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On 27 July 2017, nine whole years after the tampering scandal reared its ugly head, the Financial Conduct Authority announced that LIBOR will likely be phased out by 2021. While some commentators have said the FCA’s announcement may be premature, it has been in the works for some time.
Since its introduction in 1984, Libor has become a cornerstone of loan and derivative markets, with over $350tn of contracts referencing the rate. As it has grown in use, however, so too have markets changed. Libor is not as robust as it once was, and newer alternatives offer fundamental improvements. Different countries have selected different successors to LIBOR but in the UK, this is expected to be SONIA.
What is SONIA?
SONIA stands for Sterling Over-Night Index Average.
Every day, banks and building societies cover their short-term sterling funding requirements by entering into unsecured overnight transactions. The market for such transactions is intermediated by brokers, who are usually members of the Wholesale Markets Brokers’ Association (WMBA). All transactions brokered by a WMBA member in London between midnight and 18:00 with a deal size of £25m or more are taken by the WMBA who, as calculation and publication agent, calculates the volume weighted average annualised interest rate across these transactions. This is then published as SONIA at 18:30 each day and from Spring 2018 will be published at 09:00 on the next business day.
SONIA should be distinguished from RONIA (R for Repurchase), its sister index which uses secured overnight transactions, rather than unsecured.
What are the key differences between SONIA and Libor?
SONIA is by definition an overnight rate, whereas Libor fixes for a range of tenors
Another point linked to this is that SONIA fixes daily in arrears, whereas Libor fixes in advance for the given tenor, for example 3-month.
The fact that SONIA fixes in arrears and is purely an overnight rate may cause more issues for many end-users, particularly smaller derivative end-users and borrowers. For example, as a borrower looking to manage cash flow within your business it can be valuable to understand what your interest expense for the quarter will be at the beginning rather than at the end of the quarter.
It may be possible to utilise short-term swaps that reference SONIA, called Overnight Index Swaps (OIS), to generate a mechanism that will both fix in advance and provide fixing values for different tenors. However, this may re-introduce liquidity issues in the benchmark (i.e. if there is limited trading in a particular OIS tenor) and it would need to be determined who would calculate and produce these indices.
SONIA is a near risk-free-rate, whereas Libor captures a credit risk component
This may not actually be a desirable feature of Libor and many participants in the UK market welcome the move to a near risk-free rate. However, the credit component of Libor will need to be a consideration for legacy instruments and their migration.
In figure 1 below, the historical difference between three-month Libor and OIS shows that during periods of uncertainty the differential gets wider. It is expected that ISDA’s working groups for formulating fall-backs in the event that Libor is unavailable will likely be the relevant risk-free OIS rate for each currency, with the addition of a spread to incorporate residual term bank credit premia.
SONIA is a transaction-based benchmark, whereas Libor is a judgement-based benchmark
Fundamentally, it is this point that has written Libor’s death certificate. As Mark Carney outlined2, a lack of unsecured term deposit transactions – and therefore a continued reliance on judgement – represents a serious structural weakness in LIBOR. A situation in which a judgement-based benchmark underpins an estimated US $350 trillion-worth of contracts is not desirable.
Figure 1: Historical 3-month GBP Libor-OIS Spread
Source: Bank of England
Impact on Interest Rate Derivatives
From a technical or pricing perspective, the move to a single benchmark will make derivative pricing simpler and more efficient. We have been operating in a multi-curve environment for the last decade and it is evident that it adds to the complexity of derivative pricing and risk management. The move to a single benchmark will be a change welcomed by many and lead to improved pricing for the market.
As seen in figure 2 below, there is already a market for OIS, which is helpful in the transition from Libor to SONIA. Currently, the OIS curve is quoted from 1-week up to 50-year maturities. There are pockets of liquidity in tenor beyond one year. The recent decision with regard to SONIA as the chosen risk free rate will help improve liquidity. In addition, it is clear that there are concerted efforts from regulators, industry bodies and market participants to continue to improve liquidity especially in longer tenors. Currently, OIS is only clearable out to a 30-year maturity. There is an effort to make OIS clearable out to 50 years and certainly, with quotes now available out to this tenor, it should only be a matter of time before LCH adds these maturity points.
The other segment of liquidity in the curve is that of Libor futures. Further work will need to be undertaken to migrate Libor futures contracts to SONIA and we will continue to monitor developments in this area.
Figure 2: Interest rate instrument and illustrative liquidity
Source: Bank of England
Impact on Floating Rate Debt
The Loan Market Association (LMA) overhauled the fall-back interest rate benchmark provisions in their recommended form facility agreements in November 2014.
Currently, the LMA provisions do not provide for an automatic switch to a different public rate.
Preliminary conclusions from ISDA suggest possible triggers could include:
• insolvency of the relevant IBOR administrator
• a public statement by the relevant IBOR administrator that it will cease publishing the relevant IBOR permanently or indefinitely
• a public statement by the supervisor for the relevant IBOR administrator that the relevant IBOR has been permanently or indefinitely discontinued
• a statement by the supervisor for the relevant IBOR administrator that the relevant IBOR may no longer be used3
Given that the choice of SONIA as a risk-free benchmark is relatively recent, this may be a development that will come into place over the next year or two. However, it is clear that SONIA and Libor are different so a simple switch may not be appropriate without some adjustment to the rate or margin.
For end-users, it will be important that any transition takes place across both debt and derivative instruments in a similar fashion, and on a similar timetable to avoid introducing new risks that would be difficult to manage efficiently. It is quite likely that ISDA will seek to adopt a protocol approach leading to a large widespread change in the derivatives market, so it would be good to see the lending market start to prepare itself for the change.
Many corporate end-users of derivative instruments seek to apply hedge accounting in order to prevent volatility of reported profit and loss. A material amendment to an existing derivative could result in a requirement to dedesignate an existing hedging relationship and re-designate a new one.
Even if the change of reference rate is the same on the debt and the derivative instrument, this could still lead to ineffectiveness as the re-designated hedging relationship may be off-market. Further ineffectiveness would occur if the changes to the reference rate for the debt and derivative are different or happen at different points in time.
Under EMIR, some market counterparties are required to clear or otherwise collaterise new derivative instruments. However, to soften the impact of this change there has been some grandfathering of legacy swaps. Any ‘material amendment’ to an existing trade would lead to it being brought into scope – a rule that was intended to avoid participants perpetually modifying trades to avoid the rules. The change of reference risk free rate could result in a material amendment to legacy swaps, which may prevent the grandfathering that many market participants have relied upon. This is already on the agenda for market participants and ISDA, amongst others, is likely to lead on the lobbying with regard to this area.
While it is a little early to give specific direction on commercial or documentation points that will arise from the transition, JCRA are engaging with the Bank of England on their consultation process with regard to benchmark risk-freerates. We will continue to monitor developments, engage with government and industry bodies and provide updates on Libor as the story evolves.
1 Available at http://www.fsb.org/2014/07/r_140722/.
2 6th July 2017, available at: http://www.bankofengland.co.uk/markets/Documents/sterlingoperations/rfr/2017/record060717.pdf.
3 ISDA, 'Benchmarks – Fallbacks for LIBOR and other key IBORs ISDA': http://www2.isda.org/functional-areas/infrastructure-management/interest-rates-derivatives/.
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