The Bank of England and the FCA have been working together to catalyse a transition away from the well-known, slightly infamous but, nevertheless, ubiquitous and widely used LIBOR to the lesser known SONIA by 2021.
The Sterling Overnight Index Average (SONIA) was initiated in 1997 by the Wholesale Markets Brokers’ Association and represented, at the time, the weighted average rate for unsecured overnight sterling transactions by its members. Prior to its creation there was no published sterling overnight funding rate and so SONIA was welcomed as it created transparency and stability in overnight sterling rates and led to the Overnight Index Swaps market, further enhancing liquidity in inter-bank funding markets.
SONIA has been administered by the BoE since 2016 but as of April 2018 the Bank assumed responsibility for its calculation and publication. It can now be defined as an overnight rate for sterling transactions that:
- are unsecured (both brokered and bilateral);
- have a maturity of one business day;
- have minimal credit, liquidity and other risks
Given these characteristics it is a reasonable proxy for a risk-free rate in normal market conditions.
The Bank of England’s Sterling Money Market Data Collection is the source of transaction data. Eligible transactions are those that occur between 00:00 hours and 18:00 hours UK time, are at least £25 million, are unsecured and settle on the same day. A volume weighted trimmed mean method is used to calculate the rate; it is based on the central 50% of the volume-weighted distribution rates. Once the data has been collected and processed, SONIA is published at 9 am on the following business day.
One of the main reasons for the move to SONIA is that it is calculated on the basis of actual transactions and volumes; this is not the case with LIBOR. At present, LIBOR is administered by ICE Benchmark Administration (IBA) and regulated by the FCA. The Chief Executive of the FCA has stated that banks will no longer be required to submit LIBOR quotes after 2021. But does this mean the end of LIBOR? The short answer is not necessarily.
There are two fundamental differences between LIBOR and SONIA which may not allow for a swift transition:
- SONIA is an overnight rate – the 35 LIBOR rates are available for maturities of one month, three months and longer in five major currencies.
- SONIA is backward looking – this means that at contract inception, interest to be paid will not be known.
The IBA have been working on reforms to LIBOR and are hoping that banks will continue to provide data after 2021. Other initiatives include the Singaporean Swap Offer Rate model, whereby interest rates are sourced by those implied by the extremely large (and consequently difficult to manipulate) FX Swap market, and the Secured Overnight Financing Rate (SOFR) in the US based on transactions in the Treasury repurchase market. Could this mean the battle of the benchmarks? Watch this space…