News & Events
The Financial Conduct Authority (FCA) announced back in July 2017 that LIBOR, a globally accepted benchmark indicator of borrowing costs between banks, will cease operating after the end of 2021. As that deadline steadily approaches, what does this mean for those businesses who are borrowing on LIBOR terms?
What is LIBOR?
LIBOR is a globally accepted benchmark indicator of borrowing costs between banks. It is calculated using submissions from a group of 20 major global banks as to the price they charge one another in the London interbank market for short-term unsecured loans in five different currencies. It is published daily by the Intercontinental Exchange (ICE) and is available for varying lending periods. A particular feature of LIBOR is that it takes into account credit term risk: the longer the lending period, the more expensive the rate.
The end of LIBOR
The decline in liquidity following the near collapse of the UK banking sector, together with widely publicised scandals involving the manipulation of LIBOR (the London Inter-bank Offered Rate), inevitably led the FCA to announce in 2017 its decision to end LIBOR from the end of 2021, the FCA’s hope being that the market would use that time to find appropriate replacements. SONIA (Sterling Overnight Index Average) appears to be the preferred contender, however, whilst a move to SONIA may seem sensible, it is not without its critics.
However, the decline in inter-bank lending following the near collapse in 2008 of the UK banking sector led to insufficient submissions being made to the ICA to enable a meaningful benchmark rate to be determined. The participating banks had to start estimating rates in order for the benchmark rate to be set. The legitimacy of LIBOR as a bench rate was therefore prejudiced.
Then, in 2012, news broke of banks colluding to fix the LIBOR rates to their commercial advantage by manipulating the estimated information they were submitting to the ICA. The scandal spelt the end for LIBOR, which has only been kept alive since due to the FCA instructing banks to continue making submissions to the ICE whilst appropriate replacement benchmarks are identified.
So will SONIA replace LIBOR?
The working party that has been set up by the FCA is currently focused on SONIA for adoption here in the UK market, although no official announcement has been made to that effect. However, there are other benchmark options that are already being used around the world instead of LIBOR. In the US, there is the newly established Secured Overnight Financing Rate (SOFR); in Japan there is TONAR (Tokyo Overnight Average Rate); and the Swiss have SARON (Swiss Average Rate Overnight).
There are good reasons why the FCA is favouring SONIA. In use since early 2016, SONIA is considered to be reliable and predictable, closely tracking the Bank of England base rate. It is attractive to the regulators on the basis of it being virtually risk-free. Unlike LIBOR, SONIA does not take account of term bank credit risk, nor does it look ahead to future periods of time. SONIA is an overnight rate, and therefore looks back at actual market transaction data. This removes both the requirement for judgment-based submissions from banks and the notion of banks being compensated for taking longer term credit risks.
Is the 2021 deadline set in stone?
No clear decision has been reached on when LIBOR will stop being calculated. It is conceivable that there may be a short run-off period from the end of 2021, although that will require the banks to continue making submissions on a voluntary basis, which may prove unworkable. The main UK clearing banks are already responding to guidance issued by the FCA and the Bank of England by writing to customers with LIBOR based loans in order to inform them of the likelihood of these changes taking place from the end of 2021.
Could SONIA have adverse consequences for borrowers?
The FCA and the Bank of England both appear to believe that there will be significant advantages to both lenders and borrowers of moving to a risk-free benchmark.
However, switching from LIBOR to SONIA for sterling does raise some issues, as SONIA operates very differently to LIBOR. SONIA is backward looking, meaning that the rate of SONIA cannot be determined until the end of the applicable period. LIBOR is pre determined for each period on the first day of each applicable interest period, which gives certainty and transparency at the beginning of each interest period, so both borrower and lender know upfront the rate that will apply for the duration of each interest period. With SONIA, the benchmark rate (and therefore the interest payable by the borrower on the final day of any interest period) cannot be determined until the final day of that interest period.
This backward looking feature of SONIA may make it more difficult for borrowers to work out the cost to them of prepaying or refinancing borrowings mid interest period. A lender will usually look to recover break costs in such circumstances (i.e. costs that the lender incurs as a result of meeting its matched funding obligations for the loan in the interbank market), but under SONIA the exact amount of those break costs will not be known in advance of the prepayment being made. Under SONIA, borrowers may need to consider having some cash reserves available in order to meet unknown break costs, which are usually required to be paid within days of a prepayment.
One thing we can say with certainty is that LIBOR is going to be scrapped. Whether that happens instantly at the end of 2021, or following a short run-off period, during which time the banks continue to volunteer submissions to the ICA, remains to be seen.
Many UK banks are already undergoing a process of amending their facility agreements to incorporate up to date market disruption provisions. Traditionally, these provisions were aimed at allowing interest rates to be calculated if LIBOR was temporarily unavailable, but we are now seeing these clauses being expanded to include appropriate fall back provisions in the event of LIBOR ceasing to be available altogether.
Further amendments to facility documents may be required once the market settles on LIBOR’s replacement. If this is to be SONIA, switching over to a risk-free backward looking rate is likely to involve substantial mechanical and pricing related changes to existing loan documents. It is probable that lawyers acting for corporate borrowers will look to build in clarity and assurances around how interest rates and break costs should be calculated, and how and when such interest and break costs are paid. It is not unforeseeable that some large corporate borrowers might want flexibility building into their funding documents to allow the parties to select from a number of alternative replacement benchmark rates once the LIBOR screens are unavailable.
For now, it is a case of waiting for further clarification as to the cut-off for LIBOR and identity of its successor.