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In a Financial Conduct Authority (FCA) statement published on 25 March 2020, the FCA confirmed that whilst Covid-19 has interrupted, and will continue to interrupt, every segment of the UK financial services market, and will no doubt cause some interim LIBOR transition milestones to be missed, the existing end date for the use of LIBOR – being 31 December 2021 – will not, at this stage, be pushed back.
The FCA’s intention here appears to be to remind all market participants that, Covid-19 aside, work continues to be undertaken in the background for LIBOR transition and so all market participants should retain some focus on their preparations for the same.
The London Interbank Offered Rate (LIBOR) is a measure of the average rate at which banks are willing to borrow wholesale, unsecured funds. It is now widely accepted that this rate is unreliable. Not only is there potential for rate manipulation but the rate has also become less reliable as the number of unsecured, interbank lending transactions (on which the rate is based) has fallen.
To address the pitfalls in LIBOR, the FCA obtained a voluntary agreement from the LIBOR panel banks in 2017 to continue to submit LIBOR until the end of 2021, but not beyond. All banks and other market participants need to have removed their dependencies on LIBOR by this date if they are to avoid disruption when publication of LIBOR comes to an end.
At the time of writing, it appears that different countries will use their own local reference rates as an alternative to LIBOR. In the UK, the frontrunner for a local reference rate (as championed by the FCA and the Bank of England (BOE)) is the Sterling Overnight Indexed Average (SONIA). Whilst other rate options remain available and will likely be used alongside SONIA in a post-LIBOR world, the UK’s Working Group on Sterling Risk Free Rates has focussed its attention on SONIA from as early as November 2017.
SONIA is based on actual transactions and reflects the average of the interest rates that banks pay to borrow sterling overnight from other financial institutions as opposed to rates for a longer-term. Whilst LIBOR is forward-looking and relies upon ‘expert’ judgment calls to be made, SONIA is backward-looking. It is published by the BOE and is already used to value around £30 trillion of assets each year.
The primary challenge with SONIA is that because it is an overnight rate there is, as yet, no consensus for how it can be successfully applied as a replacement for forward-looking LIBOR term rates.
In order to address this challenge, the BOE is (as of March 2020) seeking views from market participants on:
- the BOE’s intention to publish a daily SONIA compounded index that should support the use of SONIA in a wide range of financial products by simplifying the calculation of compounded interest rates; and
- the usefulness of the BOE publishing a simple set of compounded SONIA Period Averages that would give users easy access to SONIA interest rates compounded over a range of set time periods.
While we wait to see the market response to the BOE’s proposals, we can see that SONIA is already being applied to an expanding array of products and in new areas of the financial services market. By way of example, SONIA will soon be the predominant rate for sterling interest rate swaps after the FCA and the BOE encouraged a switch from LIBOR to SONIA from 2 March 2020 onwards. We are also aware of the completion of what we understand to be the housing sector’s first loan facility for Riverside using the SONIA interest benchmark. The march, it seems, goes on.
Notwithstanding the current climate, it remains important for all our borrower clients, where time, resource and energies can be spared, to take the following steps:
- examine your existing loan arrangements and make an inventory of your LIBOR exposures;
- analyse those loan arrangements dependent on LIBOR and assess the impact of affected products;
- consult with your lenders to find out what they intend to do (or what they are already doing) and what this will mean for you; and
- assess your own accounting/tax systems to ensure that they will not be undermined by the transition away from LIBOR.
In any event, all of our clients participating in the UK financial services market should; where time, resource and energies can be spared:
- keep a ‘weather eye’ on the latest developments and consider how these might impact on your organisation and the products in which you transact;
- use independent professional advisers as and when appropriate; and
- engage with and (if possible) participate in industry consultations often fronted by the FCA and/or BOE.
For further information or to discuss any of these issues, please contact Michael Nutman.
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