January 22, 2020 - “The intention is that sterling LIBOR will cease to exist after the end of 2021. No firm should plan otherwise.” That quote – and emphasis – was highlighted in a joint letter sent from the Bank of England’s Prudential Regulation Authority (PRA) and the U.K.’s Financial Conduct Authority (FCA) to major banks and insurers they supervise. The letter sets out the regulators’ expectations of firms’ progress meeting the U.K.’s Risk Free Rate Working Group (“RFRWG”) 2020 targets. Said targets include i) enabling a further shift of volumes from LIBOR to SONIA derivatives, ii) ceasing sterling LIBOR cash issuance (including loans) by end-3Q20, and iii) significantly reducing stock of LIBOR-referencing contracts by 1Q21. To do so, the FCA and PRA expect firms’ planning to include: i) product development, ii) reviewing infrastructure, including updating loan systems capabilities (emphasis added), iii) client communication and iv) updating documentation. These are not simply nice sentiments: In mid-2020, the PRA will consider “whether sufficient progress is being made to avoid seeking recourse to supervisory tools”.
In light of these…suggestions, what is U.K. Industry doing? First, they are considering where term SONIA reference rates (“TSRR”) and SONIA Compounded in Arrears rates fit best. (Spoiler #1: They recommend most syndicated loans go to SONIA Compounded in Arrears.) Second, they are setting out timelines to meet the FCA and BOE’s timelines. (Spoiler #2: This will impact U.S. loan systems.)
In considering SONIA, the RFRWG notes that TSRR must be limited. Why? The existence of a TSRR is predicated on having a robust SONIA hedging market, which in turn is predicated on lots of SONIA Compounded in Arrears loans and notes being hedged. If you don’t have Compounded SONIA products being hedged, it’s harder to have a robust forward looking term SONIA rate. (The same circular logic applies to term SOFR.) For this reason, both U.S. and U.K. regulators want to limit term rates to entities that absolutely need them. So who needs them? The RFRWG suggests that 90% of the Sterling LIBOR loan market likely could go to SONIA Compounded in Arrears, while 10% would need alternative rates (like Bank Rate or TSRR). The 10% tend to be smaller borrowers without operational capability, trade and working capital products that require forward discounted cash flows, export finance/emerging markets products that need more time to pay, or Islamic facilities that can only pay variable rates of return if the variable element is predetermined. There are also some products where compounded in arrears could create operational difficulty, regardless of the sophistication of the borrower.
So what’s the U.K.’s roadmap for getting to SONIA for new loans by the end of 3Q20? By end of 1Q20, the “Loan Enablers taskforce” will publish a detailed roadmap and loan vendors and treasury management systems will make key compounded SONIA infrastructure available. And by the end of 2Q20, end-users of loan systems should be ready to support SONIA syndicated loans. (Editorial comment: A three-month turnaround for systems implementation is very fast.)
The U.S. has not accelerated its timeframe for SOFR in the same manner, and ARRC loan working groups also are considering the use of Simple Daily SOFR in Arrears where appropriate. Nonetheless, the same loan systems will support both SONIA and SOFR and therefore the U.K.’s fast pace should help accelerate U.S. implementation.