FAQ: GBP LIBOR transition to SONIA

In July 2017, the UK Financial Conduct Authority announced that it would no longer require banks to submit cost of funds quotes in support of calculating LIBOR, calling into question LIBOR’s viability and availability beyond 2021. LIBOR underlies hundreds of trillions of pounds in financial instruments, including loans and derivatives, and the idea of transitioning to a new rate continues to raise many questions among our clients and industry partners.

Chatham has been active in the LIBOR transition, representing end users before the key players identified below, to ensure as smooth a transition as possible from their perspective. These are some of the LIBOR transition-related questions we receive most often. You can find more information in our LIBOR transition resource stream.

Basics of transition

• Who are the key players in LIBOR transition?
• When will LIBOR be discontinued, and what are the key milestones between now and then?
• Will LIBOR's discontinuation be delayed?
• When will lenders stop signing new loans based on LIBOR?
• What is SONIA, and how is it different from LIBOR?
• What hedging products are available for SONIA-linked debt?
• What are the key operational challenges associated with borrowing on SONIA?
• Will there be a forward-looking term rate version of SONIA?

Transition of existing loans and derivatives

• What are the main issues that must be addressed in transitioning a loan or derivative from LIBOR to SONIA?
• How are fallback triggers, rates, and spread adjustments addressed in loan and derivative documents?
• What happens to my existing LIBOR cap or swap once LIBOR is discontinued?
• How do I document my loan and derivative so they convert from LIBOR to SONIA at the same time?

Accounting considerations

• Overall, how will accounting be impacted during the period prior to transition to SONIA?
• How will accounting be impacted during the transition to SONIA?
• How will the accounting be impacted if an entity adhered to the ISDA Fallbacks Protocol on the hedging instrument (the derivative) but not the hedged item?
• What financial statement disclosures do I need to provide prior to transition?

Chatham recommendations

• What do we need to do to prepare for the transition? When will I need to act and how?
• What strategies are we seeing clients use to hedge through the LIBOR transition?

Basics of transition

Who are the key players in the LIBOR transition?

The key players include:

Financial Conduct Authority (FCA): The FCA regulates the Intercontinental Exchange (ICE), which is the administrator for LIBOR, as well as the panel banks involved in LIBOR’s calculation. More broadly, it regulates the UK financial sector and can set boundaries on LIBOR’s permitted uses in contracts.

Intercontinental Exchange (ICE) Benchmark Administration (IBA): ICE plays a number of roles in global financial markets, including through IBA, which serves as the administrator of LIBOR.

Bank of England (BoE): The BoE established the Working Group on Sterling Risk-Free Reference Rates in 2015. This Working Group comprises most of the major financial institutions that are stakeholders in GBP LIBOR, and its aim is to facilitate the transition from GBP LIBOR to SONIA across all relevant markets by the end of 2021.

International Swaps and Derivatives Association (ISDA): ISDA is the trade body for derivatives, and its purpose is to foster safe and efficient derivatives markets. ISDA is currently drafting new forms of derivative documentation, informed by public feedback, in order to facilitate a smooth transition.

Loan Market Association (LMA): The LMA is the trade body for the loan market. Similar to ISDA, it is consulting across the market and drafting new forms of loan documentation to facilitate a smooth transition.

International Organization of Securities Commissions (IOSCO): IOSCO regulates and sets standards for the global securities sector. In 2013, IOSCO released its Final Report on Principles for Financial Benchmarks, establishing guidance for selecting replacement benchmark rates as the market transitions away from LIBOR and other similar interbank offered rates. (Back to top)

When will GBP LIBOR be discontinued, and what are the key milestones between now and then?

In July 2017, the FCA announced that GBP LIBOR is at risk of discontinuation after the end of 2021. On 5 March 2021, a series of announcements and guidance by the UK Financial Conduct Authority (FCA), the ICE Benchmark Administration (IBA), the International Swaps and Derivatives Association (ISDA), and Bloomberg, answered a number of open questions regarding the timing of the end of publication of all LIBORs. After considering the results of their recent consultation, the FCA announced that all tenors of GBP LIBOR will be published and representative through December 2021 and will not be representative thereafter. The announcements set the ISDA spread adjustments, which provides more concrete guidance around the calculation of the fallback rate.

