Preparations being made in the UK | replacement Sterling Risk Free Rate
Over the last few years regulators around the globe have been engaging with the financial services industry to transition markets from IBOR based interest calculations to Risk Free Rates under a framework which has been set out by the Financial Stability Board, which is made up of the world largest central banks and regulators.
In the UK the Financial Conduct Authority has signalled that the base case assumption should be that LIBOR a will cease to be a practical reference rate by the end of 2021, by which time new Risk Free Rates will need to have become effective.
Andrew Bailey said in July 2017, “In our view it is not only potentially unsustainable, but also undesirable, for market participants to rely indefinitely on reference rates that do not have active underlying markets to support them.”
This represents one of the biggest changes in the financial services industry ever, with an estimated $300tr of Libor related activity globally, covering derivatives, loans bonds and trade and working capital.
All market participants – lenders and borrowers – will need to make changes over the coming months and years. The purpose of this [call] is to set out a foundation level of information about IBOR reform, why it has come about, what are the alternatives and some of the practical considerations.
In this podcast we will cover:
• The history- how did we get here?
• What are Risk Free Rates such as SONIA much better than LIBOR
• What can’t it do?
• What is happening to non Libor currencies/ jurisdictions
• Key Dates and Timings
• Next Steps
The interbank markets allow banks to borrow wholesale deposits from other banks over a shorter term at a relatively low cost compared to bond or equity funding.
The cost of doing so is published daily and is derived from submissions by panel banks where they state how much interest they pay to borrow a given currency for a tenor ranging from overnight to 12 months. The FCA has asked panel banks to continue to make these daily submissions until the end of 2021, but the FCA has said it will not compel banks to submit beyond that point
In the years following the Wheatley Review, as bank funding has become ever less reliant on short-term wholesale deposits, liquidity has continued to fall – such that panel banks are having to exercise more “expert judgement” in order to comply with daily submission requirements
This is as unsatisfactory for panel banks as it is for regulators and is the reason why, in March 2015, the Bank of England began consultations for the replacement for LIBOR Risk Free Rates. In July 2017 SONIA was identified as the Risk Free Rate for Sterling markets, with similar exercises have led in the other major currencies. Regulatory efforts since have been geared to moving financing markets from LIBOR to SONIA based interest calculations.
What are Risk Free Rates such as SONIA and why are they better than LIBOR?
SONIA, the Sterling Overnight Index Average, is published daily by the Bank of England. It represents the rate paid on overnight unsecured deposits, greater than or equal to £25m, as reported to the Bank’s Sterling Money Market daily data collection.
As an overnight rate it reflects minimal credit, liquidity and tenor risk. It is derived from real transactions with daily volumes of more than £50bn. Administered by the Bank of England, its governance is robust.
These key features of the SONIA market: a high volume of real activity, minimal additional credit premia and strong governance made it the strongest candidate to be the replacement Risk Free Rate in Sterling.
What can’t it do?
SONIA is a purer risk free, or near risk free rate for determining the cost of borrowing in sterling. But it is not a like for like replacement of LIBOR.
Crucially, SONIA only measures and prices overnight risk. Whereas LIBOR quotes for a range of tenors ranging from overnight to 12 months.
It is not, for example, possible to set an interest period with a -month SONIA reference rate.
It is, however, possible to set an interest period at  months based on SONIA by compounding the daily SONIA rates during the three months.
[The difference between the SONIA rate at the start of the interest period and the compounded rate at the end of that period is conceptually equivalent to the tenor premium found in term LIBOR rates, for example 1 month or 3 months LIBOR.
But whereas the LIBOR rate is known in advance, fixed at the start of the interest period, a compounded SONIA rate will not be known until the end of the period. LIBOR is set in advance and pays in arrears; a SONIA RFR would be set in arrears and pay in arrears.
From the consultation exercises held over recent years regulators have confidence that a compounded overnight rate is, for the majority of LIBOR users, a satisfactory mechanism to reflect a tenor premium.
It is, however, recognised that there is a set of LIBOR users – for example corporate loan borrowers – where the ability to know a future cash outflow, at the start of a borrowing period, has utility. A compounded overnight rate will not offer the same level of cashflow certainty.
Regulators appreciate this dynamic and continue to consult with market participants with a view to identifying and proving a satisfactory Term Risk Free Rate or other alternative to compound in arrears rates.
But they also warn that the eventual emergence of a TRFR should not be taken for granted. The bar, in terms of real activity, liquidity and governance, is high.
Their advice to market participants is to ensure preparations are made for a compounding SONIA regime and the expectation is that the majority of the loans market should be able to use compound in arrears rates
Regulators also advise that A Risk Free Rate Term Rate or alternative methodology should be focussed on smaller Corporate or retail based clients.
Other currencies and jurisdictions
This call has focused on the preparations being made in the UK for a replacement Sterling Risk Free Rate. Our engagement is with the Bank of England, through the FCA and the Working Group on Sterling Risk Free Reference Rates which is chaired by Barclays
Other jurisdictions and regulatory bodies are making similar preparations, under the Financial Stability Framework, but the timetable in which different currencies move to new RFRs may not be in sync, and the nature of the replacement RFRs may not be equivalent.
For example, we know in Europe that there has been a decision to enhance EURIBOR to use a more transactions based approach and use it as a Term Reference Rate in at least the medium term. What is not clear is whether Euribor will continue to be used by large corporate borrowers, or whether this move is to protect the European mortgage market which typically uses Euribor in many countries.
However the Swiss working group have decided not to build a new Risk Free Rate term rate for Swiss Francs.
Borrowers with exposure to multiple currencies should be aware that there will likely be a transition period where markets, systems and documentation need to cater for new RFRs alongside existing LIBOR mechanisms.
Timetable to Implementation
The Bank of England has stated that by the end of 2021 it will not compel panel banks to make daily LIBOR submissions, by which point all Sterling market participants will need to have moved to the new Risk Free Rates.
For Sterling, a number of Floating Rate Note issues in the bond market this year have referenced compounding SONIA instead of LIBOR. To date there has been one corporate bilateral loan facility arranged, with more expected to follow over H2 and Q1 2020.
The proposals for a Sterling Term RFR are not expected until Q2 2020.
The SONIA equivalent in the Eurozone, €STR, will be launched Q4 this year and US regulators are expected to publish the USD Term Rate towards the end of 2020.
UK regulators are working to the assumption that there will be no new LIBOR Sterling issuance beyond Q3 2020 and you should expect similar style targets for other currencies
Today’s podcast was designed to set the scene and provide a foundation level of information.
We will shortly publish more in depth recordings targeting specific products and topics, for example: loan facilities and their documentation; the derivatives markets and ISDA; systems and technology
We recommend firms start to prioritise scoping out your IBOR exposure, focussing on Libor and engage with key stakeholders and advisors to start to build initial transitions plans and approach
Each client impact is likely to be different and therefore we suggest engaging with your key stakeholders, including banks and advisors to build out your transition plans and approach, considering the timing as pressure to transition is likely to intensify over time.
Our website contains lots of additional information and links to guide you through your journey. Your Barclays Relationship Director is available for additional information or support to answer any specific questions or queries you may have on this topic.