Tarred by a fixing scandal that struck at the height of the financial crisis, bankers and investors for years have been grappling with finding a replacement for the Libor benchmark used to set borrowing rates on trillions of loans and derivatives.
Now the Bank of England has finally unveiled a key part. On Tuesday, the BOE for the first time published a revamped version of the Sterling Overnight Index Average, known as Sonia. Unlike Libor, Sonia is based on actual transactions, making it hard to manipulate. “Reforming Sonia is an important step in moving away from the market’s dependency on Libor,” said Deepak Sitlani, a partner at London-based law firm Linklaters. “No one is very comfortable with the risks that stem from Libor being based on subjective expert judgment, rather than real transactions.”
Yet problems remain. Sonia is an overnight rate only, whereas Libor has longer-term rates — everything from one week, through three months and even 50 years. The authorities are leaving it to the market to work out how to get from the new overnight rate to these so-called term rates, creating uncertainty for the industry. “This is a key need for those in the market who need to have certainty of theirinterest-rate exposure at the start of an interest-rate period, rather than at the end,” Sitlani said.
For decades, Libor was a seemingly reliable benchmark set daily by banks to determine interest rates on everything from student loans and mortgages to derivatives and credit cards. That all changed when European and US banks were found to have manipulated rates to benefit their own portfolios, tainting the benchmark’s reputation.
Banks plumped for Sonia as Libor’s replacement almost exactly a year ago. The sterling working group — the industry organisation that’s pondering how to move from one benchmark to another — may use the swaps market as the basis for adding a term element to Sonia, according to Sitlani.
Swaps traders already transact using the current version of Sonia, giving some insight into expectations of future borrowing costs. In such a swap, the two sides agree to exchange a fixed- for floating-rate payment, based on an overnight rate. For example, a 10-year interest-rate swap at the current level of about 1.3 percent tells you investors’ expectations for the average overnight Sonia rate for the next 10 years.
CurveGlobal, a platform for interest-rate derivatives that’s a unit of London Stock Exchange Group Plc, plans to offer a three-month Sonia futures contract at the end of April. Still, some say term structures may not be as important for the new Sonia.
“There are some scenarios in fixed-income markets where a term structure is required,” said Andy Ross, chief executive officer of CurveGlobal. “However, in the majority of those, you don’t need that structure.” The premium for bank credit risk that’s in Libor isn’t needed either, he said.
Another possibility is to compound Sonia in arrears, for example by doing the calculation at the end of each week, Ross said. While that might work as a hedge, it might not suit everyone because it would mean the borrower’s liability is only apparent at the end of a period, he said.
To be sure, Libor is still the interest rate used as the baseline for many bonds, business loans and mortgages. The UK Financial Conduct Authority said last year that banks won’t be obliged to help set the rate after 2021, though Chief Executive Officer Andrew Bailey has said banks may need to rely on a version of Libor for years to come, simply because of its importance.