Should ICE continue to publish LIBOR after the end of 2021, some or all of the banks involved in LIBOR’s calculation could still drop out of the panel. If at any point there were five or fewer banks in the panel, LIBOR would be discontinued at that point. The FCA could also step in after a number of banks have left the process and state that the reduced size of the panel prevents LIBOR from being robust enough for use.

Between now and the end of 2021, key milestones include:

• Updated ISDA documentation: On October 23, 2020, ISDA published its IBOR Fallbacks Protocol (the Protocol) and related updates to the 2006 ISDA Definitions, with an effective date of 25 January 2021, to better accommodate permanent cessation of LIBOR. The Protocol is designed to facilitate an efficient transition of existing derivatives. Any derivative executed on or after the effective date that incorporates the 2006 ISDA Definitions will automatically incorporate these changes without need for the Protocol.
• Banks to stop signing new GBP LIBOR loans: In accordance with the FCA deadline, the majority of U.K. Banks ceased signing new loans on a GBP LIBOR basis from 31 March 2021. This applies to both new and refinancing or restatement of existing facilities (i.e. LIBOR transition will typically be “wrapped up” in amendments)
• Publication of SONIA term rates: Term SONIA Reference Rates, “TSRRs”, are forward-looking term SONIA rates. As described in more detail below, they are currently being published in Beta form. However, the regulator has repeatedly warned market participants against an overreliance on these, and to prepare for direct use of (overnight) SONIA in many cases.
• Path to discontinuation of new GBP LIBOR lending by end-Q1 2021: This was published by the Loan Enablers task force of the Working Group on Sterling Risk-Free Reference Rates in December 2020
• Assessment of loan contracts exposed to LIBOR: By the end of Q1 2021, the Working Group on Sterling Risk-Free Reference Rates expects all financial institutions to have completed their assessment of LIBOR-linked loans maturing after 2021. This should identify those contracts that can be actively converted and accelerate this active conversion in Q2/Q3 2021. (Back to top)

Will GBP LIBOR’s discontinuation be delayed?

Not at present. Although the FCA has pushed back some interim deadlines relevant to LIBOR’s cessation (for example the deadline for banks to stop signing new loans underpinned by LIBOR, which was originally set for Q3 2020), the overall deadline of 31 December 2021 has not changed. After considering the results of its consultation, the IBA confirmed its intention to cease the publication of GBP LIBOR after 31 December 2021, despite announcing its intent to extend publication of the most commonly used tenors of USD LIBOR through 30 June 2023. (Back to top)

When will lenders stop signing new loans based on LIBOR?

The majority of U.K. lenders have now ceased offering new LIBOR-referencing facilities. New facilities will typically reference SONIA. Existing facilities which are restated will required to incorporate LIBOR transition language with the objective of minimising the transfer of economic value between the parties on transition to a replacement reference rate made up of SONIA plus a Credit Adjustment Spread. (Back to top)

What is SONIA, and how is it different to LIBOR?

SONIA is the Sterling Overnight Index Average. It is published at 9 a.m. each London business day by the BoE and measures the cost of overnight, unsecured borrowing. Unlike many replacement rates for other currencies, SONIA is a long-established benchmark and has been published on a daily basis since 1998.

SONIA is calculated as the trimmed mean, rounded to four decimal places, of interest rates paid on eligible sterling-denominated deposit transactions. This trimmed mean is calculated as the volume-weighted mean rate, based on the central 50% of the volume-weighted distribution of rates. Eligible transactions are those that are:

• Reported to the BoE’s Sterling Money Market daily data collection
• Unsecured and of one business day maturity
• Executed between 00:00 and 18:00 UK time, and settled that same day
• Greater than or equal to £25 million in value

From a borrower’s perspective, there are three key differences between SONIA and LIBOR:

• SONIA is an overnight rate, not a term rate: Whereas LIBOR gives the cost of borrowing for a range of different periods (1 month, 3 months, 6 months, etc.), SONIA is a single rate that measures the cost of overnight borrowing. As a result, in order to use SONIA to calculate the floating rate of interest on a multi-day borrowing period, each SONIA fixing during that period must be collected and compounded.
• SONIA is a backward-looking rate: While LIBOR is forward looking, giving the cost of borrowing for the future period starting on the day it is published, SONIA is backward looking. This means that borrowers with debt linked to SONIA will not know the floating rate for each interest period until the end of the period.
• SONIA typically fixes lower than LIBOR: As SONIA does not include an implicit credit premium for the banking sector, it typically fixes lower than LIBOR. This means that references to LIBOR in a debt or derivative contract cannot simply be replaced by references to SONIA without the amendment resulting in a (potentially significant) transfer of economic value. To avoid this, counterparties will need to determine an appropriate spread adjustment to be added to the replacement rate.

