With IBOR gone, what comes next?

The transition away from interbank offered rates is one of the biggest changes to happen in the global financial services industry. IBOR is no longer available for all sterling, Swiss franc and yen currencies, as well as for one-week and two-month US dollar interest periods. For the remaining US dollar tenors, IBOR will no longer be provided after 30 June, 2023, and there is currently no mandatory transition away from EURIBOR.

We discuss here the move away from pound sterling and US dollar IBOR towards risk-free rates in loan documentation.

Alternatives: SONIA and SOFR

In the UK and the US, the approach for replacing IBOR has been to adopt RFRs, since they are considered a means of avoiding the manipulation that IBOR rates were subject to.

In the UK, the popular alternative has been the Secured Overnight Index Average. SONIA is the average at which banks and other financial institutions pay to borrow sterling on an unsecured basis from other financial institutions overnight.

The US loan market appears to have settled on the Secured Overnight Financing Rate. SOFR is based on transactions in the US Treasury repurchase market and measures the cost of borrowing cash overnight collateralised by US Treasury securities. Since the beginning of 2022, the majority of new financings have adopted SOFR out of the gate, though most loan documents still include an interest rate switch mechanism to address any future market shifts in the benchmark for prevailing interest rates.

While arguably both are a marked improvement over IBOR, SONIA and SOFR have their own distinct problems. For starters, SONIA is a compounding overnight rate, not a term rate, and therefore the rate is not known until the end of the interest period, which makes it difficult to forecast cashflow. However, SONIA is truly reflective of interest rates, given
that it is historic. To mitigate this, loan documents typically include a “lookback” period, which means that
the interest is calculated over an observation period, not the actual interest period.

Discussion continues with respect to creating a forward-looking “term SONIA” rate, which would be required for areas such as SME lending and would likely operate similarly to a term IBOR, the main benefit being that the rate would be known at the beginning of the interest period.

Meanwhile, SOFR is also an overnight rate. The SOFR-based methodologies recommended by the Alternative Reference Rates Committee include SOFR in arrears, SOFR averages applied in advance and a forward-looking SOFR term rate (term SOFR). SOFR in arrears are backward-looking overnight rates based on actual transactions and are only known at the end of an interest period.

Although SOFR averages are known in advance of the interest period, they do not always reflect the market expectations for the upcoming interest period because they are calculated based on historic rates for the prior equivalent interest period. Term SOFR, most similar to IBOR, is a forward-looking published rate and known in advance of the interest period. Although the ARRC still recommends the use of overnight SOFR and SOFR averages, the difficulty of relying on overnight rates in the loan market has led to the increasing adoption of Term SOFR.

Another obstacle is the need to account for an economic spread. There is a small economic difference between IBORs and RFRs, which predominantly results from the credit risk premium that is built into IBORs but not RFRs. The market has used the credit adjustment spread (CAS) to mitigate this economic difference, but this is an increasingly difficult argument for lenders, since RFRs are definitionally not looking to incorporate margins. CAS has all but disappeared in the UK, and US market trends suggest that the use of CAS will eventually fall away.

Finally, neither SONIA nor SOFR are uniform across currencies. Each currency has a different RFR with variations. This might well create the requirement for particular attention to companies’ hedging needs.

Looking ahead

SONIA and SOFR more accurately reflect an average and do away with any margin, leaving very little opportunity for gamesmanship. In addition, the movement away from any CAS, particularly in the ever-growing private credit market, shows that lenders will need to accurately reflect their returns in the more open margin.

While deadlines in the US markets are less forced than in the UK, it is clear that the US has moved to adopt pre-deadline measures. It will be interesting to see how US dollar IBOR is treated under the longer applicable deadline.

Aymen Mahmoud (London) and Stephanie McCann (Chicago) are partners at law firm McDermott Will & Emery. Senior associate Nicholas Jupp (London) and associate Nicole Briody (Chicago) also contributed to this feature