“If you’re taking a new loan or swap and tying it to Libor for the remainder of this period, to me that would be short sighted.”

 

The end of March marked the deadline set by the Financial Conduct Authority (FCA) and Bank of England’s (BoE) to end the issuances of new Libor contracts. Come December, the IBA will cease publishing Sterling Libor as a representative rate and many corporates are pushing to complete their transition to the risk-free rate (RFR), Sonia.

“In terms of our clients, some have started to change their contracts and migrate others to Sterling Overnight Index Average (Sonia),” says John Byrne, CEO of Salmon Software. “Some are planning to do this at the end of the third quarter. Pretty much everybody that we speak to is gearing up to ensure that everything is migrated prior to the year end.”

The market is still far from completing the transition to Sonia. Only 51 percent of Sterling OTC interest rate derivatives, used RFRs. One reason the market has been slow to adopt Sonia is the perceived lack of liquidity.

“It’s hard to buy into that lack of liquidity argument too much,” Byrne says. “Reference Rates are not an option, they are coming as a result of a directive to discontinue Libor. There isn’t a choice”

“If you’re taking a new loan or swap and tying it to Libor for the remainder of this period, to me that would be short sighted. The new regime is coming in, everybody’s going to be on it this time next year. It’s hard to envisage a problem with liquidity?”

The FCA along with other regulators have been pushing firms to adopt RFRs sooner rather than later, they have gone as far as saying individual bonuses should be tied to how well a firm transitions away from Libor. This is part of an effort to both increase the liquidity of the RFRs and build confidence and understanding in how the new RFRs are calculated.

“The mechanisms and calculations under Sonia are so seismically different to Libor,” says Byrne.

“Libor was one rate for a period, struck at the start and you knew exactly what it was. Sonia is an entirely different proposition. It has 25 rates each month representing 25 mini periods including weekends. Also, the rate for any given day is not today’s rate. It’s a rate from a few business days earlier, based on the ‘lag’ period. Furthermore, each daily rate must be compounded.”

With Sonia, calculations are more complex than those used for Libor, therefore market participants have been eager for tech solutions to help with the transition.

“We’ve got a number of clients who are actually starting to use our new module and have been very anxious to get it because they felt that they couldn’t migrate until they had a system in place,” Byrne says.

“This was a serious challenge for software companies like us. We’ve invested over two years of development looking at what’s required.”

He adds that for firms who were manually calculating Libor rates using Excel, doing something similar for Sonia would be much more resource intensive and would carry increased operational risk.

“You have to compound rates on a daily basis. You have to round to 16 decimals places. Excel can store numbers from 1.79769313486232E308 to 2.2250738585072E-308; however, it can only do so within 15 digits of precision.”

For a 10-year loan referencing Libor, interest would need to be recalculated 120 times, with Sonia that becomes close to 3,000.

“If you’ve got a portfolio of swaps and loans, you can see just the sheer volume first of all is going to be difficult to maintain on Excel. And that’s before you get to the calculations,” Byrne says.

“If there are any additional complications thrown in such, capital movement in mid-period, interest margins, then the complexities mount. Or if you need to do a cross currency swap where one side references Sonia and the other references SOFR, you now have two sets of rates to deal with, doubling the number of calculations you have to do.”

 

Grasping the Nettle

To help ease the market off Libor and further strengthen financial stability, the FCA has recently opened a consultation period to determine if a non-representative synthetic Libor rate is needed so that tough legacy contracts can mature naturally.

“I believe if something comes of that, it’s going to be a very short-term solution,” Byrne says. Synthetic Libor is not even really defined and it still has complexities associated with it.

A final decision and statement of policy will be released in the third quarter. However, Byrne believes firms should not be holding out to see what synthetic Libor will look like.

“Firms need to grasp the Nettle.

“If there was an alternative, it would be available.”

Ultimately it will be a combination of tech providers and market participants like banks and CCPs that will enable corporates to switch to the RFRs.

“I suspect a lot of corporates may rely on their banks or counterparties to actually provide the calculations for them,” says Byrne. “There is an onus on systems’ provider to provide elegant solutions. We made sure that our TMS, Salmon Treasurer offers just that.”

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