New lending using LIBOR is to stop from Q3 2020. That is the target the Bank of England’s Working Group on Sterling Risk-Free Reference Rates (WGSRFR) have set. Last month in a speech delivered by Edwin Schooling Latter, Director of Markets and Wholesale Policy, the FCA commented that for some banks this Q3 2020 target will involve “significant infrastructure and documentation preparation”. A key factor in the success of a firm’s smooth transition away from LIBOR is the capabilities of its IT infrastructure.
To prepare for the Q3 2020 target firms need to ensure that their systems have the functionality to do the following 5 key things:
● support loans based on overnight rates compounded in arrears, whilst also allowing for the potential for forward-looking term rates to become available in the future. The LMA exposure draft SONIA-based facilities agreement uses a compounded average of SONIA to make the overnight rate capable of use over a period. While the FCA has made clear that the transition of new business away from LIBOR should not be delayed until forward-looking term rates based on SONIA are produced, the WGSRFR is supporting the development of a forward-looking SONIA-based term loan, which will be attractive to borrowers seeking payment certainty.
● reference historic SONIA rates to accommodate different lags. To ensure the outstanding interest payment is known before the end of the interest period, the lag structure used in the LMA exposure drafts involves using an average of SONIA calculated over an earlier period equal in length to the relevant interest period. The lag in the LMA exposure draft is not specified. While convention of choice in the SONIA-referencing FRN market so far is a 5 day lag, the lag may be subject to negotiation between the lender and borrower, and will involve a balancing of cash flow certainty, length of advance notice needed to make payments and better alignment of interest rates. Systems ought also to be capable of taking into account international alternatives, such as lockout (which repeats one of the daily rates for the final few days of the calculation).
● exclude the margin and spread adjustment from compounding. The recent SONIA-referencing loan from NatWest to National Express, in line with practice in SONIA-referencing bonds, added the margin after the compounding calculation. This approach is also taken in the LMA exposure draft and is expected to be market standard. As well as introducing additional complexity, and making the benchmarking of transactions more difficult, margin compounding may not be compatible with a screen rate.
● accommodate manual entering of compounded SONIA and also be capable of adaptation for automated compounded SONIA screen rate feeds becoming available. In the LMA exposure draft the compounded average RFR is determined by reference to an externally produced compounded average of the RFR made available by an information provider, with a fallback waterfall. Although there is currently no daily publication of a SONIA screen rate it is anticipated that this infrastructure structure will be developed and systems should be able to adapt to this change.
● take account of potential differences across jurisdictions in both transition timelines and conventions in new markets in RFRs. Systems should be capable of calculating backward- and forward-looking rates to cover multi-currency deals where the market is fragmented due to differing IBOR transition timelines, and different credit spread adjustments across currencies.
If you have any questions about the transition away from LIBOR please contact Bruce Stephen or your usual Brodies contact.
On December 4, 2019