PRIMER: Sonia – what next? (part 2)
The second part of IFLR's Sonia primer looks at how a new forward-looking rate could work
In part 1 of this primer, IFLR considered what the Sterling overnight index average was and why it was being re-developed to take the place held by its long-standing counterpart, the London interbank offered rate (Libor).
The second instalment of this primer takes a more in-depth look at how a new Sonia+ rate is emerging and how it could work in practice.
What is Sonia+?
Work is currently ongoing to turn Sonia into a term rate and make it more forward-looking like Libor – the so-called Sonia+ rate. Setting aside the discussion as to whether a term rate is needed for all products – swaps, for instance, can rely on overnight rates – how a next-generation Sonia rate will function is key. One challenge is that, for now, Sonia has less history and liquidity, and a smaller track record than Libor.
“Before a bank can offer a Sonia-backed product, it needs to understand things like risk and pricing approaches,” said a consultant. “You also need transactions and executable prices to base any rate on – for example, the ICE swap rate benchmark relies on live executable quotes from different multilateral traded funds, and takes a snapshot of these to establish the benchmark.”
Several suggestions have been made on how to devise Sonia+, though these rely on the market having sufficient transaction volume and executable prices. For instance, the ICE swap rate benchmark is based on live executable quotes from different multilateral trading facilities, and a snapshot of these at different times of the day is taken to establish the rate.
This may be an issue for loans as there have been no deals that reference Sonia so far. One way to introduce this would be to amend the fallback provision by including terms in vanilla deals to so that an alternative to Libor can be selected that provides an adjustment spread.
The bond market also has some unique challenges. Solutions could include a fallback on the most recently calculated rate, or if a benchmark isn’t published, a legacy floating rate would become a fixed rate at the most recently calculated rate.
“I think users have a part to play in this,” said a market participant on the advisory side. “I would organise some sort of data collection system where rates applied in transactions are looked at various points during the day, and use an algorithm to determine the price based on these.”
What happens to existing contracts that rely on a reference to Libor?
One key problem is the legacy one: novating existing long-term contracts (those with terms beyond 2021) from existing Libor rates and re-pricing existing products.
“If someone has one interest payment to go, then it is much less of an issue; but if there are more, terms will need to be changed to reflect a new rate,” said Linklaters partner Richard Levy. “An issuer could do this by gaining consent from bondholders to change the terms, but in practice this will be operationally difficult and could be expensive.”
So far, only one company has approached its noteholders to discuss benchmark changes. Associated British Ports announced in September that it was ‘exploring possible restructuring of the GBP Libor linked floating rate notes…which may include but not be limited to a change in the Interest Basis from Libor to the Bank of England administered benchmark interest rate, Sonia’.
“If an issuer doesn’t get the consent of its bondholders, then a legacy bond would typically provide for the interest to default to a fixed rate,” said Levy. “But if rates rise, bondholders will feel out of pocket. There are bound to be winners and losers in any scenarios that play out.”
Is the market ready for the transition?
The real question was posed by Oliver Wyman partner Serge Gwynne in part 1 of this primer: how do you wean the system off Libor?
Market participants are reluctant to drive all initiatives to determine how a Sonia+ rate should be shaped. But banks for instance have a big role to play in communicating changes with clients.
“The transition needs to be market-led,” said Phil Lloyd, head of market structure & regulatory customer engagement at NatWest Markets. “The market needs to avoid a scattergun approach, different paces of change. As a financial institution, you need to ensure you are speaking to all your customers and addressing the needs of all the market participants.”
Corporates and financial institutions have a key role to play. One market participant says it’s about shifting new business to the new benchmark rather than continuing to issue Libor-based products and shift them to the new rate. In addition, corporates fear that if banks lend on a Sonia base this will push prices up.