Advisors - June 7, 2021
LIBOR is Going Away. Get to Know SONIA
Goodbye, LIBOR. And hello, SONIA.
First launched in London in 1986, LIBOR has spent the last 35 years as a globally accepted benchmark for short-term interest rates. As many banks (and popular credit and loan products) begin their transition to SONIA, let’s break down why LIBOR is going away and what the new SONIA means for you.
What is the Difference Between LIBOR and SONIA?
Previously, LIBOR served as the benchmark interest rate at which banks loaned overnight funds between and among each other. LIBOR was calculated every morning by a group of sixteen leading global banks, each of whom submitted their own forward-looking rate estimate for borrowing money on unsecured terms from the other banks. The average of the sixteen figures then became LIBOR for that day. When a loan agreement was entered into, both LIBOR and any credit risk premium were set at the start of each interest period and gave borrowers certainty regarding the amount of interest they would owe at the period’s end.
However, there wasn’t just one single LIBOR rate. Variations were created with durations ranging from overnight to a year out. On top of that, all LIBOR durations were denoted in five major currencies, thereby bringing the short-term lending benchmark’s total to 150 published rates.
SONIA, in its current state, is a single, backward-looking rate denoted in British pound sterling. This means SONIA — unlike LIBOR — cannot be determined until the interest period is over. The retrospective design also means SONIA carries no credit risk premium, reflecting just the previous day’s interest rate paid on overnight deposits in active, liquid cash and derivative markets.
It should be noted that regulators are already working on evolving SONIA, creating rates that are forward-looking, incorporate credit risk premiums, and reflect more time periods.
Why is LIBOR Going Away?
According to the Bank of England’s The Working Group on Sterling Risk-Free Reference Rates, SONIA “is a better measure of the general level of interest rates than LIBOR”. SONIA better serves as a benchmark lending rate as it’s a less volatile and tighter, more accurate read on short-term lending rates than LIBOR is or was.
Because SONIA’s current historical nature prohibits factoring in forward-looking credit risk premiums, SONIA is essentially treated as a risk-free rate. The Working Group also says SONIA is more robust than LIBOR due to its liquid underlying market that contains a consistently healthy number of transactions which form the rate.
As for LIBOR, because rates were set by a self-selected group of banks free from virtually any external policing, its integrity was inherently flawed.
In the months leading up to the global financial crisis, a rate-rigging scandal emerged where traders at the sixteen banks influenced their respective institution’s rate-setters to submit artificially low rates on a daily basis. As this cartel-of-sorts kept rates suppressed, market makers profited immensely from inflated spreads when trading LIBOR-based securities. LIBOR, a globally-followed benchmark for determining borrowing costs, wasn’t meant to be manipulated for trading purposes, and as a result the practice painted a systemically untrue picture of actual borrowing costs.
With SONIA, rate-setting will be more centralized. Rather than being set by a group of banks with little oversight, SONIA will be administered and published by the Bank of England, thereby eliminating the influence of middlemen (traders, bankers, market makers, etc.) who might carry ulterior motives and interests.
Financial Impacts of Switching to Sonia
A downside of SONIA is that borrowers won’t have upfront certainty about their interest payments. This is due to SONIA’s backward-looking nature, where the amount owed can only be determined after the agreed interest period is over. Thus, SONIA participants have developed a workaround solution to calculate interest until a forward-looking rate is established:
• Aggregate SONIA rates on a compounded basis over an interest period to produce a term interest rate. Essentially, resetting the interest rate on a SONIA loan daily.
• Ex. A 3 month interest period would be made up of the last 3 months’ daily rates.
• Use a “lag period” and “observation shift” to reference the SONIA rate
• Ex. the period over which the daily SONIA rate is compounded “lags” the interest period by X business days before the start and end of the interest period;
• The “observation shift” results in interest being calculated from the start of the “lag” period to its end;
• This allows the compounded rate and connected interest payment to be known X days before the payment is due. The net benefit: providing borrowers X days to acquire funds in order to pay the interest due
It’s unlikely that interest rates will be lower, and thus borrowing less expensive, under SONIA. In fact, lenders will likely add “credit adjustment spreads” to SONIA in an effort to mimic the comprehensive “all in” interest rate captured by LIBOR. Though this practice might sound reminiscent of the LIBOR rigging scandal in which traders could add artificially high credit risk premiums for their own benefit, the difference is SONIA rates will be set by the Bank of England. Private banks’ inability to set the rates by themselves AND for themselves limits the risk premium that rate traders can realistically add to SONIA rates.
SONIA on YCharts
YCharts users can access the one daily SONIA rate here, and use it to make investment decisions. Currently, all 150 LIBOR rates are still available on YCharts, though marked as discontinued as the underlying market it measures is no longer liquid. As The Working Group and Bank of England develop more SONIA rates, look for them to be available in YCharts in due time — so keep calm and carry on!
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