By Alasdair Reilly
LONDON, July 29 (LPC) - Syndicated loans based on the sterling overnight index average (Sonia) may not be seen for at least a year, as banks and borrowers scramble to put expensive new technology and systems in place that can cope with backward-looking compounded rates.
The loan market must transition away from products that use Libor towards risk free rates (RFRs) by the end of 2021, in one of the most significant changes ever to the contracts that underpin lending.
Progress in the syndicated loan market on a Libor replacement has been slow to date as the market has been waiting for forward-looking rates to be created that would mimic Libor and allow them to predict their borrowing costs with few changes to existing systems.
The development of a workable forward-looking term rate has taken longer than expected, hampered by a relatively small number of issuers and a lack of demand, as borrowers hesitated over making expensive changes.
A handful of borrowers are now starting to use Sonia’s backward-looking compounded rate on bilateral loans, which requires a significant investment of time and capital to change systems to deal with backward-looking compounded rates.
UK transport group National Express agreed the first bilateral corporate loan referencing Sonia via NatWest in June. The deal took three weeks to close from start to finish, but setting up systems to handle the new RFR took a lot longer, sources said.
NatWest’s pilot scheme uses the same methodology seen in the sterling FRN market, which includes the compounding of interest and ability to hedge.
‘NatWest is developing various alternatives for existing Libor transactions, including the recent new Sonia loan product we were pleased to launch in June," Nick Kent, Libor Transition at NatWest, said.
The loan market is currently least advanced in making the transition away from Libor, despite the continuing development of risk free alternatives in other markets, Andrew Bailey, chief executive of the FCA said.
The loan market is now realising that forward-looking term rates may not be available, or could be one of several options as any forward-looking rate could face the same speculative issues as the discredited Libor reference rate.
“Development of alternatives - such as term Sonia - are expected to have limited application in situations where an overnight rate is not appropriate,” Kent said.
Companies that need to know their funding costs in advance may need to use short-term hedges to swap Sonia interest to a more certain forward looking rate.
Banks and borrowers that have been trying to avoid making significant and costly systems changes, now have little choice. Highly complex systems geared to the use of Libor, need to be radically overhauled to operate RFRs, which will take time and money.
“Loans have not got to grips with reference rates and replacement structures yet. Unless there’s demand from clients and infrastructure plays catch up, then there’s no easy solution,” a senior banker said.
Although work on internal systems at individual banks is progressing, it is not being done on a multibank basis. This means that syndicated loans referencing Sonia are still a long away, until more banks are involved and their internal systems are aligned.
The enforced systems upgrade for banks and issuers could hasten the move towards developing much-needed loan technology and systems that can span the market, rather than relying on proprietary bank systems.
UK banks are currently leading the transition process, despite the distraction of Brexit, due to London’s strong position in FinTech and its position as a global financial centre.
Development of a reformed Euribor is further behind as the Eurozone wrestles with the sheer number of counterparties and clients that will be affected by the transition to a RFR. Unlike Libor, thousands of people in Europe have Euribor-linked mortgages that need to be switched to a RFR within the timeframe.
Different replacement rates are being developed for different currencies. This will potentially impact multicurrency syndicated loans, which allow borrowers to arbitrage between currencies.
Multicurrency loan agreements could become far more complex, as they will have to reference several different rates that were created using different methodologies, which will potentially boost transaction costs.
“Clients are keen to find a solution that’s net neutral, they don’t expect to benefit or be penalized, they are trying to achieve a middle path with a seamless conversion from one RFR to another,“ the senior banker said.
Banks are also facing a major challenge over legacy loans and contracts that reference Libor, which need to be amended to reference RFRs before the deadline. New loans continue to reference Libor, which is making the already massive job more challenging.
Transition language developed by the Loan Market Association (LMA) to be used in loan documentation should make the amendment process easier, by changing lender voting rights from 100% to majority, but all these contracts will still have to be renegotiated, which could also prove costly.
Meanwhile, both LMA and the Loan Syndications and Trading Association (LSTA) in the US, are working to develop new standardised documentation for syndicated loans referencing overnight RFRs.
Although technology may help, the lack of standardization in the loan market is hampering automation and smart contracts, particularly considering the tight timeframe for transition.
There is also a danger that Libor will become too volatile to use before the 2021 deadline, which is adding further impetus to the push to transition.
Although Libor could still limp on after 2021, before finally becoming unworkable as panel banks cease to provide quotes, that is a risk banks and borrowers will want to avoid. (Reporting by Alasdair Reilly. Editing by Tessa Walsh) ))