Whitepaper : UK Weaning the world off Libor Project Finance Private Equity Corporates Social Infrastructure Real Estate Financial Risk Advisors jcragroup.com
Whitepaper Contents Background 1 What is SONIA? 1 What are the key differences between SONIA and Libor? 2 Impact on Interest Rate Derivatives 3 Impact on Floating Rate Debt 4 Unintended consequences 4 What next? 4
Whitepaper 1 Libor has become a cornerstone of loan and derivative markets, with over $350tn of contracts referencing the rate. Background On 27 July 2017, nine whole years after the tampering scandal reared its ugly head, the Financial Conduct Authority announced that LIBOR will likely be phased out by 2021. While some commentators have said the FCA s announcement may be premature, it has been in the works for some time. Since its introduction in 1984, Libor has become a cornerstone of loan and derivative markets, with over $350tn of contracts referencing the rate. As it has grown in use, however, so too have markets changed. Libor is not as robust as it once was, and newer alternatives offer fundamental improvements. Different countries have selected different successors to LIBOR but in the UK, this is expected to be SONIA. Timeline July 2014 - the Financial Stability Board (FSB) published its report 1 on interest rate benchmark reform prompting the formation of working groups across the G20. March 2015 - the Bank of England commences a working group on Sterling Risk-Free Reference Rates; the US starts the Alternative Reference Rates Committee, the Swiss start National Working Group and the Japanese Study Group on Risk-Free Rates. April 2017 - the Bank of England s working group announces that it has decided on SONIA as its preferred near risk-free interest rate benchmark for use in sterling derivative and other financial contracts. 15 June 2017 - International Swaps and Derivatives Association (ISDA) Chief Executive, Scott O Malia announces formation of working groups to agree fall-backs in the event that Libor was unavailable, and to assist with the transition from Libor in the derivatives markets 29 June 2017 - Bank of England working group publishes a whitepaper on potential approaches to a broader adoption in sterling markets of the SONIA benchmark. 27 July 2017 - the CEO of the Financial Conduct Authority (FCA), Andrew Bailey, announced that Libor will be phased out by 2021. 29 September 2017 - Bank of England whitepaper closes to feedback after which the working group should publish a summary. What is SONIA? SONIA stands for Sterling Over-Night Index Average. Every day, banks and building societies cover their short-term sterling funding requirements by entering into unsecured overnight transactions. The market for such transactions is intermediated by brokers, who are usually members of the Wholesale Markets Brokers Association (WMBA). All transactions brokered by a WMBA member in London between midnight and 18:00 with a deal size of 25m or more are taken by the WMBA who, as calculation and publication agent, calculates the volume weighted average annualised interest rate across these transactions. This is then published as SONIA at 18:30 each day and from Spring 2018 will be published at 09:00 on the next business day. SONIA should be distinguished from RONIA (R for Repurchase), its sister index which uses secured overnight transactions, rather than unsecured. 1 Available at http://www.fsb.org/2014/07/r_140722/.
2 Whitepaper SONIA fixes in arrears and is purely an overnight rate which may cause more issues for many end-users, particularly smaller derivative end-users and borrowers. What are the key differences between SONIA and Libor? SONIA is by definition an overnight rate, whereas Libor fixes for a range of tenors Another point linked to this is that SONIA fixes daily in arrears, whereas Libor fixes in advance for the given tenor, for example 3-month. The fact that SONIA fixes in arrears and is purely an overnight rate may cause more issues for many end-users, particularly smaller derivative end-users and borrowers. For example, as a borrower looking to manage cash flow within your business it can be valuable to understand what your interest expense for the quarter will be at the beginning rather than at the end of the quarter. It may be possible to utilise short-term swaps that reference SONIA, called Overnight Index Swaps (OIS), to generate a mechanism that will both fix in advance and provide fixing values for different tenors. However, this may re-introduce liquidity issues in the benchmark (i.e. if there is limited trading in a particular OIS tenor) and it would need to be determined who would calculate and produce these indices. Figure 1: Historical 3-month GBP Libor-OIS Spread SONIA is a near risk-free-rate, whereas Libor captures a credit risk component This may not actually be a desirable feature of Libor and many participants in the UK market welcome the move to a near risk-free rate. However, the credit component of Libor will need to be a consideration for legacy instruments and their migration. In figure 1 below, the historical difference between three-month Libor and OIS shows that during periods of uncertainty the differential gets wider. It is expected that ISDA s working groups for formulating fall-backs in the event that Libor is unavailable will likely be the relevant risk-free OIS rate for each currency, with the addition of a spread to incorporate residual term bank credit premia. SONIA is a transaction-based benchmark, whereas Libor is a judgement-based benchmark Fundamentally, it is this point that has written Libor s death certificate. As Mark Carney outlined 2, a lack of unsecured term deposit transactions and therefore a continued reliance on judgement represents a serious structural weakness in LIBOR. A situation in which a judgement-based benchmark underpins an estimated US $350 trillion-worth of contracts is not desirable. Source: Bank of England 2 6th July 2017, available at: http://www.bankofengland.co.uk/markets/documents/sterlingoperations/rfr/2017/record060717.pdf.