For more detailed information about SONIA, please read SONIA: An end user's guide. (Back to top)

What hedging products are available for SONIA-linked debt?

The SONIA swap market is already well-established, and since the second half of 2019, the average daily volume of new SONIA swaps traded has exceeded that for GBP LIBOR. In the first quarter of 2020, we saw a particularly large spike in the volume of new SONIA-linked transactions compared to LIBOR ones. Although activity for the remainder of the year was more muted, the SONIA swap market has remained liquid across the tenor spectrum.

It is also possible to hedge SONIA-linked debt with caps, floors, and swaptions. The market for these option-based products, however, is currently less liquid. As a result, the cost of these products is currently higher than that for the equivalent LIBOR product, and some banks are currently unable to provide them. However, liquidity is building quickly across the market and we anticipate that the volume of SONIA-linked options will overtake their LIBOR equivalents by the end of 2021. For more information about SONIA transaction volume, please visit our GBP LIBOR transition market brief — Q4 2020. (Back to top)

What are the key operational challenges associated with borrowing on SONIA?

Whereas LIBOR fixes in advance (i.e., at the start of an interest period), compounded SONIA is backward-looking and can only be calculated once the period has ended, as its calculation requires each daily fixing of the rate. Borrowers using compound SONIA will therefore no longer be able to plan their interest cost cash flows at the start of each interest period, as they will only know the final interest rate on period’s end date.

There are a variety of ways to deal with this, and the most popular to date has been to introduce a five-day “lag” in the SONIA fixings which are observed in order to calculate each interest period’s floating rate. Using this methodology, the final rate is known five business days before the interest period ends and payment is due — not as much notice as borrowers using LIBOR are accustomed to, but significantly better than a same-day cash flow.

It is also worth noting that, while borrowers using compounded SONIA will not have complete certainty of their interest cost until the end of each period, they will have a reasonable estimate much earlier than this. Compounding daily SONIA fixings is similar to averaging, meaning that by the midpoint of the calculation period, each subsequent daily fixing only has a limited impact on the final figure. Even a significant change towards the end of the period (due to an interest rate hike or cut by the BoE, for instance) may only change the total interest cost by a few basis points. (Back to top)

Will there be a forward-looking term rate version of SONIA?

Since mid-2020, FTSE Rusell, ICE and Refinitiv have published in Beta form 1/3/6/12 month tenor Term SONIA Reference Rates (TSRRs). These rates are known at the beginning of the interest period as opposed to the end of the interest period and are being developed for contracts where early cash flow certainty is an important operational consideration.

In theory it is possible to derive forward looking term rates from a variety of instruments included swaps and futures. So far all three providers follow a consensus waterfall methodology where the first step is to use spot starting SONIA OIS swap data. At the moment trade execution data is not sufficiently liquid to produce robust TSRRs, so the swap data is based on interdealer brokers quotes. As liquidity increases, the waterfall methodology may change.

While TSSRs are being developed for limited use in some cash markets, the current market consensus is that overnight SONIA compounded in arrears is the default approach for transition to SONIA in most derivatives, bonds, and bilateral and syndicated loans and that use of TSSRs should limited so as to not fragment the SONIA market. Also, while a forward-looking term rate version of SONIA may eventually be officially published, only a limited range of products may be available for such a term rate, and the trading and execution charges associated with these products may be higher than for the equivalent compound SONIA products. (Back to top)

Transition of existing loans and derivatives

What are the main issues that must be addressed in transitioning a loan or derivative from LIBOR to SONIA?

