In the absence of a mandatory fallback or active rate-switch requirement, some firms have been hesitant to switch customers to RFRs while LIBOR has continued to be published and markets have been some way from a consistent approach to the adoption of replacement rates. In early May, the Governor of the Bank of England warned that firms who persist in "lazy" behaviour in unnecessarily sustaining LIBOR-linked products will be treated by their supervisors as demonstrating failures in governance and risk management. That said, the Governor also noted that billions of pounds of GBP facilities and bonds are now linked to compounded SONIA in arrears. To support a substantial move in trading volumes from GBP LIBOR to SONIA, the Bank has also encouraged a change in interdealer quoting conventions for linear and non-linear sterling derivatives from LIBOR to SONIA pricing, a switch which has now gone ahead with the broad support of the markets.
However the sterling markets are still using a variety of approaches to SONIA-based rates and the application of compounding conventions and credit adjustments. As discussed in our earlier briefing, the ISDA 2020 IBOR Fallbacks Protocol relied for rate-switches on a manufactured rate published by Bloomberg, which compounds SONIA over a backward-looking period corresponding to the replaced LIBOR tenor. This created a certain degree of fallback uniformity in the OTC derivatives markets, but "day one" compounded SONIA instruments reflecting cash market approaches were still required to be developed. Where there is not a uniform fallback mechanism across the derivatives, loan, bond and repo markets, mismatches and gaps will appear, for example where a party has entered into a derivative to hedge a risk arising under another financial arrangement, such as a loan. On 14th June, ISDA published its new 2021 Interest Rate Definitions booklet, allowing counterparties various options to tailor the compounded SONIA floating rate option and apply various shift, lookback and lockout approaches to match those used in the cash markets.
Initial progress towards SONIA adoption in sterling loan markets was slow. Publication of market conventions for a compounded rate by the SRFRWG in September 2020 was swiftly followed by the launch of RFR-priced "exposure draft" facility agreement templates published by the Loan Market Association ("LMA"). This significantly facilitated the documentation of new SONIA-priced loans. However these templates went through a number of iterations and were not published in "recommended form" until the end of March 2021, by which time parties were expected to cease writing new GBP LIBOR-linked facilities.
Challenges in the way of transition have included education of market participants on the fine detail of the new documentation, which include complex mathematical formulae for calculating compounded SONIA. Some firms have also struggled to make the necessary IT changes to facilitate the adoption of new loan pricing.
In many cases, SONIA-based pricing has been adopted through the amendment of existing documentation. This presents multiple challenges because there is no "one size fits all" approach and changes have to be made to multiple parts of the document, often with a dual pricing structure in place for existing vs. new interest periods. In recent years attempts were made to "future proof" loan documents, to allow for RFR re-pricing decisions to be made via lower consent thresholds. In many cases this wording was bespoke and so the pre-existing documentation requires consideration to see whether amendments are feasible. Another challenge is that multicurrency facilities have seen a divergence of approach between currencies, such that some currencies (e.g. euro) continue to be priced off a forward-looking screen rate whilst others (e.g. sterling) adopt a compounded RFR rate.
The LMA documents do not address definitively the consequences of SONIA re-pricing in many areas for which a consistent market practice has yet to emerge. These include the management of prepayment and other intra-period events, the use of fallbacks (e.g. cost of funds) and the impact on financial covenants. Instead the LMA has published discussion papers detailing considerations which firms need to focus on, for instance when documenting RFR-priced leveraged finance or real estate finance transactions. The larger banks were quick to publish their policies on some of these issues. Smaller lenders have taken longer to adopt policies and some lenders that fall outside the FCA regulatory framework have sought to delay adoption of RFR pricing or pursue other options. This presents challenges when lenders are unable to agree on a common approach, requiring "re-tranching" of existing facilities in some cases.