PRIMER: Sonia (the Sterling overnight index average) – part 1
The first part of this primer takes a look at the benchmark that is being touted as the one the market will use post-Libor in the UK
What is Sonia?
Introduced in March 1997, Sonia stands for the sterling overnight index average. It has historically been used as a benchmark for overnight unsecured transactions denominated in GBP.
The Bank of England (BoE) became Sonia’s administrator in April 2016, and as of April 2018, has also taken over the Wholesale Markets Brokers' Association’s (WMBA, now the European Venues and Intermediaries Association, or EVIA) calculation and publication duties.
The rate is in the process of being reformed with a view to it becoming the benchmark more widely used in the debt, structured finance and loan markets as the London interbank offered rate (Libor) is being phased out. Libor has been the dominant rate in the market since its introduction in the 1980s but recent controversy surrounding its manipulation by a number of banks led to the Financial Conduct Authority (FCA) announcing its discontinuation it by the end of 2021.
The overarching framework of reference is the Benchmarks Regulation, which entered into force in January this year and sets out common rules all rates have to abide by to minimise conflicts of interest in benchmark-setting processes.
How is it calculated?
Sonia is a measure of the rate at which interest is paid on eligible sterling denominated deposit transactions. It’s an overnight rate, so by definition it has a backward-looking application. Unlike Libor, where the interest payments are known at the start of the interest period, the interest amount in respect of Sonia-linked floating rate notes (FRNs) isn’t known until close to the end of the relevant interest period. When used as a reference rate for FRNs, it can be calculated either on a compounded basis or by taking a weighted average rate over a particular period, and adding a margin to it.
Recent Sonia-linked floating rate note issuances have used the compounded basis and also use a so-called five-day observation lag period, meaning the end of the interest observation period lags the interest payment date by five days to provide cashflow certainty.
“This is different to other instruments, such as FRNs linked to the secured overnight financing rate [SOFR] used in the US, under which a weighted average rate is used, and the same rate is applied for the final four days of the interest period,” said Katie Kelly, senior director, market practice and regulatory policy at the International Capital Market Association (ICMA).
Unlike Libor, Sonia has no term structure meaning it doesn’t have relevant yield curves for different maturities (one-week, three months or even 10-year transactions for example). Libor is also quoted in five currencies including the US dollar and the euro.
Sonia is referred to as a risk-free rate (RFR) because its calculation doesn’t include the bank credit risk or the liquidity premium inherent in Libor.
“We are in a situation post-Libor scandal, where the global regulatory community, led by the Fed, the BoE and the Commodity Futures Trading Commission, is taking a strong position that says: anything that is transaction-linked is better than something that involves a level of expert judgement,” says one market participant on the advisory side. “I would argue that there is a role for well-controlled expert judgement or a range of reasons.”
Because it’s based on actual transactions, Sonia can be a more volatile rate than Libor, and typically sits a few basis points above or below it at any given time. Similar concerns have been voiced against Sofr, as its calculation is based on transactions in the overnight repurchase agreement market which can be subject to big fluctuations.
If Sonia is to follow in Libor’s steps and become more widely used in the market, some adjustment is needed. The BoE’s Working Group on Sterling Risk-Free Reference Rates, established in 2015 to explore RFR alternatives to Libor, consulted until October 26 on how to ensure a broad transition to Sonia. Many other jurisdictions are actually also considering or consulting on moving away from interbank rates to an overnight RFR.
But according to the advisor, “even if you build a term structure into Sonia, and it becomes a proxy for Libor, there still will be a delta between Sonia and Libor products”.
How widely is Sonia used?
It’s been used as the reference rates for GBP-denominated transactions for nearly 20 years. But the BoE has previously stated that while there is awareness of RFRs such as Sonia, there is still huge scope for the market to grow. The Sonia market is estimated to be worth anything between £100 billion ($129 billion approximately) or £150 billion based on the volume of GBP denominated overnight transactions.
This compares to the $350 trillion+ Libor market though the value and volume of GBP contracts using Libor as their benchmark remain uncertain.
“There isn’t currently a lot of liquidity in Sonia contracts but there is no reason decent liquidity couldn’t build up over time,” said David Clark, chairman of EVIA and member of the former BoE’s Sonia advisory committee. “But this can only happen if work is done to improve Sonia liquidity in various tenors.”
Nine debt transactions have used Sonia as the reference rate since the beginning of the year, including issuances from RBC, Lloyds, Santander, EuroClear, EBRD and the African Development Bank. The European Investment Bank carried out a small test case issuance in March 2018, following which it sold a £1 billion bond in June. It initially carried out the first ever recorded Sonia-linked issuance, a £300 million issue, in March 2010. There have not yet been any loans issued using the new benchmark.
“The core point here is shifting to new Sonia-based products, and managing the business conduct and risk around these,” said Oliver Wyman partner Serge Gwynne. “But for a bank to be able to offer these, they need to understand risks, pricing approaches and timelines.”
Is Sonia a replacement for or an alternative to Libor?
Both BoE governor Mark Carney, and Andrew Bailey, the chief executive of the FCA have said that Sonia doesn’t replace Libor but is a GBP alternative to the 30-year old rate. The two rates have historically been built and functioned differently so replacing one with the other wouldn’t necessarily be the best way forward.
“Solving the Sonia issue is different from solving the Libor problem,” said Clark. “Ultimately, what the market wants and needs is a Sonia curve for it to become a viable and more widely-used rate, but this is not certain to happen before the end of 2021.”
Preparations are ongoing to transition from Libor to an RFR though there is no concrete plan of action, which some in the industry are growing increasingly weary of.
In the eurozone, the European Central Bank (ECB) asked for a stay of execution to migrate to new benchmarks, giving banks the time to prepare for an organised transition and highlighting a degree of uncertainty – the EU Commission refused this in October 2018. “The European Commission will not grant an extension. It’s as simple as that,” said Tilman Lueder, the head of its securities markets unit.
The ECB’s working group on euro RFRs has chosen the unsecured overnight Ester rate (euro short-term rate), which will be published by October 2019.
In the UK, the BoE’s Prudential Regulation Authority and the FCA sent a letter in September 2018 to the chief executives of the UK’s largest banks and insurers asking them for feedback on the firms’ ‘preparations for transition from Libor to risk-free rates…and ensure they are taking appropriate action now so that your firm can transition to alternative rates ahead of end-2021’.
What is Sonia+?
Work is currently ongoing to turn Sonia into a term rate, and make it forward-looking like Libor – the so-called Sonia+ rate. How this can be achieved will be the subject of part 2 of this primer.
While derivatives such as futures or overnight indexed swaps may transition more or less easily to Sonia – swaps can be written on a more bespoke basis than other products – the loan and debt markets rely on forward-looking term structures typical of Libor, making a switch less straightforward.
“Concerns about not knowing the interest amount in advance are helped by the fact that Sonia tracks bank base rate quite closely,” said Kelly. “But there may be other issues, such as infrastructure and systems’ capabilities.”
Also, one key question remains: is a term rate needed for all products?
“For some products, it’s not necessary: for swaps, you can use overnight rates,” said Gwynne. “But for other parts of the market, in the corporate lending market, there would be real value for the end user to have longer-term visibility.”