The main issues in transitioning a given loan or derivative are:

1. Fallback triggers: what event(s) will give rise to a transition from LIBOR?
2. Fallback rates: what rate will replace LIBOR?
3. Spread adjustment: how will the loan spread and derivative economics be adjusted to reflect any difference between LIBOR and its replacement rate?
4. Calculation of interest: what will be the calculation methodology to convert many SONIA fixings into one overall floating rate for each interest period?
5. Timing of transition: at cessation (31 December 2021) or pre-cessation, for example, on an IPD between now and cessation with the objective of effecting a smooth transition with minimal disruption to the underlying business. (Back to top)

How are fallback triggers, rates, and spread adjustments addressed in loan and derivative documentation?

In general, fallback triggers fall into one of two categories:

• Cessation: Public statements by relevant authorities indicative of permanent discontinuation
• Pre-cessation: Declaration (by relevant authorities or by lenders) that LIBOR is no longer representative, or is insufficiently robust (e.g., due to an insufficient number of panel banks providing estimates for its calculation)

Permanent replacement rates are not typically specified explicitly in many loan or derivative documents dated before 2020. Many loan documents specify an estimate of lenders’ cost of funds in the event that LIBOR is unavailable, but this is a stopgap designed to cover the period until a replacement rate can be agreed. As such, the replacement rate for most existing loans and derivatives will need to be inserted by amendment to the documentation, after agreement by borrower and lenders.

The spread adjustment recommended by ISDA, following consultation with the industry, is the median of the five-year historical spread between compounded SONIA and GBP LIBOR, with this being measured from the date that the fallback is triggered. This method for calculating the spread adjustment, as well as the specification of compounded SONIA as the replacement rate, have been published by ISDA in October 2020, in the Protocol and revised set of definitions allowing derivative counterparties to agree on amendments necessary to smooth the transition from LIBOR to SONIA.

For loan agreements, there is less of a consensus over the calculation of the spread adjustment, driven in part by the more fragmented and diverse nature of the loan market compared to that for derivatives. Borrowers seeking to retain their derivatives as efficient hedges should attempt to mirror their derivative spread adjustments in their loan agreements. (Back to top)

What happens to my existing LIBOR cap or swap once LIBOR is discontinued?

In the event of LIBOR’s discontinuation, ISDA’s existing benchmark fallback language, which contemplates temporary unavailability, rather than wholesale discontinuation/replacement, calls for the parties to request and average quotes from a group of banks; but in that scenario, it is likely that most banks would be unwilling to provide a quote on a permanently discontinued rate. This is one of the reasons that ISDA has introduced revised definitions to include more robust fallback language. To the extent that the updated fallback methodology is incorporated into the terms of the existing trade, once fallback is triggered, the derivative will be updated to begin referencing the new fallback rate (e.g., SONIA). If an entity does not incorporate the revised ISDA definitions into the terms of its derivative, it remains to be seen how this will play out in practice. It is unclear what will happen if an entity does not, or refuses, to incorporate the updated fallback methodology into the terms of its transaction.

Chatham expects much of the market to use SONIA compounded in arrears as the derivatives fallback rate. Unfortunately, it’s too early to tell how the volatility markets will develop; data necessary to calculate volatility and convexity isn’t readily available at present. Nearly all the regulators’ focus at this stage has been on determining rates and calculating payments, as compared with related issues like volatility markets. This presents challenges not only for caps but also for calculating XVAs (Credit Valuation Adjustments, Debit Value Adjustments, Funding Value Adjustments, etc.) on other products like swaps.

That said, liquidity is building quickly across the SONIA volatility market, and we anticipate that SONIA-linked options, together with the associated volatility data, will be far more prevalent by the end of 2021. (Back to top)

How do I document my loan and derivative so they convert from LIBOR to SONIA at the same time?

One significant open question is whether loans and hedges can convert in such a way as to minimize unnecessary cost to a borrower. The answer lies in whether the transition language in the loan and cap or swap are consistent in terms of the fallback trigger, fallback rate, and spread adjustment. If any of these do not match, there could be a negative impact to a borrower, particularly those sensitive to hedge accounting treatment.

If any differences between lending and derivatives markets continue through implementation, they could drive market participants to negotiate bilateral adjustments to their derivative transactions (to match their hedged items) rather than adhering to the new ISDA protocol as a standardized practice. This concern about the need for consistency has been echoed by other stakeholders responding to ISDA’s public consultations regarding fallback methodology and pre-cessation triggers. End users need to be aware of the potential for mismatch and what that could mean from a risk perspective, advocating and pushing for change where necessary to minimize the gap. (Back to top)

Accounting considerations

Overall, how will accounting be impacted during the period prior to transition to SONIA?

