SONIA: A comprehensive guide

Summary

Why do we need SONIA?

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.

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:

1. SONIA is an overnight rate, not a term rate

   1. 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.

2. SONIA is a backward-looking rate

   1. 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.

3. SONIA typically fixes lower than LIBOR

   1. 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.