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21 August 2020

SONIA is set to replace LIBOR at the end of 2021

In 2015, the Working Group on Sterling Risk Free Reference Rates set to work identifying a potential GBP London Interbank Offered Rate (LIBOR) successor. Their criteria included the availability of meaningful market data, robustness to changes in market structure, appropriate governance and commercial sustainability, the extent to which the risk-free rates reflect actual market funding rates and the importance of actual and potential end-user demand for risk-free rate-linked derivatives. The working group then evaluated several rates against these criteria, including the Sterling Overnight Index Average (SONIA). In 2017, they announced reformed SONIA as their recommended risk-free rate.

LIBOR is set for retirement at the end of 2021 and will be replaced with SONIA. LIBOR is a measure of the average interest rates charged by banks when they borrow from each other, and figures are released daily showing rates over various periods, in various currencies. Along with the base rates set by central banks, it impacts the rates of loans and investments offered by banks to their customers and is one of the benchmarks used to gauge the state of the global economy.

However, LIBOR is calculated by only looking at a limited set of data, and this weakness was brought to light during 2012, still in the aftermath of the 2008 global financial crisis, the LIBOR scandal broke that unveiled the manipulation of this key benchmark by some prominent international banks. In response, regulators chose to abandon LIBOR for a risk-free rate (RFR), such as SONIA.

What is SONIA?

SONIA is calculated daily and is a measure of the cost of sterling short-term wholesale funding in a risk-free market between banks, i.e. a market environment where credit, liquidity and other risk factors are minimal. SONIA is underpinned by a daily average of 375 transactions, with a value of approximately £50 billion. While LIBOR was calculated for many different maturities, ranging from overnight to 1 year, SONIA is an overnight rate. It is calculated in arrears, in contrast to LIBOR, which is based upon agreed interest rates that are set before a transaction. Borrowers should take note as this means that they can no longer be certain about the rates they will be paying over the duration of the loan. In an attempt to mitigate this problem, the Working Group on Sterling Risk Free Reference Rates (Working Group) has proposed a set of recommendations:

  • SONIA compounded in arrears

The prevailing view within the Working Group appears to be that the SONIA rate should be compounded in arrears, with a 5-day lag period. This will become the norm in most derivatives, bonds, and bilateral and syndicated loan markets, and is already established in SONIA bond and loan transactions. This provides a window at the end of the interest period for calculating, agreeing and reconciling the SONIA rate, interest amounts and making payment on the due date. The number of lag days can be varied, within limits, and it remains to be seen how the market will implement these lags or whether a standard practice will emerge.

  • Other alternative rates

The working group believes that SONIA compounded in arrears is appropriate and achievable for the majority on the Sterling LIBOR market. A small minority, however, may find alternative rates to be more suitable. This could be the case when simplicity and payment certainty are critical. In these cases, a fixed rate, or forward-looking SONIA rate, may be more appropriate. This means that, while SONIA has been found to be the most appropriate successor to GBP LIBOR, participants in the market are not required to use it in every instance.

  • Forward-looking term SONIA reference rates

There are cases, specifically in loan and debt capital markets, which could make users reluctant to adopt the use of an overnight rate. For this reason, the Working Group has found that robust forward-looking rates could provide a transition path to SONIA for these users. Indicative term SONIA reference rates are already being made available, and a decision around term SONIA reference rates is expected by the end of this year. However, the UK Financial Conduct Authority has indicated that firms should not wait for, nor rely on, the development of a term rate and should rather develop their own LIBOR transition plans. 

  • SONIA Compounded Index

The Bank of England has begun publishing a SONIA Compounded Index to support the adoption of SONIA, starting from 3 August 2020. The SONIA Compounded Index is intended to simplify compounded interest rate calculations and make it less likely that different calculation conventions will arise. The index is conceptually the same as a series of daily data, representing the returns from a rolling unit of investment earning daily interest, compounded at the SONIA rate. The change in the index between any two dates can be used to calculate that period’s payable interest rate.