The IASB’s Phase 1 on IBOR reform deals with pre-replacement issues arising on IBOR reform and in September 2019 an amendment was issued to IFRS 9, IAS 39, and IFRS 7. The amendment provides a temporary exception from applying the highly probable requirement in determining whether a hedge forecast transaction is still expected to occur during the period in which uncertainties exist about the designated interest rate benchmark and/or the timing or the cash flows of the hedged item or hedging instrument. Consequently, during this period of uncertainty, the reliefs provided allow almost all entities to continue to apply hedge accounting without changing their existing processes. These reliefs apply for periods beginning on or after 1 January 2020, with earlier application permitted. Without this guidance hedge accounting for interest rate exposures would be lost by many market participants. (Back to top)

How will accounting be impacted during the transition to SONIA?

In August 2020, the IASB issued its Phase 2 of IBOR reform amendments related to the measurement of financial instruments, including simple loans, and hedge accounting arising as a result of IBOR reform. The objective of these amendments is to provide useful information about the effects of the transition to Risk Free Rates (RFRs) on financial statements and support preparers in applying the requirements of IFRS during IBOR reform. These amendments, which can be early adopted, are applicable for annual periods beginning on or after 1 January 2021 assuming endorsement of the amendments has been made by the relevant national standards setting authority. Unless an entity has transitioned any of its loans or derivatives to RFR rates, there should be no need to early adopt Phase 2 for December 2020 year-ends.

• Debt and loans: when a debt contract is modified as a direct consequence of IBOR reform and is done on an economically equivalent basis, the guidance provides a practical expedient in that the modification is accounted for prospectively as an adjustment to the effective interest rate of the instrument with no day one P&L impact. Some examples of such modifications would be changes in the existing benchmark rate from IBOR to RFR, changes to incorporate a fixed spread to reflect the historical basis difference between IBOR and the RFR, the addition of a fallback provision to the contractual terms of a financial asset or financial liability and changes to the reset periods and payment dates flowing from transition to the RFR. However, the accounting implications from modifications to the terms of a loan contract that are not related to IBOR reform would need to be assessed in accordance with the current modification guidance in IFRS 9. Examples of such modifications could be changes to the loan’s notional amount, maturity, counterparty credit spread unrelated to IBOR reform or insertion of prepayment conversion or interest rate cap, or floor features.
• Hedge accounting: the amendments extend the practical expedients from the aforementioned loan modifications to allow hedging relationships to continue in situations where the changes to either the hedging instrument and/or the hedged item are directly required by IBOR reform and are executed on an economically equivalent basis. This is achieved by the allowance to make updates the hedge documentation to reflect changes to the hedged risk, the hedged item and/or the hedging instrument as a result of IBOR reform. One point to emphasise though is the importance of the timing of transition for both the hedged item (loans) and hedging instrument (derivatives) to be aligned in terms of the date of transition and from an economic perspective. Failure to do so is likely to result in significant accounting complexity and potential P&L noise.
• Embedded derivative review: Upon issuance and modification, all contracts must be analysed for embedded derivatives. Both qualitative and quantitative factors are considered to determine whether the embedded derivative should be accounted for separate from the host contract. Although the amendments do not grant specific relief, making economically equivalent changes required by IBOR reform would generally not significantly modify the cash flows to trigger a reassessment of embedded derivatives. (Back to top)

How will the accounting be impacted if an entity adhered to the ISDA Fallbacks Protocol on the hedging instrument (the derivative) but not the hedged item?

