New year, new benchmark rate: An update on the sterling LIBOR transition

LIBOR transition November 2020 - LIBOR pains before SONIAs delivery

For many people, New Year’s Day is a time to change. The finance market was no exception. On 1 January 2022, the recommended benchmark rate for sterling corporate loans officially shifted from the London Interbank Offered Rate (LIBOR) to the Sterling Overnight Index Average (SONIA).

What was sterling LIBOR?

Sterling LIBOR was the average rate at which a group of major financial institutions could borrow money from each other in sterling in the London Interbank Market on unsecured terms for specified periods of time.

Why was sterling LIBOR abolished?

LIBOR had three main drawbacks. Firstly, the rate had the potential to be rigged (as evidenced in recent scandals). Secondly, the rate was based on a market that lacked sufficient activity. Recent commentary suggests that the financial institutions often submitted estimates instead of transaction data. Thirdly, the rate was forward-looking (i.e. set at the start of the interest period) and thus led banks to incorporate premiums for market factors, credit risk and term liquidity.

So what now? Enter SONIA

SONIA is the average rate at which financial institutions borrowed money from each other in eligible unsecured transactions overnight.

Why is SONIA preferred?

SONIA is reflective of actual market practice. This ensures that the rate is current, robust and exclusive of the premiums mentioned above. Though, in many cases, lenders will increase the margin or add a ‘credit adjustment spread,’ especially as SONIA will usually be lower than LIBOR (without the premiums referred to above). Lenders will want to adjust the overall lending cost to ensure that they are not worse off with the switch to SONIA.

What is the status of SONIA?

SONIA is the market’s preferred benchmark rate. Parties can deviate from it. This is envisaged as the rate is backward-looking (i.e. set at the end of the interest period). Parties may consider this too financially uncertain. Most commonly parties are aggregating the SONIA rate on a compounded basis over the interest period and including an "observation period" (also referred to as a "lag period") to reference the SONIA rate – i.e. the period for calculating interest may start (typically) five days before the actual interest period begins, so that it finishes five days before the interest is due. This gives the parties a few days advance notice of how much interest is payable at the end of the interest period. Whilst there is still a risk for the parties as they will be entering a credit transaction without the interest rate being fixed, the current financial effect has not been dramatic due to the present base interest rates being so low. If interest rates start to rise, as seems likely, larger problems may arise. A forward-looking prototype of SONIA is being discussed and we will learn more in due course.

Is this the end for sterling LIBOR?

This is the end for sterling LIBOR as we knew it. All that remains is a variant of the USD LIBOR and a synthetic sterling LIBOR for eligible legacy contracts. Even still, this will be calculated via a different method.

What next?

All existing and future corporate loans must reflect the recent changes. This may be via transitioning to SONIA, shifting towards a deviation or alternative rate or ensuring that fall-back clauses are effective. For commercial loans not involving financial institutions it may be simpler to refer to the Bank of England Base Rate from time to time.

Useful links

Contact our experts for further advice

Jonathan Porteous