternative rates available to replace Sterling LIBOR:

Of these rates, it is expected that about 90% of the market for syndicated and bilateral transactions will move to SONIA compounded in arrears and indeed there have now been a number of large syndicated transactions on this basis.[4]

As SONIA is a backward looking ‘overnight rate’, the daily rate is not available until the following day. Since 11 January 2021, there have been two forward-looking TSRRs published by ICE Benchmark Administration Limited and Refinitiv Benchmark Services (UK) Limited, both of which are publishing 1, 3, 6 and 12 month rates for Sterling TSRRs. Fixed rates or a bank base rate plus a margin are also viable options for pricing, as is an objective published rate like the Bank of England Bank Rate, especially where a forward-looking rate is needed.

So, rather than using Sterling LIBOR, which could be open to manipulation, the market for Sterling transactions should use alternative rates including SONIA as the preferred (nearly) Risk-Free Reference Rate (RFR). (This diagram shows possible alternative rates and RFRs for Sterling, US dollar and euro LIBOR.[5])

Diagram of alternative rates and RFRs

How does this affect Trade and Export Finance?

By January 2020, the Working Group had established that some sectors and in particular, trade finance and export finance, but also some SMEs and Islamic finance transactions, had a need for a forward-looking term rate in its paper “Use Cases of Benchmark Rates: Compounded in Arrears, Term Rate and Further Alternatives”[6]. Given the international nature of transactions in the trade and export finance sphere, to function effectively, these sectors require: (i) certainty on what the rate is; (ii) a rate which can be forward-looking; (iii) a rate which could be used as a discount rate; and (iv) time for parties to know what the interest payment will be and arrange payments accordingly.  However, it was not until a year later that the Term SONIA Reference Rates (TSRRs) appeared, and it was only on 26 March 2021 that we saw any suggested wording from the Loan Market Association (LMA) with illustrative definitions of two TSSRs and a helpful note on issues to consider.

Yet, as the deadline is upon us for Sterling loans to switch to alternative rates, there is still more for this sector to digest in the form of published guides and draft market principles on the use of both SONIA compounded in arrears and TSSRs:

What should I do if I need to use Term SONIA?

1.  Read the Working Group Use Cases paper
See the “Decision Tree Model to determine SONIA Compounded in Arrears vs TSRR usage” to determine the appropriate client breakdown, considerations and alternative rates.

2.  Read the LMA Note
The LMA’s note is a welcome round-up of issues to be considered on using a TSRR and recommends that parties read the Working Group Use Cases paper and the FMSB Draft.

A large part of the note looks at ‘fallbacks’ both for temporary unavailability[7] of the TSRR and on a permanent basis[8]. Working from the premise that the RFRs are based in real transaction data,  and arguably more objective than LIBOR, it also considers whether the concept of ‘cost of funds’ should still be an appropriate ultimate fallback if the TSRR is not available, as this would be clearly linked to the funding costs of a particular bank. Similarly, in market disruption provisions where a lender claims that LIBOR would not cover its funding costs and requests its cost of funds instead, should ‘cost of funds’ continue to be a viable the replacement?

The LMA suggests that for temporary unavailability of a TSRR, the Bank of England Base Rate could be used, which matches the fallback waterfall drafting in the LMA SONIA compounded in arrears documentation. For permanent cessation of a rate, the LMA lists some options, however, it will be for the parties to agree and the market to reach some norms, for example:

Bank of England Bank Rate…SONIA compounded in advance[9]…SONIA compounded over the week prior to the interest period to determine the interest to be applied on a forward basis…bond index yields[10]… fixed rate..or alternative TSRR”. (Extracts from LMA Note).

The LMA Note also raises whether a Credit Adjustment Spread (CAS) will be used in pricing to balance the need for economic parity with LIBOR when switching to an RFR, but a CAS is less likely to be used in a new Sterling LIBOR transaction.

3. Read the FMSB Draft
The FMSB Draft sets out eight draft Core Principle for the use of TSRRs, and the key message seems to be that lenders and market participants should have a very good reason for using a TSRR! It is more eloquently put in Core Principle 1:

Market participants should assess, in a manner consistent with this Standard and the RFR Working Group Use Cases, whether there is a robust rationale when deciding to use Term SONIA in lending products taking into account the reduced systemic risks associated with a broad-based adoption of overnight risk-free rates.”

The FMSB Draft proposes that participants assess the recommended “use cases”, and banks have adequate policies, procedures and controls in place to identify and mitigate conflict of interest through the use of Term SONIA, tracking and recording their use of Term SONIA. Corporates too should have a robust rationale for using Term SONIA. Where Term SONIA is used,  the eighth Core Principle suggests that there should be “robust fallback arrangements…in place to allow orderly transition if Term SONIA were itself discontinued or declared unrepresentative under the Benchmarks Regulation.”[11]  Could this suggest TSRRs to be short-lived?

At the moment these are draft recommendations and when brought in will have the status of a Code of Conduct between market participants however, the UK regulator could elevate them to  regulation when they become Standards, which may bring with it compliance and conduct requirements for UK regulated financial institutions.

As trade and export finance market participants, please do read the draft core principles and send your views by 28 May 2021 to the FICC Markets Standards Board if you wish the wider market to take account of your needs and any operational constraints.