IFRS 9 paras. 6.8.11 and 5.4.5 require entities to cease applying the Phase 1 reliefs to the hedging instrument when:

1. Uncertainty has ended with respect to the timing and amount of the IBOR-based cash flows of the hedging instrument
2. There has been a change to the basis for determining the contractual cash flows from IBOR to the RFR rate

For entities that adopted the ISDA Fallback Protocol on their GBP LIBOR-based derivatives, two important events happened for the derivative, namely:

• The effective date of RFR rate (SONIA) was announced by the FCA as 31 Dec 2021
• The credit adjustment spread (CAS) between the GBP LIBOR and the SONIA became known, which was the 5-year median spread adjustment between SONIA and the relevant GBP LIBOR tenor as of 5 March 2021

Although the 31 Dec 2021 was announced as the date of permanent discontinuation of GBP LIBOR, there is the possibility that the FCA could bring forward the cessation of GBP LIBOR before the end of 2021. Alternatively, the FCA could decide to delay this effective date which makes the timing of the cash flows of hedging instrument still uncertain. Furthermore, entities who have adhered to the protocol might have gotten their CAS determined, they could choose to bilaterally amend contracts sooner especially if the market spreads between GBP LIBOR and SONIA widen from the hard-wired CAS implied from the ISDA Protocol. Assessing when the uncertainty ends is an area of judgment and many market participants are of the view that adhering to the ISDA Protocol alone does not necessarily mean that entities can no longer apply the Phase 1 reliefs on the derivative. (Back to top)

What financial statement disclosures do I need to provide for IBOR transition?

For entities that are in Phase 1 of the relief, they should be disclosing the following in their financial statements:

1. the significant interest rate benchmarks to which the entity’s hedging relationships are exposed
2. the extent of the risk exposure the entity manages that is directly affected by IBOR reform
3. how the entity is managing the process to transition to RFRs
4. a description of significant assumptions or judgements made in applying the Phase 1 relief
5. the nominal amount of the hedging instruments affected by Phase 1 relief

Entities that have early adopted Phase 2 relief should be disclosing the following in their financial statements:

1. the fact that they have early adopted Phase 2 relief
2. how the entity is managing the IBOR reform transition process
3. progress to date in completing the transition to RFRs
4. risks to which the entity is exposed to from the transition
5. quantitative information about financial instruments that have yet to transition to RFRs
6. changes to an entity’s risk management strategy arising from IBOR reform

(Back to top)

Chatham recommendations

What do we need to do to prepare for the transition? When will I need to act and how?

Chatham recommends that all GBP LIBOR-based borrowers do the following:

• Review and inventory their loans and associated derivatives as to trigger, fallback, and spread adjustment language (or lack thereof) as soon as possible
• Incorporate more robust fallback language into their loans (see Chatham’s recommendations)
• Monitor the LIBOR transition, specifically including:
  • Issuance of non-LIBOR indexed debt for signs of preparedness on the part of lenders and increased appetite from lenders and investors for exposures to benchmarks other than LIBOR
• Understand transition guidance and any relief afforded
• Assess potential regulatory scrutiny as to various entities within an organization

Chatham further recommends that GBP LIBOR-based borrowers who hedge their interest rate exposure with OTC caps, swaps, etc., spend time reviewing the revised ISDA definitions and the ISDA protocol, along with any bilateral agreements issued by ISDA or specific lenders/hedge providers, to determine the optimal hedge fallback mechanism for their specific situation. (Back to top)

What strategies are we seeing clients use to hedge through the LIBOR transition?

LIBOR-based borrowing/hedging is by far the most prevalent among our real estate, private equity, and corporate client bases. These clients use LIBOR swaps, caps, and swaptions to hedge floating-rate loans and future issuance or refinancing of fixed-rate debt. Most of our clients focus on ensuring flexibility for LIBOR fallbacks and cessation events in loan documentation. Some clients have included trigger language in derivative trade confirmations for longer-dated trades, likewise, focusing on flexibility and commercial reasonableness.

In addition, although SONIA-based term rates are now being published by a variety of data providers, markets for these term rates are yet to develop. In view of the limited time until GBP LIBOR’s potential discontinuation, it would be prudent not to wait for term rate markets to develop and to instead prepare to use SONIA compounded in arrears (or compounded in advance, as appropriate) directly. (Back to top)

What LIBOR transition-related resources are available?

Chatham Financial frequently publishes LIBOR content, here are some essential entries:

• FAQ: USD LIBOR transition to SOFR
  
• SONIA: An end user’s guide
  
• GBP LIBOR transition market brief — Q4 2020
  
• ISDA's IBOR Fallbacks Protocol FAQ
• Understanding ASC 848
• EURIBOR, GBP LIBOR, SONIA, and Swap Rates
  

The Bank of England publishes SONIA by 9 a.m. each business day:

• The BoE's SONIA data series

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