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2021 will be the last year we see the LIBOR rate used in the global financial markets as we transition to the SONIA rate. But what does this mean for the syndicated and bilateral loan markets and for borrowers?

The History of LIBOR and SONIA

On 7 April 2017, the industry-led Working Group on Sterling Risk-Free Reference Rates (“the Working Group”) selected the Sterling Overnight Index Average (“SONIA”) as the preferred alternative to the London Interbank Offered Rate (“LIBOR”).

Notwithstanding the technical challenges involved and the wide usage of LIBOR in various finance markets, there is also heightened pressure due to the continuation of Euro Interbank Offer Rate (“EURIBOR”) and US Dollar Libor (“USD LIBOR”) (in the US case, until mid-2023).

Nonetheless, despite these obstacles and the disruptions caused by the pandemic, 2020 saw a great deal of work on the transition away from LIBOR to the SONIA rate.

What is LIBOR?

LIBOR is one of the main benchmark interest rates used in financial markets which determines the interest rate for LIBOR panel banks to lend to one another. LIBOR is based on five currencies: Sterling, the US Dollar, the Euro, the Yen and the Swiss Franc.

LIBOR is administered by the ICE Benchmark Administration (“IBA”) and is regulated by the Financial Conduct Authority (“FCA”).

Calculated at the average rate from a group of 20 banks who borrow money from each other in the London Interbank Market via surveys, it determines the rate at which the banks can procure unsecured funding in one of the five currencies across a range of tenors from overnight to 12 months.

What is SONIA?

SONIA, the risk-free rate (“RFR”) for sterling, is the overnight interest rate benchmark in the sterling market.

SONIA is administered by The Bank of England.

The SONIA rate is calculated as the weighted average of all unsecured overnight sterling transactions with a minimum size of £25m. The top 25% and the bottom 25% of transactions are removed and the mean of the central 50% is presented (rounded to 4 decimal points).

The rate of interest on a multi-day borrowing facility with a SONIA loan is to be collected and compounded over the interest period daily to produce a term interest rate. For example, a SONIA loan with an interest period of 12 months would be made up of 12 months’ worth of daily rates.

LIBOR v SONIA – The Key Difference

The key difference between these two rates is that LIBOR is a forward looking pre-determined term rate based on surveys, giving the cost of borrowing for the future period starting on the day it is published for seven different periods (overnight, 1 week, and 1, 2, 3, 6 and 12 months), whereas SONIA is a backward-looking single rate based on actual transactions. For example, Thursday’s SONIA rate reflects the transaction data from Wednesday and so forth.

The Reform – Focus Areas

As preparations to move away from LIBOR accelerate, set out below is a birds-eye view of the five focus areas for the LIBOR transition throughout 2021.

1. Phasing out LIBOR – Guidance published by the FCA, the Bank of England and the Working Group outlines that all new issuances of GBP LIBOR loans expiring at the end of 2021 should cease by the end of Q1 2021.
2. “Tough Legacy” Contracts – Tough legacy contracts are contracts that are unable, before the end of 2021, to make the transition from LIBOR to an RFR. Proposals have been made to give the FCA the ability to change the calculation methodology for LIBOR, ensuring its use in tough legacy contracts continues. We await the FCA’s statements of policy on its approach to the potential use of its powers.
3. Pricing – SONIA does not embed a liquidity premium and a credit premium as LIBOR. The risk premiums contained in LIBOR reflect the credit risk that a bank takes on the other for a specified time-period. In terms of pricing in the risk elements into the SONIA rate, lenders will look to add a “credit adjustment spread” to cover the difference.
4. Documentation – existing and new facility agreements:
   1. Existing Loans – review existing facility agreements. References to LIBOR will likely need to be amended to provide for SONIA provisions.
   2. New Loans – the Loan Market Association (“LMA”) has produced standardised draft documentation relating to the SONIA provisions for the bilateral and syndicated loan markets – i.e. including the Replacement of the Screen Rate Clause and incorporating ‘pre-agreed conversion terms’ or ‘an agreed process for renegotiation’.
5. Break Costs – A break cost relates to the economic cost a lender incurs for the early repayment of a loan by the borrower during the interest period. As the loan is priced against the overnight SONIA rate and not against a term benchmark, there is a debate as to whether facility agreements should include the provision of break costs or move to a prepayment structure instead.

Key Takeaways for Financial Institutions

The baton is in the hands of the market participants to ensure that operational changes are dealt with and for necessary arrangements to be in place for the effective transition. Points to consider:

• Continue to actively prepare for the cessation of LIBOR.
• By the end of Q1 2021, to cease issuing new LIBOR loans expiring at the end of 2021.
• Incorporate adequate and robust fall-back provisions that includes either clearly defined alternative reference rate after LIBOR’s discontinuation or a reference rate other than LIBOR within those LIBOR-referenced contracts that will mature after 2021.
• Develop plans to introduce RFR products and evaluate the risks involved with the transition.
• Identify the IT systems which are likely to be affected and invest early in the relevant technology systems to be able to deal with transferring the legacy loans to new systems.
• Look out for the FCA’s statement of policy.

What Does this Mean for Borrowers?

If Borrowers haven’t already, they should consult with their lenders about plans for the LIBOR replacement and ensure they understand the impact on existing facility agreements and future loan agreements.

The backward-looking SONIA rate may put financial pressure on borrowers in having to better maintain cash liquidity to accommodate rate movements during the interest period, whereas the forward-looking LIBOR rate enables borrowers to know what the costs are in the future, ensuring certainty and greater scope for cash flow planning. It is therefore important for borrowers to consider the impact of the new benchmark rates on their cash flows, intercompany debt levels and tax position.

It is not all doom and gloom for borrowers. Since SONIA’s creation in 1997, the rate has been less volatile than LIBOR and tracks the Bank of England rate very closely.

Final Thoughts

The Regulatory bodies involved have made great progress in terms of educating and guiding market participants in relation to the transition away from LIBOR to SONIA. The implementation of the SONIA rate is unlike any regulatory reform in the structured finance market witnessed before and whilst many have become accustomed to the LIBOR rate, it important to focus on engaging with the SONIA rate now and for lenders, borrowers and solicitors to work alongside each other to ensure the smooth transition, notwithstanding the complexities involved with regards to its understanding and in drafting provisions within in each facility agreement to reflect the new compounded methodology.