Goodbye LIBOR, Hello SONIA

What is LIBOR?
The London Interbank Offered Rate (LIBOR) is an interest rate benchmark which was designed, like other Interbank Offered Rates (or IBORs) around the world, to reflect on a daily basis the average interest rate at which banks are able to obtain funding from other banks in the interbank market. Several rates of LIBOR are published as each individual rate varies according to, inter alia, the borrowing banks’ credit rating, the liquidity of the interbank market, the currency and the term of the loan.
Banks typically need to borrow from other banks before being able to loan large sums to their own borrowers, and this interbank borrowing comes at a cost (which includes the interest LIBOR is based on). In order to recoup their own cost of funding, banks therefore commonly use LIBOR to calculate interest payments under loans to borrowers.

Why are changes necessary?
Andrew Bailey, chief executive of the Financial Conduct Authority, made it clear in a speech given in July this year that LIBOR must be abandoned by the end of 2021.
To start with, scandals involving the manipulation of LIBOR in the late 2000s led to a lack of confidence in the benchmark and the appointment of ICE Benchmark Administration Limited (IBA) to replace the British Bankers Association as administrator of LIBOR. Despite various government initiatives to restore faith in the benchmark, the situation is still not seen as satisfactory.
Furthermore, it is arguable that LIBOR is now an obsolete benchmark which no longer reflects the reality of financial markets; not only has bank funding largely moved away from the international interbank market, but LIBOR is also based on the expert judgement of the panel banks (estimates of hypothetical borrowing costs) rather than the cost of actual transactions – which, according to Andrew Bailey, makes LIBOR no longer representative of the true cost of funding.
Finally, LIBOR is already no longer published for several currencies and tenors due to a lack of data to corroborate submissions and the number of panel banks is steadily dwindling.

What is LIBOR’s replacement?
In 2015, the Bank of England set up the Sterling Working Group to try and identify a so called “near risk-free rate” (RFR) as an alternative to LIBOR. RFRs are currency-specific rates of interest used as benchmarks in financial transactions, which do not take into account credit risk but focus solely on economic factors. As such, they are designed to be more robust than IBORs but also a lot less vulnerable to manipulation – the hope being that the challenges identified in the previous paragraph will not apply to RFRs.
The Sterling Working Group identified the Sterling Overnight Index Average (SONIA), initially introduced in 1997, as the most suitable alternative to LIBOR. SONIA is a benchmark published at 9 am every day and which broadly represents the trimmed mean of the previous day’s unsecured, one-day maturity transactions of at least £25 million. The Bank of England has confirmed that SONIA complies with the International Organization of Securities Commissions’ principles for financial benchmarks and various committees have been set up in order to oversee the quality of the data underlying SONIA, short-term contingency arrangements, data errors handling and to generally scrutinise the administration and methodology of the benchmark.

What are the main differences between LIBOR and SONIA?
Whilst SONIA is set to replace LIBOR, the two benchmarks are nevertheless not equivalent to each other. As an illustration, LIBOR is a forward-looking rate which establishes the interest rate for the next interest period (which usually lasts 1, 3 or 6 months). A new interest rate is therefore calculated for each interest period for the term of the loan, and borrowers benefit from the certainty of knowing in advance what this rate will be. By contrast, SONIA is a backward-looking rate which calculates the previous day’s rate. Each day’s rate is then compounded and, whilst this has the advantage of accurately reflecting the underlying financial transactions, the unavoidable uncertainty may represent a cash flow issue.
As already mentioned above, unlike SONIA, LIBOR includes an element of credit risk, since one of its key components is term bank credit risk. SONIA is published at 9 am every day, whilst LIBOR is published at 11 am. Finally, SONIA does not include the premium paid on longer-dated funds and currently does not cater to term facilities the same way LIBOR does, since SONIA is calculated on a daily basis.

Has SONIA started to be used?
Publication of SONIA by its authorised distributors, Bloomberg and Reuters, started on 23 April 2018. In June, the European Investment Bank issued a significantly oversubscribed, £1 billion SONIA-linked bond. In September 2018, Lloyds Banking Group issued a £750 million bond at 43 basis points above SONIA for which demand was so high that order books exceeded £1.4 billion. In October 2018, the Asian Development Bank issued a £600 million bond, increased from an initial goal of £500 million due to investor demand. Finally, both in September 2018 and in May 2019, the World Bank issued £1.25 billion bonds at 24 basis points over SONIA – which hold the record for the largest SONIA-linked bond to date – and Natwest is planning a £750 million bond at a staggering 60 basis points over SONIA. Whilst it is likely that the transition from LIBOR will be met with challenges, it is therefore nonetheless clear that SONIA already inspires enough confidence as the new alternative to LIBOR. Indeed, the European head of debt capital markets at the Royal Bank of Canada commented in September that “the investor base for [SONIA-linked] deals has more than doubled since June”, showing that financial institutions and investors are ready to embrace LIBOR’s replacement.

What about RFRs in the rest of the world?
Whilst SONIA is the Sterling RFR, other benchmarks have been devised in other jurisdictions as substitutes to various IBORs. By way of illustration, the Secured Overnight Funding Rate (SOFR) was created in relation to US Dollar transactions, the Swiss Averaged Rate Overnight (SARON) deals with Swiss Franc financial products and the Tokyo Overnight Average Rate (TONAR) relates to Japanese Yen deals. The European Central Bank settled on the Euro Short-Term Rate (€STR) as their recommended Euro RFR, and daily publication of the benchmark commenced in October 2019.
SOFR is a good example of the popularity of alternatives to LIBOR: in the summer 2018, the Federal National Mortgage Association issued $6 billion’s worth of SOFR-linked bonds in what commentators described as “a fire under the seat of those market participants that were not yet able to transact in SOFR to get their systems up to speed”, followed by the World Bank and Credit Suisse.

With over 100 firms and trade associations involved in the Sterling Working Group tasked with smoothing out the transition from LIBOR to SONIA, it is clear that this is a priority for Prudential Regulation Authority and the Financial Conduct Authority and that the end of LIBOR is not merely a hypothetical possibility but a definite event for which banks and other financial instructions must prepare. However, investors appear keen to adapt to this move and, whilst not entirely bump-free, the future is looking bright for SONIA.