The scandals involving manipulation of LIBOR over the last few years have resulted in LIBOR being phased out and it will no longer be available after 2021. ICE Benchmark Administration Limited, which currently administers LIBOR for the finance market, has responsibility for a smooth transition from LIBOR to an alternative interest rate. The market offers no clear like for like alternative to LIBOR and it is anticipated LIBOR will be replaced with a risk free rate.
The Bank of England has been administering the Sterling Overnight Index Average (SONIA) since April 2016 and it is SONIA which has been proposed as LIBOR's successor. However a move from LIBOR to SONIA for sterling would be far from straightforward because it operates on a very different basis. In particular:
- LIBOR is published for seven different lengths of interest period but SONIA is an overnight rate
- LIBOR is forward looking whereas SONIA is backward looking - the rate of SONIA cannot be determined until the end of the applicable period. LIBOR creates certainty and transparency at the beginning of each interest period because LIBOR is pre determined for each period on the first day of each applicable interest period. Both borrower and lender therefore know what rate applies for the duration of each interest period. A move to SONIA would therefore create uncertainty in the market because the applicable rate, and therefore the interest payable on the final day of any interest period, cannot be determined until the final day of that interest period. Likewise, SONIA might make it more difficult for borrowers to prepay principal or refinance their facilities mid interest period, since calculations cannot be carried out in advance of the prepayment being made
- LIBOR is calculated to reflect term bank credit risk, with longer tenors generally being more expensive to reflect the increased exposure on longer term funding. SONIA is near risk free because it does not look at future periods of time so lenders are not compensated for taking longer term credit risks
- Given the key differences in the way LIBOR and SONIA operate and are calculated, it would be reasonable to assume that month end processing and reconciliation will be more time consuming and complicated and present more of an administrative headache for lenders and borrowers alike
The alternatives to LIBOR in other key currencies (namely the Euro Short-Term Rate (ESTER), the US Dollar Secured Overnight Funding Rate (SOFR), the Swiss Average Rate Overnight (SARON) and the Tokyo Overnight Average Rate (TONA)) are fraught with the same difficulties because they also operate on a risk free basis, in the same way as SONIA. Larger corporates are more likely to have readily available cash resources than small sized borrower businesses - it is the latter which is most likely to be affected and a move to SONIA or some other form of risk free rate would likely result in all borrowers, regardless of their size, having to maintain better surplus cash liquidity. It is not yet clear how lenders are expected to identify the applicable rate before booking a transaction - daily rate movement makes things even more uncertain. Is it possible that more smaller sized borrowers will look to the derivatives market for certainty on interest rates if the market transitions to SONIA without any supporting forward looking measures? If so, that would, presumably, mean a greater need for regulation and scrutiny of the derivatives market to avoid further mis-selling scandals.
If SONIA is to replace LIBOR, significant disruption must be expected in the market but lawyers cannot draft to protect borrowers or lenders until the market determines LIBOR's successor, how interest rates should be calculated and applicable interest payable. In the meantime, it would be prudent for lenders and borrowers to consider their existing facility documents and their agreed market disruption language. In particular they should look to ensure that their documents contain appropriate fall back provisions in the event that LIBOR ceases to be available before LIBOR's true successor is found.