GBP LIBOR’s last days, SONIA, and the start of synthetic GBP LIBOR

As we noted in our previous update the pathway for GBP LIBOR transition is well trodden, and there is less ambiguity about the choice of alternative reference rate and the appropriate credit adjustment spread. The FCA/BoE recommends non-cumulative compounded SONIA in arrears plus a fixed credit adjustment spread (11.93 bps for three months) as the replacement rate and most commonly adopted position for pre- or at cessation transitions.

It is clear from the inbound calls we are receiving that there are many contracts which will not be transitioned by 31 December; and target dates now for effective transition is the first IPD of 2022 — for many borrowers this seems to be at or around the end of the first quarter 2022. This is common practice for loans where the final LIBOR setting has already taken place in Q4 2021.

The Financial Conduct Authority (FCA) also has clarified the circumstances in which synthetic LIBOR may continue to be used. Even with this clarification, there still exists in the market place some confusion as to exactly what it is (i.e., how is the rate calculated) and in what circumstances it can be deployed.

Firstly, the stance of the FCA and other bodies has not altered; they continue to state that all contracts should be actively transitioned to an alternative reference rate, and investors should not rely upon synthetic LIBOR. They are reinforcing this message by only committing to the publication of synthetic LIBOR for 12 months (in that there will be a review of it every 12 months on whether to continue publication of synthetic LIBOR for up to 10 years). Consequently, further replacement rate risk increases with the outstanding term of (longer dated) facilities and instruments.

Synthetic LIBOR is made up of two components:

1. The Term SONIA rate (published by ICE Benchmark Administration (IBA) or Refinitv and currently in the public domain free of charge) plus
2. The appropriate credit adjustment spread for one-, three-, and six-month tenors based off of the ISDA five-year historic median calculations published in March. Under this methodology, the credit adjustment spread for a three-month term is 11.93 bps.

Term SONIA is a forward-looking term rate — so arguably operates similarly to LIBOR in that it sets in advance (at the beginning of the interest period) and pays at the end. It is calculated from SONIA-linked overnight interest rate swaps. Refinitv/Ice Benchmark Administration (IBA) collects the tradeable bid and offer prices and volumes for eligible SONIA overnight interest rate swaps on the order books of regulated electronic trading venues. Term rates can then be calculated.

Synthetic LIBOR is permitted for use in all contracts other than cleared derivatives — but we would remind borrowers of the FCA stance on its adoption; the FCA discourages the use of non-representative synthetic LIBOR settings where appropriate alternatives are available.

Term SONIA has begun to receive more attention in recent weeks because of concerns that contracts may not be actively transitioned by the first interest payment date of 2022. If a debt instrument has not transitioned to SONIA compounded in arrears, or whatever replacement rate is selected by the lenders and the borrower, the instrument will fall back to synthetic LIBOR for most GBP LIBOR English law contracts which have not taken action to transition or have not adhered to defined protocols (like ISDA for example).

The application of synthetic LIBOR to a debt instrument will occur by operation of law. This is important for borrowers to understand: the transition to synthetic LIBOR will be like the contract always provided for the change. Market standard pre-cessation triggers will be unaffected.

If cessation triggers contractual fallbacks or unavailability of the setting (which will be the situation on 31 December 2021), then the synthetic methodology will override any pre-existing contractual fallback.

Separating the market impact on your interest rate from the transition impact

One complaint from borrowers is that the compounded SONIA in arrears rate plus the credit spread means that, on transition, borrowers will end up with a higher rate than they would under current LIBOR. Some borrowers are pointing to this increased spread as a rationale to let the instrument automatically convert to synthetic LIBOR rather than actively transition the instrument. However, this rationale is based on the assumption that synthetic LIBOR bears some resemblance to LIBOR — and it doesn’t. From the borrower’s perspective, the biggest issue with this strategy is that Term SONIA currently sets higher than SONIA compounded in arrears (Term SONIA is forward looking so reflects some of the market expectation of higher rates already). The table below shows the comparison of the rates as of 2 December.

It is unfortunate that LIBOR cessation is occurring coincidentally with the timing of expected interest rate increases by the Bank of England (BoE). While the BoE did not move rates in November, they may still do so in December. That means the first interest rate calculation of 2022 for many borrowers could be materially higher than what is being paid currently with a LIBOR reference. We predict many phone calls from borrowers asking that their interest cost calculation be double checked!

There are some murmurings already from borrowers about unfair treatment in the transition, and the move to synthetic LIBOR not being agreed to by them. Current legislation is anticipating this with the Critical Benchmarks (References and Administrators Liability) Bill which creates a safe harbour. This protection only applies to the transition from LIBOR to synthetic LIBOR; it does not apply to the transition from LIBOR to the alternative reference rate. The aim of the safe harbour is to create some legal certainty and prevent claims brought by parties whose contracts incorporate a designated benchmark.

We were perhaps a little optimistic that our LIBOR transition conversations would be tapering off as we head toward the deadline — but based on what we are seeing in the market at the moment, it looks like we will be well into 2022 before borrowers are fully transitioned.