What is LIBOR and why is it important?
The London Interbank Offered Rate (LIBOR) is the most commonly used benchmark for short-term interest rates and often is referenced globally in documentation for derivatives, bonds, business loans and consumer financial products. The setting of LIBOR is made daily on London business days by submissions from LIBOR panel banks of indications of the average rates they can obtain wholesale unsecured funding in 5 currencies (USD, GBP, EUR, JPY and CHF) and 7 maturities (from overnight to 12 months). It is a major interest rate benchmark which as at November 2018 was estimated to underpin approximately $300tn ($30tn in GBP markets) of financial contracts including, derivatives, bonds and loans.
What is happening with LIBOR and why transition away from it?
In 2017, the UK Financial Conduct Authority (FCA), LIBOR's regulator, decided that it would not compel LIBOR panel banks to continue to make LIBOR submissions after 2021. Accordingly, it is very likely that LIBOR will no longer be available after the end of 2021 and therefore LIBOR is expected to be phased out. Transition to alternative benchmark interest rates is underway, but much work lies ahead in order to implement a successful reference rate change by the end of 2021.
What is the role of the Working Group on Sterling Risk-Free Reference Rates?
The Working Group on Sterling Risk-Free Reference Rates (the Sterling Working Group) was set up by the Bank of England to recommend a near risk-free reference rate (RFR) and promote its adoption as an alternative to sterling LIBOR. In April 2017, the Sterling Working Group recommended the Sterling Overnight Indexed Average (SONIA) as its preferred RFR.
What is SONIA?
SONIA measures the rate paid by banks on unsecured overnight funds. In April 2017, the Sterling Working Group recommended SONIA as the preferred sterling RFR citing a number of reasons:
- SONIA has the capability to evolve over time so is robust to changes in its underlying markets.
- SONIA tends to be predictable and tracks Bank Rate very closely.
- SONIA is referenced in the already liquid sterling overnight indexed swap (OIS) market making the path to transition easier.
How is SONIA calculated?
Each London business day, SONIA is measured as the trimmed mean of interest rates paid on eligible sterling denominated deposit transactions and rounded to four decimal places. The trimmed mean is calculated as the volume-weighted mean rate, based on the central 50% of the volume-weighted distribution of rates.
For the derivatives market, SONIA will be calculated the same but operate under different parameters. ISDA found that market participants preferred SONIA to apply on a historical median approach over a five-year lookback period. SONIA will also be compounded setting in arrears with a two-banking-day backward shift adjustment for operational and payment purposes. The cash market's response to how SONIA will operate is under review at the time of writing.
Does the Sterling Working Group have a timeline for the adoption of SONIA?
In 2019, the Sterling Working Group published a roadmap which set out progress to date as well as outlining some of the key steps and targets until the end of 2021:
- Q1 Target: Term rate(s) produced and made available to use where appropriate
- Q2 Target: Critical infrastructure build completion
- Q2 Target: Funds transfer pricing, intercompany loans, pricing/valuation/risk models updated
- Q3 Target: GBP issuance of LIBOR-based products maturing beyond 2021 has ceased
- Q1 Target: Stock of LIBOR referencing contracts reduces significantly.
The roadmap can be found at www.bankofengland.co.uk
What happens to existing transactions and contracts?
A transaction, which references LIBOR and matures, or expires, after the time LIBOR is expected to be phased out, will likely need to be amended. This will be an expansive task given the large number of contracts referencing LIBOR.
What is happening to new transactions entered into now and in the near future?
Trade associations and industry working groups such as the International Swaps and Derivatives Association (ISDA) and the Loan Market Association (LMA), have developed and continue to work on contractual terms to be included in contracts known as “fallback provisions" that specify what will happen when a benchmark rate (such as LIBOR) is no longer available.
What is a fallback provision?
It is simply a contractual provision that specifies either (i) what will be the applicable new benchmark interest rate or (ii) the negotiation process to be followed by the parties to determine a replacement rate, in the event that the referenced interest rate used in that contract becomes unavailable. The Sterling Working Group has been supportive of robust contractual fallback terms being in place to facilitate a smooth transition from LIBOR to SONIA. Such terms should include consideration of a credit spread adjustment to account for differences between LIBOR and SONIA. In the derivatives market, ISDA consulted on the final parameters for the spread and term adjustments in derivative fallbacks for LIBOR. ISDA recommended the use of the the historical median approach over a five-year lookback period for the spread adjustment to address credit risk and other premia between LIBOR and SONIA.
Given that SONIA is an overnight rate, will forward looking term SONIA be available?
There are currently no forward-looking term rates based on RFRs available. The development of a forward looking SONIA rate is being looked at by the Sterling Working Group. The FCA has discouraged market participants from delaying the transition of new business away from LIBOR until the production of a SONIA forward looking rate. However the Sterling Working Group has recognised the role that a forward-looking term rate could play a part in facilitating the transition from LIBOR to SONIA and three potential benchmark providers have confirmed that they are working on such a term rate with a view to making a rate available in 2020.
Where can I get updates regarding the transition process for GBP LIBOR?
The Sterling Working Group publishes a monthly newsletter providing key news updates relating to the LIBOR transition in the UK and other markets. The Sterling Working Group's current and past newsletters can be found at www.bankofengland.co.uk in the section titled "Working Group newsletters".
Is MUFG actively working on the transition away from LIBOR?
Yes. Even though LIBOR may continue to exist until December 31, 2021, planning has already begun to migrate away from LIBOR to one or more replacement rates. We are assessing impacts, managing LIBOR transition and seeking to mitigate risks. Our clients will hear more from us as transition tools, methods and timing become clearer.
What should my firm do right now?
(1) Learn more about LIBOR cessation, transition and replacement rate developments; (2) analyse its LIBOR exposure with a focus on financial instruments maturing beyond 2021 and what effect the discontinuation of LIBOR might have on that exposure; (3) engage with its counterparties, vendors and financial institutions to begin the process of identifying and amending LIBOR-dependent contracts to which it is a party; and (4) consider the impact that a change to a replacement rate may have on accounting, tax, IT, systems and operations.
For further information on, please visit the MUFG Global IBORs webpage here.
This page and its related content are not intended to be, and should not be relied upon as, legal, financial, tax, accounting or other advice. We are not providing you with any such advice and you should consult your own advisors for advice on the reform of interest rate benchmarks and the related risks. We make no representation and provide no warranty as to the information set out in herein, which is based on information from third parties, and you should not rely on any such information as constituting a representation or warranty. The content herein is not intended to be comprehensive and were last updated in Feb 2020. Material developments may have occurred since this last update. This page and its related content do not consider risks to you from interest rate reform and there may be other issues that are not highlighted below. Without limiting the foregoing, this page and its related content do not address issues specific to any particular sector or business. We are not acting as your fiduciary or adviser and the provision of this information to you will not give rise to any duty of care. We assume no responsibility for any use to which these this information may be put. The areas covered herein are continually evolving and you should consult the relevant sources. Links to some of the relevant working and industry groups are at the end of this document.