The main use cases where a robust rationale may be identified for using Term SONIA in lending products include trade finance, working capital, and Islamic finance products.
The FMSB (FICC Markets Standards Board) has proposed a new draft standard on the use of forward-looking term SONIA reference rates in GBP markets transitioning away from LIBOR.
The proposed standard has been welcomed by the Working Group on Sterling Risk-Free Reference Rates, the FCA (Financial Conduct Authority) and the BOE (Bank of England).
Regulatory expectations are for overnight SONIA, compounded in arrears, to become the norm in most derivatives, bonds and bilateral and syndicated loan markets, as it will provide “the most robust foundation for sterling interest rate markets.”
However, there will be some circumstances where the use of a rate compounded in arrears is not appropriate or operationally achievable, the draft standard says.
“For example, Term SONIA may be valuable where market participants need advance knowledge and certainty of their interest rate obligations, or where the rate is used for discounting future cash flows such as in trade finance.”
In GBP lending markets, market participants are expected to assess whether there is a robust rationale when deciding to use Term SONIA.
The main use cases where market participants may be able to identify a robust rationale for using Term SONIA in lending products include:
- Trade and working capital products which require a forward-looking interest rate for discounting
- Islamic finance products which can pay variable rates of return as long as the variable element is pre-determined
There may also be a robust rationale for using alternatives to SONIA compounded in arrears in mid corporate/private banking and retail and export finance/emerging markets lending, the draft standard says.
“Lenders should have internal processes in place to approve any product types that reference Term SONIA and evidence the alignment of product approvals with this Standard and the rationale for any exceptions.”
In GBP bond markets, SONIA compounded in arrears has been adopted as the main reference rate, including for floating rate notes and securitisations.
“SONIA compounded in arrears may be better suited to floating rate bonds than Term SONIA, due to the sophistication of issuers and investors and the possibility that issuers or investors may wish to hedge interest rates using derivative products.”
Market participants are asked to carefully assess whether there is a robust rationale when deciding to use Term SONIA for any bonds, floating rate notes and securitisations.
In derivatives markets, SONIA compounded in arrears has been adopted as the main alternative reference rate to LIBOR for GBP linear derivatives products, including interest rate swaps.
Exceptions may include:
- End-user-facing derivatives used to hedge cash products which reference Term SONIA or end-user derivatives used to manage such hedges
- End-user-facing derivatives used to hedge tough legacy products which reference synthetic LIBOR (if synthetic LIBOR is based on Term SONIA) or end-user derivatives used to manage such hedges
In a set of general principles contained in the draft standard, banks and dealers are asked to:
- track and retain records of the volume of products used or issued which reference Term SONIA
- ensure adequate policies, procedures, systems and controls are in place to identify and mitigate any conflicts of interest which may arise through the use of products referencing Term SONIA
- provide comprehensive risk disclosures to end users who are offered products referencing Term SONIA to highlight any relevant risks
The draft standard also says corporates and buy-side firms should assess whether there is a robust rationale for any requests made to dealers to provide products referencing Term SONIA.
Any products referencing Term SONIA should have robust fallback arrangements in place to allow orderly transition if Term SONIA were to be discontinued or declared non-representative, in accordance with the Benchmark Regulation.
The draft standard, available here, is open for comment until 28 May 2021.
