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This article was co-authored by Isaac Chulu Chinn, Trainee Solicitor, London.
From FOREX to FTSE it can feel like the commercial world is already full to the brim with acronyms. However, if you are a business that deals with loans, bonds, derivatives or other financial instruments and contracts, it is time to include a new one in your vocabulary: SONIA, which stands for the Sterling Overnight Index Average. SONIA is replacing LIBOR (the London Inter-bank Offered Rate) as the industry standard sterling benchmark reference rate on 1 January 2022.
What is LIBOR?
To get to grips with SONIA, it is first important to be familiar with LIBOR. LIBOR is a longstanding interest rate benchmark and is the average interest rate at which leading banks charge one another to borrow. It is calculated by an assessment of five major currencies and serves seven different maturities (one day, one week, one month etc.). This produces 35 currency tenors which are published daily on weekdays. Significantly, LIBOR is a forward looking estimate, with banks asked to provide submissions on what rate they believe they can borrow unsecured from other banks.
LIBOR has been important because it serves as a worldwide benchmark for short-term interest rates. Lenders and other financial institutions frequently use LIBOR (and its equivalents for other currencies) as a reference for determining the interest they charge on various debt instruments including corporate loans, real estate finance and other commercial arrangements. It is estimated that worldwide over 100 million contracts are underpinned by LIBOR, with a value of around £290 trillion.
Issues with LIBOR
The reliability of LIBOR came into question in the aftermath of the 2008 financial crisis. In what became known as the ‘LIBOR Scandal’, it emerged that banks had been understating borrowing costs for LIBOR, giving the false impression that they were in better financial health than they were in reality.
Similarly, bankers, traders, and brokers at multiple institutions were found to be manipulating LIBOR for profit. Although this manipulation only came to light after the financial crisis, multiple testimonials from bankers suggest that the practice dates back to the 1990s.
However, what has ultimately turned out to be the death knell of LIBOR is the depreciation of the liquidity of the underlying market LIBOR measures. Banks are no longer lending as much to each other as they have in previous years. Therefore, LIBOR, already a collection of opinions, has developed into essentially expert speculation and a much less reliable measurement of the market.
SONIA
As a solution to this, financial authorities in many jurisdictions have made the decision to transition away from LIBOR to what are known as alternative risk-free rates (RFRs). In the UK the FCA, LIBOR’s regulator, announced that it will cease to compel banks to publish LIBOR, and any sterling inter-bank rate published will be deemed to be ‘not representative’ after 31 December 2021.
In the UK market, the RFR will be SONIA, administered by the Bank of England. Unlike LIBOR which is a forward-looking rate, SONIA is backwards-looking, reflecting interest rates that banks pay to borrow sterling overnight from other banks. The key differentiator from LIBOR is that SONIA is based on real market transaction data, and thus perceived to be ‘risk free’ and more robust. SONIA will replace LIBOR as the industry standard benchmark for sterling debt instruments and other financial products, and this means that significant changes to documentation and the way interest is calculated are required. Borrowers in particular will need to be ensure these changes are identified and properly implemented so as to avoid any adverse impact on their position.
A tough transition?
Although the deadline for LIBOR transition is looming, many businesses remain unprepared. A survey conducted by UK Finance in May 2021 found that 25% of the financial decision makers questioned were unsure if they have a product linked to LIBOR. The vast majority of those unaware of their exposure were SMEs.
Of the 100 million LIBOR-linked contracts, it is estimated at least US$52 trillion of these are set to mature after the end of year deadline. This could create major issues for the affected parties unless they are identified and dealt with in good time. Research conducted by Factor, a leading legal service provider, has found that two-in-five of the 100 million contracts that reference LIBOR contain no adequate fall-back provisions dealing with the discontinuation of LIBOR or the transition to an RFR.
The UK Government has introduced legislation (the Critical Benchmarks (References and Administrators’ Liability) Bill) to tackle the issue of ‘tough legacy’ contracts, being those contracts which reference LIBOR but which realistically cannot be amended to transition to alternative rates. Once enacted, this is intended to provide a legislative solution to deal with this category of contracts and to provide some certainty as to how contractual references to LIBOR in them should be interpreted, particularly around the continued availability of a published ‘synthetic LIBOR’ rate. It is also intended to provide a potential defence against claims for breach of contract or frustration. However, there remains some uncertainly as to which contracts will benefit from the provisions of the legislation and so cannot be relied upon as a failsafe.
Comment
LIBOR is deeply engrained in the financial landscape. Unfortunately, a wide variety of companies party to LIBOR-based arrangements could find themselves unknowingly exposed come 1 January 2022 unless steps are taken to review and identify any risks.
Assessing a company’s LIBOR exposure can be a cumbersome task but, with the deadline looming, companies who have not yet addressed this must act now. Many SME’s do not have the capacity to conduct this review, so seeking expert advice and guidance is advisable in order to be able to benefit from the more robust risk-free rate and to reduce exposure to any potential uncertainty in the market.
United Kingdom