The latest development in the Bank of England’s (BoE) attempts to support the adoption of SONIA in cash products – and to speed up the transition away from LIBOR-linked products – is the publication of its response to the consultation it conducted into the publication of a SONIA index: Supporting Risk-Free Rate transition through the provision of compounded SONIA: summary and response to market feedback (June 2020).
The report follows a discussion paper that the BoE published earlier this year, seeking views on: (a) the BoE’s intention to publish a daily SONIA compounded index; and (b) the usefulness of the publishing a simple set of compounded SONIA period averages. These proposals were part of the BoE’s attempt to “turbo-charge” sterling LIBOR transition (see our previous blog post: The Bank of England’s attempts to “turbo-charge” LIBOR transition in the cash markets: will these increase or decrease the litigation risks?).
The report confirms that the BoE will produce a daily SONIA compounded index, following near universal support from the market in response to the discussion paper. The aim of the SONIA compounded index is to simplify the calculation of compounded interest rates for market participants and avoiding the potential for different conventions about the compounding of SONIA calculation. Conceptually, the index is equivalent to a series of daily data representing the returns from a rolling unit of investment earning compound interest each day at the SONIA rate. The change in the SONIA compounded index between any two dates can be used to calculate the interest rate payable over that period. The BoE anticipates publishing the index from August 2020, but the precise date is to be confirmed.
However, the BoE does not intend to publish daily a simple set of SONIA period averages, following a “very mixed” response from the market on the merits, and risks, of publishing these screen rates. Whilst there was some broad support for the thinking behind the concept of period averages, much concern was raised about the practical utility of those averages by market participants (particularly sophisticated ones) given the often bespoke way in which interest periods are set and the risk of confusion given the likely need to publish averages for a variety of periods. However, the BoE has said it is open to considering this question again, should the market view develop to become more unified.
Impact on risk profile of LIBOR discontinuation
The outcome of the most recent report will affect the risk profile of LIBOR discontinuation in new vs legacy cash products in different ways.
1. New cash products
It is noteworthy that the publication of a SONIA compounded index is designed to overcome the primarily operational challenge of calculating compounded SONIA rates in a simple and consistent way so that borrowers can easily reconcile the rates reported to them by lenders. Publication of a “golden source” SONIA-linked index from which bespoke rates can more readily be calculated, should make it easier for market participants to transition to SONIA-based cash products. This in turn should help market participants to cease issuing GBP LIBOR-linked cash products by the deadline of end of Q1 2021 (the extended deadline, due to the impact of the COVID-19 pandemic). The simple point to make is that – by making it easier to write new cash products in SONIA – this should reduce the overall volume of LIBOR-linked products in the market when the benchmark ceases.
2. Legacy cash products
The outcome of the BoE’s latest report will not solve the inherent difficulties with transitioning legacy LIBOR cash products. Even with the publication of a SONIA compounded index, parties will need to agree the spread adjustment to mitigate value transfer when switching from LIBOR to SONIA on a product-by-product basis. While the UK’s Tough Legacy Taskforce has recommended a legislative fix for “tough legacy” contracts in all asset classes and possibly all LIBOR currencies, this will require the UK Government to intervene with primary legislation (see our recent blog post: UK Tough Legacy Taskforce recommends LIBOR legislative fix: key risks and next steps). The UK Government and FCA have recently made announcements on the scope and form of proposed legislation, which we will consider in a separate blog post.