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SONIA: The replacement to LIBOR for all commercial loans

Posted on 29 June 2021

The London Inter-Bank Offered Rate (LIBOR) has been the global benchmark interest rate since the 1970s. One estimate suggests around USD$400trn of financial instruments rely upon this figure. However LIBOR is being replaced at the end of this year by the Sterling Overnight Index Average (SONIA), and borrowers and lenders alike need to ensure their financing arrangements to reflect this.

LIBOR is broadly an average of what leading banks estimate they would pay to borrow from other banks, guided by what they see in the market. LIBOR is "forward looking," so is calculated from expected borrowing rates. For borrowing, the interest rate is known in advance at the start of an interest period (e.g. a quarter), and payable in arrears at the end.

Since the global financial crisis, a reduction in interbank lending combined with allegations of market manipulation reduced confidence in LIBOR. The Bank of England and other international financial hubs have resolved to replace LIBOR with SONIA and local equivalent rates, such as SARON in Switzerland. These are collectively referred to as Risk-Free Rates (RFRs).

Unlike LIBOR, SONIA/RFRs are "backward looking" because leading banks submit their actual agreed interest rates for recent interbank lending. When borrowing, interest is calculated and paid in arrears. While SONIA/RFRs may be more reliable, loan agreements have always been predicated on a "forward looking" basis. Borrowers (quite reasonably) want to know what the cost of borrowing will be before that cost is incurred.

Parties on both sides are finding ways to accommodate the change, and we are seeing different approaches. Without delving into them all, one common method has been to include a "Look Back Period" of five business days. This means the SONIA rate on any given day will be used to calculate interest on the date five business days in the future. Effectively this will give a borrower at least five business days' notice of the interest amount before it falls due. For larger or multi-jurisdictional arrangements this may not be sufficient. Others have tried to "word around" SONIA, using their own rates or (convolutedly) producing a forward looking rate with SONIA. This is ultimately a short term fix and untenable in the long run.

As mentioned, LIBOR will cease to be published at the end of 2021 (with very narrow exceptions). Any agreements continuing into 2022 need to adopt a replacement interest rate calculation – the choice is principally between a base rate or SONIA/RFR provisions. Typically, this will be via agreed variations to the loan agreement between borrowers and lenders. Borrowers who have not yet done so, should familiarise themselves with the options and implications as soon as possible.

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