4. Read the Best Practice Guide
The Best Practice Guide principally looks at SONIA compounded in arrears for Bilateral Loans and Syndicated Loans. It would also be useful to know how the SONIA compounded in arrears RFR works to be able to make the assessment that may be required on which alternative rate to use. “SONIA remains the Working Group’s recommended alternative to GBP LIBOR, implemented via a compounded in arrears methodology, and loan markets should now move consistently towards this.”

The conventions are set out in a Schedule with key elements  highlighted including: lookback of 5 Banking Days; whether to have Observation Shift or not, affecting which rates apply to non-Banking Days; and whether compounding should be cumulative (recommended for bilateral transactions) or non-cumulative (recommended for syndicated transactions).  There is only a brief reference to other alternative rates for other transactions, using Bank of England bank rate, a fixed rate or “Term SONIA (for acceptable use cases)”.

For loans already in place, the aim is that by the end of Q3 2021 the parties to these “legacy loans” will have negotiated, agreed and documented an amendment to their documentation to ensure that an alternative rate is operational by 1 January 2022.

5. Check how to access to your chosen Alternative Rate
Once a lender or agent has decided which alternative rate and which fallback rates are appropriate for the transaction, check that the relevant parties have access to the rates. The TSRRs will no longer be ‘Screen Rates’ in the same way as LIBOR with a page reference. TSRRs will be accessed through “RICs (Reuters Instrument Codes) and other redistributor codes”[12]. So, definitions will refer to the relevant benchmark and administrator rather than a Screen Rate.

6. Think about documentation
Look at your documentation (whether based on LMA wording, or whether bilateral and specific to your transactions) and highlight the key commercial decisions to be made in relation to new Sterling transactions which should reference alternative rates from 1 April 2021.

Check where LIBOR would currently be used within the documentation. Is LIBOR currently used merely for a default interest provision, a discount rate, an interest rate calculation, or any other calculation?  Think about the sector in which the documentation sits as well as the sector in which the financial institution or corporate sits, as it is possible one corporate could find it has a mixture of TSRRs for some transactions and SONIA compounded in arrears for others, and a lender may be required by its regulator and market principles to use SONIA compounded in arrears for certain types of transaction.

Initially, the LMA announced it would not be producing drafting for sectors which may use Term SONIA, however, it confirmed in the LMA Note that it would look at producing a facility agreement in due course.[13]

Look at existing transactions which expire after 31 December 2021, and consider implementing a timetable for negotiating, identifying an alternative rate and amending those documents to take effect on 1 January 2022. It is possible that there could be synthetic Sterling LIBOR rates published for some time after that date, as the FCA intends to consult with the rate administrators and the market, using powers under the pending Financial Services Bill, (once it has been passed by the UK Parliament), to aid transition for legacy contracts (particularly for more complex contracts which cannot be amended), but there is no guarantee.

Lots to think about as the deadline for no new Sterling LIBOR transactions arrives!

So, market participants in Sterling products in the trade and export finance markets will really have to focus on which alternative rate to use for which products. Regulated participants will also have to heed the recommendations of the Working Group and possibly the FMSB Standards once they are approved. Drafting of documentation on SONIA compounded in arrears is pretty advanced now through the LMA, especially with its publication of updated and upgraded Recommended Forms of RFR compounded in arrears documentation on 30 March 2021. However, we are likely to see market variations in drafting for TSRRs and alternative rates due to the variety of market and bespoke documents in the trade finance and export finance sector and the absence of any LMA exposure drafts.

And that is just Sterling LIBOR …! With the announcements on 22[14] and 23[15] March 2021 from the ARRC that (i) market participants in the US dollar market should carry on without a SOFR Term Rate for US dollar transactions, and (ii) there will not be a similar use cases paper for a SOFR Term Rate, the trade finance and export finance market will have to have a rethink!

[1] September 2008.

[2] Referred to here as the Working Group.

[3] Adopted as the Bank of England’s recommended alternative to Sterling LIBOR in 2018. SONIA is administered by the Bank of England.

[4] See Loan Market Association website

[5] The market has been anticipating Term SOFR for US dollar transactions to replace US dollar LIBOR, however the Alternative Reference Rate Committee announced on 23 March 2021 that the market should carry on without a term rate for US dollars and that it would not be working towards producing Term SOFR and appropriate use cases guidance. See the wording in red in the diagram to illustrate this recent change.

[6] The Working Group Use Cases paper.

[7] Similar to the ‘Unavailability of Screen Rate’ provisions in LMA facility agreement documentation.

[8] Similar to the ‘Replacement of Screen Rate’ provisions in LMA facility agreement documentation.

[9] “SONIA compounded in advance. This would involve compounding the previous period’s SONIA and then applying this calculation on a forward basis.” LMA Note

[10] “This would involve referencing the closest coupon-adjusted maturity bond yield at the relevant time (for example, UK gilts could be used.)” LMA Note

[11] Regulation (EU) 2016/1011 as now part of the law of the UK as retained EU law under European Union Withdrawal Act 2018 as amended.

[12] See LMA Note for codes for Refinitiv Term SONIA and ICE TSRR through ICE Data Services.

[13] The LMA also announced on 30 March 2021 updates to its suite of RFR facility agreements using SONIA/SOFR compounded in arrears and republished these as Recommended Forms rather than as Exposure Drafts.

[14] ARRC symposium.

[15] ARRC press release and alert.

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