Whitepaper 3 The move to a single benchmark will be a change welcomed by many and lead to improved pricing for the market. Impact on Interest Rate Derivatives From a technical or pricing perspective, the move to a single benchmark will make derivative pricing simpler and more efficient. We have been operating in a multi-curve environment for the last decade and it is evident that it adds to the complexity of derivative pricing and risk management. The move to a single benchmark will be a change welcomed by many and lead to improved pricing for the market. As seen in figure 2 below, there is already a market for OIS, which is helpful in the transition from Libor to SONIA. Currently, the OIS curve is quoted from 1-week up to 50-year maturities. There are pockets of liquidity in tenor beyond one year. The recent decision with regard to SONIA as the chosen risk free rate will help improve liquidity. In addition, it is clear that there are concerted efforts from regulators, industry bodies and market participants to continue to improve liquidity especially in longer tenors. Currently, OIS is only clearable out to a 30-year maturity. There is an effort to make OIS clearable out to 50 years and certainly, with quotes now available out to this tenor, it should only be a matter of time before LCH adds these maturity points. The other segment of liquidity in the curve is that of Libor futures. Further work will need to be undertaken to migrate Libor futures contracts to SONIA and we will continue to monitor developments in this area. Figure 2: Interest rate instrument and illustrative liquidity Source: Bank of England
4 Whitepaper For end-users, it will be important that any transition takes place across both debt and derivative instruments in a similar fashion, and on a similar timetable to avoid introducing new risks. Impact on Floating Rate Debt The Loan Market Association (LMA) overhauled the fall-back interest rate benchmark provisions in their recommended form facility agreements in November 2014. Currently, the LMA provisions do not provide for an automatic switch to a different public rate. Preliminary conclusions from ISDA suggest possible triggers could include: insolvency of the relevant IBOR administrator a public statement by the relevant IBOR administrator that it will cease publishing the relevant IBOR permanently or indefinitely a public statement by the supervisor for the relevant IBOR administrator that the relevant IBOR has been permanently or indefinitely discontinued a statement by the supervisor for the relevant IBOR administrator that the relevant IBOR may no longer be used 3 Given that the choice of SONIA as a risk-free benchmark is relatively recent, this may be a development that will come into place over the next year or two. However, it is clear that SONIA and Libor are different so a simple switch may not be appropriate without some adjustment to the rate or margin. For end-users, it will be important that any transition takes place across both debt and derivative instruments in a similar fashion, and on a similar timetable to avoid introducing new risks that would be difficult to manage efficiently. It is quite likely that ISDA will seek to adopt a protocol approach leading to a large widespread change in the derivatives market, so it would be good to see the lending market start to prepare itself for the change. Unintended consequences Hedge Accounting Many corporate end-users of derivative instruments seek to apply hedge accounting in order to prevent volatility of reported profit and loss. A material amendment to an existing derivative could result in a requirement to dedesignate an existing hedging relationship and re-designate a new one Even if the change of reference rate is the same on the debt and the derivative instrument, this could still lead to ineffectiveness as the re-designated hedging relationship may be off-market. Further ineffectiveness would occur if the changes to the reference rate for the debt and derivative are different or happen at different points in time. Collateralisation Under EMIR, some market counterparties are required to clear or otherwise collaterise new derivative instruments. However, to soften the impact of this change there has been some grandfathering of legacy swaps. Any material amendment to an existing trade would lead to it being brought into scope a rule that was intended to avoid participants perpetually modifying trades to avoid the rules. The change of reference risk free rate could result in a material amendment to legacy swaps, which may prevent the grandfathering that many market participants have relied upon. This is already on the agenda for market participants and ISDA, amongst others, is likely to lead on the lobbying with regard to this area. What next? While it is a little early to give specific direction on commercial or documentation points that will arise from the transition, JCRA are engaging with the Bank of England on their consultation process with regard to benchmark risk-freerates. We will continue to monitor developments, engage with government and industry bodies and provide updates on Libor as the story evolves. 3 ISDA, 'Benchmarks Fallbacks for LIBOR and other key IBORs ISDA': http://www2.isda.org/functional-areas/infrastructure-management/interest-rates-derivatives/.
Whitepaper 5 About JCRA JCRA are independent financial risk advisors, specialising in hedging and debt advice that is strategically aligned to what you and your business want to achieve. We have over 25 years experience structuring and advocating for competitive pricing in derivative products. We formulate and execute interest rate, foreign exchange, inflation and commodity hedging strategies and provide debt advice to real estate, project finance and infrastructure, private equity, social infrastructure and corporate clients across the globe. Helping businesses and organisations stay one step ahead. jcragroup.com For more information, or to discuss this whitepaper, please contact: Ivan Harkins Director T: +44 (0)207 493 3310 E: ivan.harkins@jcrauk.com
Disclaimer J.C. Rathbone Associates Limited is authorised and regulated by the Financial Conduct Authority (FCA) in the United Kingdom under reference number 145229. This document is intended for persons who would come within the FCA s definition of professional clients and eligible counterparties only and should not be relied upon or distributed to persons who would come within the FCA s definition of retail clients. No other person should rely upon the information contained within it. This document has been issued by J.C. Rathbone Associates Limited for information purposes only and does not constitute investment advice and is not to be construed as a solicitation or an offer to purchase or sell investments or related any financial instruments. This document has no regard for the specific investment objectives, financial situation or needs of any specific person or entity. The information contained herein is based on materials and sources that we believe to be reliable, however, J.C. Rathbone Associates Limited makes no representation or warranty, either express or implied, in relation to the accuracy, completeness or reliability of the information contained herein. The information in this document is not suitable for use in any jurisdiction where such activity or its distribution is prohibited. Any persons resident outside the United Kingdom must satisfy themselves that they are not subject to any local requirements which prohibit or restrict them from doing so. In particular, the information herein does not constitute a solicitation in the United States of America to or for the benefit of any US Person as such term is defined under the United States Securities Act of 1933, as amended. The above data and graphs are provided for illustrative purposes only and are not to be reproduced in any form without the express consent of J.C. Rathbone Associates Limited. Data has been smoothed in their preparation and have been based upon prevailing market rates as at the date given. 2017 jcragroup.com