Use Cases of Benchmark Rates: Compounded in Arrears, Term Rate and Further Alternatives (pdf, Jan 2020) Mar 09 2020 16:52 languageMoneyScience
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The Working Group on Sterling Risk-Free Reference Rates set up a Term Rate Use Case Task Force (the “Task Force”)to provide guidance on the need for and potential usage of Term SONIA Reference Rates (“TSRR”), if available, alongside SONIA compounded in arrears, across different client segments. The Task Force consisted of banks, non-banks and trade associations (ACT, LMA, ICMA, UK Finance) in order to analyse the broad range of products in the cash market that use LIBOR today. For each segment the Task Force considered both the client and operational suitability, with results where possible validated with representative clients and trade bodies representing those segments. The Task Force considered that use of SONIA compounded in arrears was appropriate and is likely operationally achievable for approximately 90% by value of the Sterling Libor loan market sampled and that the remaining 10% by total loan value would likely require alternative rates. The 10% requiring alternative rates consists primarily of lower value loans toa wide range of smaller borrowers and therefore accounts for a somewhat greater proportion when measured by borrower numbers rather than total loan values. These proportions arebased on estimates from members of the Task Force that have been collected using an anonymous survey by the RFR Secretariat. Current users of SONIA compounded in arrears include larger and more sophisticated corporates and specialist lending sectors. Smaller corporate and retail clients for whom simplicity and/or payment certainty is a key factor may wish to consider alternative rates such as a fixed rate, the Bank of England’s Bank Rate (the “Bank Rate”, which is an overnight rate), or a SONIA term rate, if available. To continue with the current market practice, alternative rates should also be considered for trade and working capital, which use discounted cash flows andtherefore require a forward-looking term rate with the ability to interpolate mid period dates, and Islamic finance which can pay variable rates of return so long as the variable element is pre-determined. Consistent with the view of the RFRWG, the UK authorities have made clear their preference for the market to adopt a broad-based transition to SONIA compounded in arrearsfor new transactions, with use of a TSRR being more limitedthan the current use of LIBOR4. This Working Paper has provided furtherclarity on the potential usage of a TSRRgoing forward and also why compounding in arrears is likely to be preferred for most types of new business.