A market-wide transition is underway, away from the Interbank Offered Rate (LIBOR) to Risk Free Rates (RFRs), and the market needs to be ready for that change, which will see the Sterling Overnight Index Average (SONIA) take LIBOR’s place as the predominant interest rate benchmark in sterling financial markets by the end of 2021.
In order to accelerate the adoption of SONIA as a reference rate in sterling markets, the Bank of England is considering publishing a daily SONIA Compounded Index. This is intended to support SONIA’s use in a wide range of financial products by simplifying the calculation of compounded interest rates; by publishing a simple set of compounded SONIA Period Averages, market participants would have easy access to SONIA interest rates compounded over a range of set time periods.
SONIA reflects the average of interest rates that banks pay to borrow overnight, unsecured sterling cash on a given day. It is widely used as a reference rate to determine the interest payable on a range of floating rate instruments.
The use of forward-looking term rates in trade finance
There is a critical need for a forward-looking rate to the solutions for trade finance products, as interest payments are typically recovered in advance and customer receives the discounted proceeds on the first day. Examples include supply chain finance solutions and discounting of letters of credit or other instruments. Also, interest payments are recoverable in arrears, and clients need an upfront fixed rate pricing structure, for example in the case of import/export loans. Whilst the market will adopt a broad-based transition to RFRs compounded in arrears, there is a belief that backward looking RFRs are not suitable for all transactions.
The rationale for trade finance requiring forward-looking rates
Trade finance lending is linked to specific, identifiable underlying trade transactions (the purchase/sale of goods or services). Customers will typically require the certainty and upfront visibility on their interest payments for pricing the goods/services, budgeting and cash flow planning. The likely loss of the upfront knowledge of interest costs when using ‘backward-looking’ RFRs, calculated at the end of the interest period, creates a challenge to participants in buying and selling goods or services at competitive margins.
Those involved in trade finance come from a wide spectrum of company profiles, including smaller companies who may not have the sophistication or access to the treasury solutions to hedge the interest. However, some sophisticated customers may selectively choose daily overnight rates and manage their interest rate risk using hedging products and derivatives markets, hence requiring market alignment.
Availability of forward-looking term rates helps in calculating coverage ratios for such loans which may be secured against collateral/security.
Some key trade finance solutions are offered with interest payable in advance. These solutions form a significant portion of the trade finance market and cannot be offered without a fixed forward-looking rate.
Trade finance customers may have trade facilities with a number of different banks, but generally use only one or two as their cash bank. Interest in arrears at a variable rate may mean the customer has insufficient time to arrange to remit the principal plus interest to the lending bank, as the total interest payable may not be known sufficiently ahead of time. The more diverse range of currencies and higher volume/lower value of trade finance transactions vs traditional lending will make this more problematic for trade.
Transaction documents containing LIBOR will be amended, and with the lack of a forward-looking term rate for trade finance transactions, it may be challenging to ensure these documents will continue to function as intended by the parties.
There is a significant secondary market for trade finance, enabling finance providers to deliver solutions to clients where funding capacity constraints may otherwise preclude them from doing so. Availability of term reference rates supports both the origination and distribution of these funded structures.
So, SONIA Compounded Index provides a reasonably accurate calculation and aligns to the interest period of the underlying loan tenor. As trade finance tenors are linked to individual trade transactions and may not have set periods, compounded index solutions can only apply to trade finance products with an interest in arrear calculation. Additionally, using a backward-looking calculation closer to the maturity of a loan may not be enough. A key requirement is the ability to accrue interest on a daily basis.
We need the calculation of the compounded index to be less disruptive and more efficient for the trade finance industry when compared to the compounding of RFR. If the wider lending and derivatives market adopts compounded index methodology, it makes sense to align the trade finance industry.
SONIA Period Averages will not work for trade finance solutions, as the transaction tenors are linked to the underlying trade transaction/trade cycle and may not be aligned to set periods. Extrapolation will result in inaccurate calculations and will not be in the interest of customers. Some products where the tenors align to set periods may adopt this methodology. However, the question of daily accrual of interest will still need to be addressed. Backward-looking period averages cannot be used as a replacement of forward-looking term rates, as they will simply introduce basis risk if deployed for interest in advance (discounting) products. We would also still require term premium adjustment whether we use a period average or a simple RFR for such products.
The Bank of England’s publication of a compounded SONIA Compounded Index is a step in the right direction for a market-wide methodology and the market should look at developing a specific term period RFR for the trade finance industry, taking into account that trade finance solutions will generally require a forward-looking term rate.