In April 2017, the Working Group on Sterling Risk-Free Reference Rates (Working Group) recommended SONIA as the preferred sterling risk-free rate. The Bank of England established the Working Group in 2015 with the intention of facilitating the transition from LIBOR to SONIA across all relevant markets by the end of 2021.
In a previous Learn episode we learned about LIBOR, its role in spreading the financial crisis worldwide, and the reasons why regulators in the UK and elsewhere are promoting the transition towards risk-free alternative rates.
Now that LIBOR is living on borrowed time and will likely disappear by the end of 2021, it is time to find out everything you need to know about SONIA, how it differs from LIBOR, and the challenges it poses to market participants.
If you want to find out more, check out my Learn episode where you can find out everything you need to know about LIBOR, as well as my Read article about The Role of Artificial Intelligence in the LIBOR Transition.
What is SONIA
More commonly known as SONIA, the Sterling Overnight Index Average measures cost of overnight, unsecured borrowing in the interbank market. Unlike many alternative rates for other currencies, SONIA is a long-established benchmark. Since 1998, it has been the effective reference for Overnight Indexed Swaps (OIS) for unsecured transaction in the Sterling market. According to the Bank of England, SONIA is used to value around £30 trillion of assets each year.
Following the Financial Conduct Authority (FCA) announcement in July 2017 that it would no longer support the publication of LIBOR after the end of 2021, the Working Group recommended SONIA as its preferred benchmark for the transition to sterling risk-free rates from LIBOR. Market participants accepted the Working Group’s recommendations and the financial market has already seen a slow but gradual shift towards SONIA as a reference rate.
Indeed, in July 2019, the UK transport group National Express obtained the first bilateral corporate loan referencing SONIA under a pilot scheme operated by NatWest.
SONIA Administration and Regulatory Framework Development
Launched in 1997 by the Wholesale Markets Brokers’ Association (WMBA), SONIA’s purpose then was to address the volatility in the overnight interest rate.
In 2015, the Bank of England convened the Working Group to identify the preferred risk-free rate for sterling markets. In November 2017, the Bank of England and the FCA announced that the Working Group would be constituted with a broader mandate and representation from the start of 2018. Its Terms of Reference can be found here.
In January 2018, the Working Group was formed – it is composed of banks and dealers, investment managers, non-financial corporations, infrastructure providers, trade associations and professional services firms. Its overall objective is to catalyse a broad-based transition to SONIA by the end of 2021 across sterling bonds, loan and derivative markets. This transition is aimed at reducing the financial stability risks from the widespread reliance of financial markets on LIBOR.
It is important to note that the Bank of England serves as the administrator for the SONIA benchmark, while the FCA regulated the WMBA as a calculation and publication agent. However, in April 2018, the Bank of England took over calculation and publication duties.
Similarly to LIBOR, SONIA falls within the scope of the Financial Services and Markets Act 2000 (as amended by the Financial Services Act 2012).
SONIA Calculation and Publication
SONIA is calculated by the Bank of England each day in London and measures the cost of overnight, unsecured borrowing. The bank uses a volume-weighted trimmed mean method for calculating the rate, based on the central 50% of the volume-weighted distribution of rates of eligible transactions. To put it simply, after ordering the transactions from the lowest to the highest rate and aggregating the transactions occurring at each rate level, the bank removes the top and bottom 25% in volume terms. It then calculates the mean of the remaining 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 day business day maturity
- Executed between 00:00 and 18:00 GMT, and settled that same day
- Equal or greater to £25 million in value
Each business day at 09:00 a.m. GMT, the Bank of England publishes the SONIA rate for that day based on the eligible transactions collected the day before. This way, the bank accounts for a higher volume of activities. This first-round publication is made available to licensees – Bloomberg, Refinitiv, ICE Group and SIX Financial Information Ltd. It is then freely available via the Bank of England’s Interactive Statistical Database by 10:00 a.m.
