On 16 January 2020, the Working Group on Sterling Risk-Free Reference Rates (RFRWG) published a paper on The use cases of benchmark rates: compounded in arrears, term rate and further alternatives.

The paper is addressed to financial firms and non-financial end users, such as corporates, small to medium size enterprises, retail consumers and others, who will be impacted by the intended cessation of GBP LIBOR. It considers the use of the Sterling Overnight Index Average (SONIA) by market participants. In particular, it: (i) outlines why the use of Term SONIA Reference Rates (TSRR) must be limited; and (ii) considers use cases within cash markets where a TSRR would be beneficial and where overnight SONIA compounding in arrears is likely appropriate, taking into consideration the operational capability and the sophistication of the borrower and the structure and characteristics of a product and its use.

Progress in LIBOR transition in loan markets

In April 2017, the RFRWG recommended the SONIA benchmark as their preferred risk-free rate. Overnight SONIA compounded in areas has become the market norm for floating rate sterling bonds and its use is increasing in other markets, such as securitisation. In the loan market, adoption of SONIA compounded in areas has been slower, although it has been used in recent bilateral loans.

The paper identifies the work that is being undertaken to overcome the barriers to widespread use of SONIA compounded in arrears for loans. This includes:

• updates to loan IT and treasury management systems to adapt to the new rate;
• revised documentation from the Loan Market Association to help facilitate use of the rate in syndicated and club loans (see LIBOR transition to Alternative Risk Free Rates: drafting new loan agreements, and amending legacy LIBOR loan agreements); and
• the development of alternative products referencing alternative rates, such as the TSRR, for clients who prefer variable rates with more cash flow certainty.

The RFRWG has set a target of end Q3 2020 to cease issuance of GBP LIBOR-based cash products with tenors past the end of 2021.

It is expected that market conventions and updates to IT and treasury management systems to deal with the use of SONIA compounded in arrears will be in place before end Q3 2020, but there may remain some products where SONIA compounded in arrears may not be appropriate.

Use of Term SONIA Reference Rate

Development of a TSSR is progressing, with the expectation that an authorised benchmark administrator will be appointed to publish an IOSCO compliant rate, based on a combination of actual OIS trade data, tradable quotes provided by market makers and OIS futures data, in Q1 2020. Market participants would be able to observe the TSSRs for a period to understand how they operate, before they are used in loan products later in 2020.

The UK authorities have made clear that the preference is for the market to adopt SONIA compounded in arrears. The use of a SONIA TSSR or an alternative rate should be limited to clients or products with may have difficulty adapting to SONIA compounded in arrears. As the paper sets out, this is because:

• SONIA compounded in arrears is inherently more robust than a TSSR, because it is based on a far greater volume of transactions;
• participants with hedging needs will want their cash and derivative products to be on the same basis to ensure effective and cost-efficient hedging;
• compounded in arrears rates can be used consistently across multiple markets, allowing participants to have consistent and reliable costs of borrowing; and
• term rates may not be available in all currencies, but compounded in arrears rates will be, supporting multi-currency borrowers to apply a consistent approach.

The Term Rate Use Case Task Force set up by the RFRWG (the Task Force) has considered the use cases within cash markets where a TSRR would be beneficial, taking into consideration the operational capability and the sophistication of the borrower and the structure and characteristics of a product and its use. The Task Force considered that the use of SONIA compounded in arrears was appropriate and is likely to be operationally achievable for approximately 90% of new loan deals by value.

The Task Force found that more sophisticated borrowers would have the understanding and ability to use SONIA compounded in arrears for new loans. This would include larger and more sophisticated corporates and specialist lending sectors such as project finance, real estate and public sector, particularly because of their use of a range of financial products, and the need to ensure effective and efficient hedging.

Smaller corporate, wealth and retail clients, who need simplicity and/or payment certainty and don’t have the understanding or resources to adapt to SONIA compounded in arrears, may need to use alternative rates, such as the overnight Bank Rate or fixed rates.

For some products, regardless of the sophistication of the borrower, a TSSR may be appropriate. The paper identifies:

• trade and working capital products such as supply chain finance and receivables facilities, which require a term rate or equivalent to calculate forward discounted cash flows to price the value of assets in the future;
• export finance and emerging markets loans, which require long notice periods for payment; and
• Islamic finance transactions, which can pay variable rates of return.

Legacy contracts

Existing contracts will need to be amended to reflect SONIA compounded in arrears, or, in limited cases, an alternative rate. The paper provides a suggested decision tree developed by the Task Force to assist participants when deciding which rate to use.

Further work

The paper flags that firms should be engaging with clients to raise awareness and set out the implications and timing of LIBOR transition. Larger corporates are generally aware of LIBOR reform but further work is needed to raise awareness and understanding in specialist lending firms and smaller corporates. The Communication and Outreach subgroup is considering ways to increase client awareness and engagement across this part of the market, including developing a free to use, trusted RFR calculator to help with transition by providing confidence to validate bank calculations and a user guide comparing the various different alternatives to compounded in arrears SONIA.

The Sub-group Benchmark Transition Issues in Syndicated Loan Markets and the Loans Enabler Task Force has been established to address remaining barriers to transition in loan markets in relation to:

• standardised documents;
• additional considerations for project finance and real estate transactions;
• loan IT systems;
• treasury management systems; and
• trade booking and settle systems.