Once the floodgates open on the debt market switch away from LIBOR, will you be ready?

November 12, 2019

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by Chris Heys Partner, PwC United Kingdom

Email +44 (0)7715 034667

In just over two years’ time, the Sterling London Interbank Offered Rate (LIBOR) will finally wind up, with the new benchmark Sterling Overnight Index Average (SONIA) taking its place. While there have been a few SONIA-based loan deals in recent months and SONIA bond issuance continues to increase, the debt market switch is yet to fully get going. What could break the logjam? How can lenders and borrowers get in the best position to respond when the floodgates open? Will you end up being a winner or a loser?

Whenever I talk to my clients about the impact to financial markets from the wind up of LIBOR, I find it helps to break down discussions into four key markets. I start with derivatives and then split debt into three broad buckets – bonds and loans, which I cover in this blog, and also securitisations, which I’ll have to save for another day. For each of these key markets it then helps to split the discussion even further, into legacy or “back book” instruments that are based on LIBOR and will exist when LIBOR goes, and new issuance instruments or “front book” that can based on LIBOR, SONIA or another replacement rate.

Each is at different stages of transition and faces distinct challenges ahead.

Derivatives make steady progress

Growth in new SONIA referenced swaps shows how derivatives markets are pushing ahead. In the first six months of 2019, SONIA accounted for over 45% of swaps traded in Sterling. The International Swaps and Derivatives Association (ISDA) has also announced a new market protocol for dealing with legacy derivatives that reference LIBOR, which is expected to launch early next year. This seeks to establish the industry’s final position on fallbacks for the key IBORs

Whilst the protocol is an important step forward, it’s by no means a silver bullet. There are many key challenges and there are two that keep getting raised to me by my clients. Firstly, the protocol is optional – so will you and all of your counterparties sign up or not? Secondly, the protocol is a one-size-fits-all solution, so there will be ‘value transfer’ on the switch – the big question is whether you’ll gain or lose on economics and also on risk management, or operational aspects?

Bond market leaders and laggards

New issuances of floating rate notes (FRNs) have been the poster child for LIBOR change, with over £50 billion of new SONIA linked FRNs issued since June 2018. This is in stark contrast to legacy FRNs, where there has only been a small handful of borrowers making the switch - there’s the landmark Associated British Ports (ABP) bond deal and recent approvals from Lloyds’s and Nationwide’s bondholders to follow suit. There is still a huge amount to do in the bonds market.

Loan markets drag their feet

Global working groups, regulators and market participants are thinking hard about the options for loans too. However, there has been little movement, with just two borrowers trailblazing so far - a legacy South West Water loan switching from LIBOR to SONIA and a new SONIA loan taken out by National Express.

Dealing with the debt market legacy

So, there is still a significant legacy to deal with. This is going to be a big challenge for the market and regulators over the next two to three years. What are the immediate plans?

The most advanced banks and lenders have a well-defined strategy and are beginning to contact their clients to explain the implications of the switch and to discuss individual borrower’s options. But not all banks are this far ahead and lenders just have so many clients to contact that most borrowers are still waiting for the call or just sitting on their hands.

This inertia comes with significant risks. In a previous blog, I looked at the danger of doing nothing until the plug is finally pulled on LIBOR in 2021. With borrowers having a last-minute rush to switch, market liquidity is likely to be squeezed and favourable contract terms hard to secure.

In turn, banks and lenders could face potential misconduct and reputational risk if the shift is left to drift towards a chaotic end-game in 2021, especially if borrowers find themselves out of pocket. In a recent speech, Andrew Bailey, Chief Executive of the FCA, said: “If you are a bank lending LIBOR to corporate and retail customers, you should have plans to explain the forthcoming change to your customers, and be explaining the potential risks of continuing with LIBOR.”

What are the hold-ups?

So why have so many debt market participants yet to make their move? There are a host of reasons, but three predominate:

1/ Reluctance to be the first mover

Understandable, but as I’ve outlined: waiting until it’s too late could be costly.

2/ Overreliance on fallbacks, market protocols and regulators

Some lenders and borrowers might assume that they can simply roll over their existing borrowing to a pre-set fallback rate that the market will sort out for you. But as Andrew Bailey, Chief Executive of the Financial Conduct Authority, has said: “Fallbacks are not designed as, and should not be relied upon, as the primary mechanism for transition. The wise driver steers a course to avoid a crash rather than relying on a seatbelt.”

From my discussions with market participants, clients and lawyers, it’s clear that there will be so many different options under discussion when the crunch comes that it could all come down to bilateral renegotiation of debt contracts. As with any renegotiation, there will inevitably be winners and losers.

3/ Waiting for a term rate

Even if borrowers would prefer to switch now rather than wait, many are waiting to see whether there will be agreed term rates. SONIA is solely an overnight rate, unlike LIBOR which has term rates, which means that with SONIA you only know the coupon amount to be paid (or received) on debt just before you need to pay (or receive) it. Many say that an agreed mechanism needs to be developed for setting SONIA term rates. But many disagree, and so the debt market may just need to get used to overnight rates, rather than term rates.

The catalysts for action

So, when could the trickle of SONIA debt deals become a flood? There are two key events on the horizon which could be catalysts for action:

1/ ISDA protocol for Derivatives in Q1/Q2 2020
When the protocol goes live, banks and lenders will need to quickly step up the pace of calls to their derivative user clients. Many borrowers will also want to sort out their debt at the same time as their derivative hedges, as they are often closely linked. SONIA debt flows should therefore pick up across the board.

2/ SONIA term rate, potentially in Q1 2020
While the FCA hasn’t given any commitment over when, or even if, SONIA term rates will come to fruition, many market participants are pressing for a solution on this. The FCA is discussing with banks how this might work and we may see something early next year.

Early mover advantage

When we do eventually see movement on these issues, and this could be soon, smart borrowers will have already assessed the impacts and will use this as the cue to switch.

In turn, smart banks and lenders will already be on the phone to both their existing and potential new clients with new SONIA products and solutions to help their clients navigate the transition.

We’re likely to see a major boost for innovation in debt markets as the pace of LIBOR transition accelerates. There will be potentially favourable terms for early movers and they are most likely to be the ‘winners’.

by Chris Heys Partner, PwC United Kingdom

Email +44 (0)7715 034667