SONIA monthly transaction activity — September 2020

Since the UK Financial Conduct Authority’s 2017 announcement that they would not support LIBOR beyond 2021, market participants have been progressing towards the adoption of replacement indices. This process has moved slowly to date, but with critical deadlines approaching over the next 18 months, UK market participants can expect SONIA-based transactions to become more prevalent.

This update addresses the current state of GBP LIBOR and SONIA markets, exploring both the performance of the rates as well as the borrowing and hedging markets that surround them.

Highlights

• The spot spread between SONIA and LIBOR is currently one basis point, down from two basis points as of our previous update in late August. Despite the narrow spread at present, it has averaged 18 basis points over the past ten years and 14 basis points over the past five years. There have been several instances where the two diverged, most recently in the first quarter this year because of the liquidity crisis that unfolded during the early days of the COVID-19 pandemic.
• The five-year historical median spread between 3-month LIBOR and compounded SONIA, identified as the preferred spread adjustment methodology in the transition from LIBOR to SONIA, has held steady between 12 and 13 bps in recent years. The recent decline in LIBOR-SONIA spreads has so far had a negligible impact on the five-year median spread.
• SONIA derivative trading volumes saw a considerable pickup in Q1 2020, but they have now reverted to historical averages, consistent with Chatham’s observation that the majority of our clients continue to borrow (and therefore hedge) based on LIBOR.
• Some expect derivative volumes to increase in Q2 2021 (when lenders will no longer be permitted to write new LIBOR-linked loan agreements), particularly for instruments with tenors of three to five years.

Performance of GBP LIBOR and SONIA

• Both 3-month GBP LIBOR and 3-month SONIA compounded daily in arrears, the backward-looking calculation methodology recommended by the Working Group on Sterling Risk-Free Reference Rates, initiated by the Bank of England (BoE) (unless otherwise indicated, all subsequent references to SONIA will mean SONIA compounded in arrears), are driven by the BoE policy rate and tend to be highly correlated and directionally aligned.
• The spot spread between SONIA and LIBOR is currently one basis point, down from two basis points in late August. Despite the narrow spread at present, it has averaged 18 basis points over the past ten years and 14 basis points over the past five years.
• There have been several instances where the two diverged, most recently in the first quarter this year because of the liquidity crisis that unfolded during the early days of the COVID-19 pandemic. For more information about the other factors that can cause LIBOR and SONIA to diverge, read our FAQ: IBOR transition to risk-free rates in Europe.

GBP LIBOR to SONIA spread adjustment

• Transitioning a GBP LIBOR-based loan or hedge to a SONIA-based instrument necessitates adjusting the loan/hedge spread to minimise value transfer between the parties.
• The consultation on credit adjustment spread methodologies for fallbacks in cash products referencing GBP LIBOR, carried out by the Working Group on Sterling Risk-Free Reference Rates, recommended a spread adjustment calculated as the median difference between GBP LIBOR and SONIA over a five-year lookback period prior to the fallback date.
• The five-year historical median spread has held steady between 12 and 13 bps over the past five years. The recent decline in LIBOR-SONIA spreads has so far had a negligible impact on the five-year median spread.

Hedging activity in GBP LIBOR and SONIA markets

• As of today, LIBOR continues to be the primary index hedged in the market while SONIA has not gained the critical mass anticipated in 2019.
• SONIA trading volumes saw a considerable pickup in Q1 2020, but they have reverted to historical averages, consistent with Chatham’s observation that most of our clients continue to borrow (and therefore hedge) based on LIBOR.
• Some expect that the Q1 2021 deadline for new LIBOR financings will have a noticeable impact on the mix of LIBOR and SONIA hedging volumes, but with LIBOR set to be published until at least the end of 2021, the transition could continue to unfold gradually.

• Most of our clients’ SONIA-based transactions mature in the one to five-year range, despite this being the most thinly traded tenor by transaction count.
• Some expect activity in the 1–5-year range (particularly 3–5 years) to increase in Q2 2021, when lenders will be prohibited from writing LIBOR-linked facilities.

• Despite the relatively even mix in transaction count by tenor, transaction volumes are dominated by trades up to one year in tenor.
• The FCA’s January 2020 press release may, in part, have driven the Q1 spike by encouraging market participants to begin the switch from LIBOR to SONIA-indexed derivatives.

With less than 18 months until LIBOR is no longer supported by the UK Financial Conduct Authority, market participants can expect the SONIA market to further develop. Many expect this will be most noticeable in both transaction count and volume for trades with a tenor of 3–5 years following the Q1 2021 hard stop on lenders issuing new LIBOR-linked facilities. Continuing low spreads between LIBOR and SONIA may also begin to compress the five-year median spread, which is currently the preferred spread adjustment mechanism for existing LIBOR-indexed financings that transition to SONIA. For more information about the transition from LIBOR to SONIA, read our FAQ: GBP LIBOR transition to SONIA.