SONIA: An end user’s guide
How SONIA, the benchmark rate chosen to replace GBP LIBOR, works and what drives its movements
The Financial Conduct Authority (FCA) announced in July 2017 that it would no longer support the publication of LIBOR following the end of 2021. This was part of a global effort, recommended by the Financial Stability Board in 2014, to develop alternative “risk-free rates” (RFRs) and promote their use as interest rate benchmarks instead of “interbank offered rates” (IBORs).
In the GBP interest rate markets, the Bank of England’s Working Group on Sterling Risk-Free Reference Rates leads the transition away from LIBOR. In April 2017, the Working Group recommended the Sterling Overnight Index Average (SONIA) as the replacement for GBP LIBOR. Market participants accepted the Working Group’s recommendation and focused on effecting a transition from LIBOR to SONIA right across the sterling debt and derivative markets.
When will LIBOR be discontinued?
Some time after the end of 2021. The exact date has not been fixed by the FCA — instead, the regulator will stop asking banks to participate in LIBOR’s calculation after 31 December 2021. It is expected that, shortly after this point, some or all of the banks involved in LIBOR’s calculation will drop out of the panel. If the entire panel drops out, LIBOR would be discontinued at that point. Otherwise, the FCA may step in after a number of banks have left the process and state that the reduced size of the panel prevents LIBOR from being robust enough for use. The FCA has also suggested that regulators could announce LIBORs discontinuation themselves — presumably for a date after 31 December 2021 — but with the announcement potentially coming as early as 2020.
It is important to note that, while LIBOR itself will still be published at the end of 2021, it may stop being possible to enter into certain LIBOR-linked contracts well before this point. In particular, the FCA has set a deadline of 31 March 2021 for banks to stop signing new loans linked to LIBOR if they mature after the end of 2021.
What is SONIA, and how is it calculated?
SONIA is the Sterling Overnight Index Average. It is published at 9 a.m. each London business day by the Bank of England and measures the cost of overnight, unsecured borrowing.
SONIA is calculated as the trimmed mean, rounded to four decimal places, of interest rates paid on eligible sterling-denominated deposit transactions. This trimmed mean is calculated as the volume-weighted mean rate, based on the central 50% of the volume-weighted distribution of rates. Eligible transactions are those which are:
- Reported to the Bank of England’s Sterling Money Market daily data collection
- Unsecured and of one business day maturity
- Executed between 00:00 and 18:00 UK time, and settled that same day
- Greater than or equal to £25 million in value
Why was SONIA selected as the replacement for GBP LIBOR?
SONIA is a well-established interest rate benchmark that has been published daily since 1997. As such, it already had a well-developed interest rate swaps market for certain tenors and had been used on an (admittedly small) number of borrowing transactions prior to the Working Group’s recommendation. As a replacement for LIBOR, SONIA has several key advantages:
- It is underpinned by a deep and liquid market, with daily transactional volume typically exceeding £40 billion
- It is based on actual transactions rather than expert judgment and is therefore less prone to manipulation
- Unlike LIBOR, it does not contain an implicit premium accounting for the credit risk of the banking sector, and so is less volatile during periods of market stress
- Being backward looking rather than forward looking, SONIA does not vary based on market participants’ views of the likelihood of future monetary policy shifts, which also makes it less volatile than LIBOR
What are the key differences between SONIA and LIBOR?
From a borrower’s perspective, there are three key differences between SONIA and LIBOR:
- SONIA is an overnight rate, not a term rate
- Whereas LIBOR gives the cost of borrowing for a range of different periods (1 month, 3 months, 6 months etc), SONIA is a single rate that only measures the cost of overnight borrowing. As a result, in order to use SONIA to calculate the floating rate of interest on a multi-day borrowing period, each SONIA fixing during that period must be collected and compounded.
- SONIA is a backward-looking rate
- While LIBOR is forward looking, giving the cost of borrowing for the future period starting on the day it is published, SONIA is backward looking. This means that borrowers with debt linked to SONIA will not know the floating rate for each interest period until the end of the period.
- SONIA typically fixes lower than LIBOR
- As SONIA does not include an implicit credit premium for the banking sector, it typically fixes lower than LIBOR. This means that references to LIBOR in a debt or derivative contract cannot simply be replaced by references to SONIA without the amendment resulting in a (potentially significant) transfer of economic value. To avoid this, counterparties will need to determine an appropriate spread adjustment to be added to the replacement rate.
What hedging products are available for SONIA-linked debt?
The SONIA swap market is already well-established, and since the second half of 2019, the average daily volume of new SONIA swaps traded has exceeded that for LIBOR.
It is also possible to hedge SONIA-linked debt with caps, floors and swaptions, however the market for these option-based products is currently less liquid. As a result, the cost of these products is currently higher than that for the equivalent LIBOR product, and some banks are unable to provide them. However, liquidity is building quickly across the market and we anticipate that SONIA-linked options will overtake their LIBOR equivalents by the end of 2021.
What SONIA-related resources are available?
Speak to a Chatham expert
Please reach out to the Chatham team if you have questions around the GBP LIBOR transition or how the use of SONIA in your loans and derivatives could impact your interest rate exposure.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.20-0314