On March 26, 2021, the LMA published a note outlining considerations for market participants regarding the use of forward-looking terms of the SONIA benchmark (SONIA forward tariffs).
SONIA forward tariffs have been available in beta form since July 2020 and can be used since January 11, 2021. SONIA forward tariffs are expected to have limited use, as the UK authorities have clearly indicated their preference for the market to adopt a large transition. scale to SONIA aggravated arrears for new transactions, use of SONIA forward rates being more limited than current use of LIBOR, and SONIA aggravated arrears being considered by Bank of England and FCA as the rate most robust and reliable replacement for LIBOR. However, it is recognized that SONIA forward rates may provide a loan transition option for certain parts of the loan market.
The LMA’s risk-free rate documentation does not contemplate the transition to SONIA forward rates, and the LMA has confirmed that it is not currently working on producing facility agreements based on SONIA rates at. term. However, they have indicated that they will seek to produce such documentation in the future, once the market receives sufficient feedback on the key considerations for such documentation.
If market participants choose to use SONIA forward rates, the LMA Note highlights a number of key considerations that should be taken into account in their use and documentation:
- Does the loan conform to the use cases specified for SONIA forward rates? The Pound Sterling Risk-Free Working Group (the working group) identified limited use cases of SONIA forward rates in certain areas of lending products, including export finance, emerging markets, and trade and working capital finance. The FICC Market Standards Council (FMSB) are also developing a proposal for a market standard to limit the use of SONIA forward tariffs. Market players need to determine if their transaction fits into these use cases and FSMB market standards.
- Which SONIA Rate term should be used? Since January 11, 2021, ICE Benchmark Administration and Refinitiv have published SONIA forward tariffs. The working group published a abstract of the main attributes of these (which also included the now discontinued FTSE Russell rate). The working group did not make a recommendation as to which term participants in the SONIA rate market should use, and parties will therefore need to choose the rate that best suits their documentation.
- What should be the alternatives to a SONIA forward rate? Back-up solutions should be considered in the context of temporary unavailability and permanent shutdown. For temporary fallback solutions, the LMA suggests that a structure similar to existing LMA primary documents could be adapted, for example using interpolated and historical forward SONIA rates. For a final termination, careful consideration will be required, with potential payoffs identified as including, among others, the Bank of England bank rate, SONIA compounded in advance and an alternative SONIA forward rate.
- Approach to market disruption and disruption costs. These provisions of the primary documents of the LMA are based on the assumption that the price of the facilities should be established on the basis of a benchmark intended to represent the probable cost of funds of the lenders plus a margin. Given the different nature of SONIA and LIBOR, parties will need to consider whether these fundamental considerations remain relevant for loans based on SONIA forward rates.
- Credit adjustment spreads. Due to the economic differences between LIBOR and SONIA, credit adjustment spreads are used to eliminate the possibility of any transfer of value during the transition. The working group recommended the use of a historical five-year median for the adjustment of the spread applicable to a SONIA rate. For new trades that reference SONIA forward rates upfront, it is less likely that a spread adjustment will be necessary, as the economics of the trade can be determined upfront.
- Interaction with the cover. ISDA is working on new rate options to facilitate the use of risk-free rates and hedges, with conventions observed in loan and other spot markets. However, it is not intended to cover the SONIA tariffs in the long term and the use of these tariffs could entail a basis risk and should be carefully considered.
Market participants are encouraged to carefully consider the possibility of using SONIA forward rates in their transactions and, if they wish, to conduct a thorough and comprehensive analysis of each of the considerations highlighted by the LMA in their note. .