March 26, 2019 - SOFR and SONIA may be the anointed replacements for LIBOR…but how do you actually make a SOFR loan work? As an ARRC member and Co-chair of the ARRC’s Business Loans Working Group, the LSTA has been in the weeds on this issue. Step One: Develop workable recommended LIBOR fallback language for syndicated loans (coming soon!). Step Two: Help lenders and vendors operationalize SOFR within loan systems.
But these issues aren’t limited to the US; and the LMA and ICMA have similar initiatives in the UK. Their efforts are detailed in the UK’s Working Group on Sterling Risk-Free Reference Rates discussion paper on “Conventions for referencing SONIA in new contracts.” We review the paper’s takeaways below and consider their applicability to US markets. While we provide a brief overview now, we’ll be diving into how to actually effectuate these changes at the LSTA Operations Conference on April 9th in NYC.
As a refresher, both SONIA and SOFR are overnight rates and will face similar issues when developing conventions, but these conventions could differ depending on “which” SONIA or SOFR becomes the replacement rate for loans. The likely replacement options are: (i) Forward Looking Term SOFR/SONIA, (ii) SOFR (and possibly SONIA) Compounded in Advance, (iii) SOFR/SONIA Compounded in Arrears or (iv) Daily Simple (overnight) SOFR/SONIA. (We offer a detailed explanation of the SOFR alternatives here.)
Many lenders and borrowers want forward looking term rates. If Forward Looking Term SOFR/SONIA becomes the reference rate, most conventions may remain the same because the interest rate is known in advance. Thus, processes like accruing interest or invoicing borrowers likely will not change, and loan conventions (such as treatment of weekends) also may remain the same.
Alas, there is no guarantee that forward term rates can be developed and, if they are not, then the likely fallbacks are SOFR/SONIA Compounded in Arrears or Daily Simple SOFR/SONIA. And if these become the market standard rates, conventions would have to change. First, the rate would not be known in advance of the interest period – and this changes many things. For a Daily Simple SOFR/SONIA loan, the overnight rate will be pulled in by loan systems to calculate daily interest, which would then accrue. Moreover, if the market chose SOFR/SONIA Compounded in Arrears, that overnight rate also would be compounded daily and accrued.
So what does this mean for conventions? First, the overnight rate should be published in a consumable fashion on screens. Second, to provide third party validation or “official” rates, a Compounded SONIA/SOFR Screen Rate for various periods (e.g., 30-day, 90-day) should be published. This is very helpful for loans that remain outstanding for their full interest period. But loans sometimes prepay intra-period, and a public Rate Calculator could provide third party validation for calculating interest payable.
Lenders offering Daily or Compounded in Arrears rates also must create a period of cash flow certainty before an interest payment is due. Two main approaches are being discussed: First is a “look back”, which basically starts calculating interest a set number of days before than the actual interest period begins. Consider an example of a 30-day SOFR loan that starts on April 1st and has a 5-day lookback (and ignores weekends for ease of use!). Day One of interest would be March 27th (five days before April 1st) and Day 30 of interest would be April 25th. In turn, the lender can invoice the borrower on April 26th, several days before the interest payment is due.
An alternative approach is the “lock out”, which simply locks the last few days of interest. Using the example above, interest would be calculated from April 1st to April 25th, and then “locked” at the April 25th level for the next five days. Thus, both the lender and the borrower would know what the rate will be.
While by no means exhaustive, these are the sorts of un-conventional changes that we’ll be considering as the market begins to put SOFR into effect. We’ll be discussing them in greater detail at the LSTA Operations Conference on April 9th in NYC.