On March 26, 2021, the LMA published a note outlining considerations for market participants relating to the use of forward-looking term SONIA reference rates (Term SONIA Rates).
Term SONIA Rates have been available in beta form since July 2020, and available for use since 11 January 2021. Term SONIA Rates are expected to have limited use as the UK authorities have made clear their preference for the market to adopt a broad-based transition to SONIA compounded in arrears for new transactions, with use of Term SONIA Rates being more limited than the current use of LIBOR, and with SONIA compounded in arrears being seen by the Bank of England and FCA as the most robust and reliable replacement rate for LIBOR. However, it is acknowledged that Term SONIA Rates may provide an option for loan transition for some parts of the loan market.
The LMA’s risk-free rate documentation does not envisage the transition to Term SONIA Rates, and the LMA have confirmed that they are not currently working on producing facility agreements based on Term SONIA Rates. However, they have indicated that they will look to produce such documentation in the future, once sufficient market feedback has been received on key considerations for such documentation.
Should market participants choose to use Term SONIA Rates, the LMA’s note highlights a number of key considerations that should be factored into their use and documentation:
- Is the loan within the specified use cases for Term SONIA Rates? The Working Group on Sterling Risk-free Rates (the Working Group) have identified limited use cases for Term SONIA Rates in some loan product areas, including export finance, emerging markets, and trade and working capital finance. The FICC Market Standards Board (FMSB) are also developing a proposed market standard for limiting the use of Term SONIA Rates. Market participants should consider whether their transaction fits within these use cases and FSMB market standards.
- Which Term SONIA Rate should be used? Since January 11, 2021, ICE Benchmark Administration and Refinitiv have published Term SONIA Rates for use. The Working Group published a summary of the key attributes of these (which also included the now discontinued FTSE Russell rate). The Working Group has not made a recommendation as to which Term SONIA Rate market participants should use, and so parties will need to choose which rate best suits their documentation.
- What should be the fallbacks to a Term SONIA Rate? Fallbacks will need to be considered in the context of temporary unavailability and permanent cessation. For temporary fallbacks, the LMA suggest that a similar structure to the existing LMA primary documents could be adapted, for example by using interpolated and historic Term SONIA Rates. For permanent cessation, careful consideration will be necessary, with potential fallbacks identified as including, among others, the Bank of England Bank Rate, SONIA Compounded in Advance and an alternative Term SONIA Rate.
- Approach to market disruption and break costs. These provisions in the LMA primary documents are underpinned by the premise that the facilities are to be priced on the basis of a benchmark that is intended to represent the lenders’ likely cost of funds plus a margin. Given the different natures of SONIA and LIBOR, the parties will need to consider whether these fundamental considerations remain relevant to loans based on Term SONIA Rates.
- Credit Adjustment spreads. Due to the economic differences between LIBOR and SONIA, credit adjustment spreads are used to eliminate the possibility of any value transfer upon transition. The Working Group has recommended the use of a five-year historical median for the spread adjustment applicable to a SONIA rate. For new transactions referencing Term SONIA Rates from the outset, it is less likely that a spread adjustment will be necessary, as the economics of the transaction can be determined at the outset.
- Interaction with hedging. ISDA is working on new rate options to facilitate the use of risk free rates and hedges with the conventions being seen in the loan and other cash markets. However, it is not planned to cover Term SONIA Rates and the use of such rates could result in basis risk and will need to be considered carefully.
Market participants are encouraged to carefully consider the potential for using Term SONIA Rates in their transactions and, if they choose to do so, to conduct a thorough and comprehensive analysis of each of the considerations highlighted by the LMA in their note.
Please contact any of the authors of this briefing or your regular McGuireWoods contact if you have questions about, or would like assistance with, the LIBOR transition.