This one-hour delay allows for the Bank of England to recover its costs in producing the benchmark by requiring users to have a direct licence.
What Makes SONIA Different
SONIA is more robust and less volatile than LIBOR, as it is based on actual overnight interest rates in active and liquid wholesale cash and derivative markets. SONIA is also risk-free as it does not include any credit risk/liquidity premium which the banks use when making their LIBOR submissions – remember that with LIBOR, banks reflect their borrowing costs when submitting the rates at which they would be prepared to pay if they were to borrow money in the London interbank market.
SONIA is a backward-looking whilst LIBOR is forward looking. This means that borrowers with a SONIA-linked credit facility agreement cannot determine the interest rate on a term loan until the end of each agreed interest period. What this means in practice is that instead of, for example, a three months’ LIBOR term rate agreed at the start of the interest period, the actual interest rate is calculated using compounded SONIA – a relatively last-minute calculation made up of SONIA’s daily rate for the previous three months. Therefore, borrowers no longer have upfront certainty about the amount of their interest payments.
SONIA typically fixes lower than LIBOR. This is because it does not include the credit/liquidity risk premium as discussed above. It is nevertheless unlikely that SONIA based loans will be cheaper as lenders will want to retain their rates of return. Therefore, lenders are likely to increase the margin or a add a mechanism in the agreement to cover the difference.
COVID-19 Impact on the LIBOR Transition
The Bank of England published a roadmap setting out a number of milestones and deadlines to enable a smooth transition from LIBOR to SONIA. This includes the requirement for lenders to stop writing LIBOR-linked loans by the end of Q3 2020. However, the Bank of England and members of the Working Group noted in a statement released by the FCA on 25 March 2020 that COVID-19 will have “an impact on the timing of some aspects of the transition programmes of many firms”.
A further statement issued by the Working Group on 29 April 2020 has led to the Q3 deadline being deferred to Q1 2021 in order to maintain the smooth flow of credit to the real economy in light of the pandemic. However, these events have not altered the main assumption that lenders and borrowers cannot rely on LIBOR being published beyond 2021.
Alasdair Reilly, ‘Sonia benchmark makes loan market debut’ (Reuters, 08 July 2019) https://www.reuters.com/article/sonia-benchmark-makes-loan-market-debut-idUSL8N249337?edition-redirect=uk> accessed 12 April 2021
BoE, 'SONIA key features and policies’ (Bank of England, 04 August 2020) <https://www.bankofengland.co.uk/markets/sonia-benchmark/sonia-key-features-and-policies#footnotes> accessed 06 April 2021
BoE, ‘SONIA interest rate benchmark’ (Bank of England, 26 November 2021) <https://www.bankofengland.co.uk/markets/sonia-benchmark> accessed 22 February 2021
Bank of England , Summary and response to market feedback: Supporting Risk-Free Rate transition through the provision of compounded SONIA (July 2020)
BoE, ‘ Transition from LIBOR to risk-free Rates’ (Bank of England, 29 March 2021) <https://www.bankofengland.co.uk/markets/transition-to-sterling-risk-free-rates-from-libor> accessed 06 April 2021
FCA, ‘Impact of the coronavirus on firms’ LIBOR transition plans’ (FCA, 25 March 2020) <https://www.fca.org.uk/news/statements/impact-coronavirus-firms-libor-transition-plans> accessed 12 April 2021
The Working Group on Sterling Risk-Free Reference Rate, ‘Further statement from the RFRWG on the impact of Coronavirus on the timeline for firms' LIBOR transition plans’ (Bank of England, 29 April 2020) <https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/rfr/rfrwg-further-statement-on-the-impact-of-coronavirus-on-timeline-for-firms-libor-transition-plans.pdf> accessed 07 April 2021
 FCA, ‘Impact of the coronavirus on firms’ LIBOR transition plans’ (FCA, 25 March 2020) <https://www.fca.org.uk/news/statements/impact-coronavirus-firms-libor-transition-plans> accessed 12 April 2021