Whilst the start of Spring conjures up images of new beginnings, for one financial institution, this April marks the beginning of its end. At least that is what the Bank of England is banking on.
The Bank of England and the Financial Conduct Authority decided to phase out the scandal-hit London Inter Bank Offer Rate (known as LIBOR) after stating it was no longer a suitable benchmark and replace it entirely with the Sterling Overnight Index Average (SONIA) by 2021. In what is widely being seen as the first nail in LIBOR's coffin, from 23 April 2018 the Bank of England will start setting the SONIA rate.
SONIA has been run by the Bank of England since April 2016 in an effort to create a useable interest rate benchmark which is not tainted by the LIBOR scandal, in which banks’ traders sought to manipulate the rate to their own advantage. They reported the cost of borrowing between banks but the way it was reported with few transactions to rely on meant it was open to illegal manipulation.
An interest rate benchmark is vital to the functioning of credit and derivatives markets, amongst others, as banks and their customers need an indication of a risk-free market rate on which to base their transactions.
SONIA will calculate the average rate of all overnight loans reported to the Bank of England with a value of more than £25m.
Under the new arrangement, the aim is to broaden out SONIA to include a larger number of transactions, keeping it in tune with real market conditions and making it less likely the benchmark will have to be estimated for lack of real data.
SONIA will include unsecured transactions negotiated bilaterally between banks and borrowers in future, as well as those through brokers. The average will be calculated on a volume-weighted basis, and outliers trimmed from the sample.
Currently the index is calculated and published by the Wholesale Markets Brokers’ Association but the Bank of England has more data available and hopes it can give markets confidence to move on a large scale from LIBOR and onto SONIA.
The FCA, the primary authority driving the promotion and publication of LIBOR, indicated that it would not require panel banks to submit LIBOR rates past 2021. While there has been no express denunciation of LIBOR, the FCA has effectively withdrawn its support for its publication, making it clear that LIBOR has no future as a global benchmark rate.
But what does all this mean in practical terms for lenders and borrowers?
To prepare for the transition away from LIBOR, existing loans tied to the benchmark should be reviewed to determine if the loan documents include sufficient language to choose a replacement rate in the event that LIBOR ceases to be published. Additionally, these documents should be reviewed to determine if amendments are permitted and are needed to account for the end of LIBOR and entry of a new rate.
With uncertainty in the future of LIBOR, new loan documents should be written to include fall-back provisions. The fall-back provisions should provide a clear alternative for choosing a rate if LIBOR is discontinued altogether, the most likely being SONIA. Additionally, the provisions should include protection for the lender if LIBOR continues to be published with less regulation and becomes an increasingly unreliable rate.
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