Goodbye LIBOR, Hello SONIA – Better the Devil you know?

LIBOR

LIBOR, or the London Interbank Offered Rate, is an interest rate benchmark used globally. LIBOR provides an indication of the average rate at which certain banks can borrow unsecured funds in the London interbank market for a given period, and in a given currency. In part as a consequence of the LIBOR scandal in 2012 (where certain banks were found to have manipulated LIBOR rates for profit), LIBOR has widely been discredited and regulators have sought alternatives to LIBOR.

LIBOR is expected to disappear after 31 December 2021, but a large number of loans and other financial products still reference LIBOR.

The Bank of England has approved the SONIA benchmark as the UK’s preferred short-term interest rate benchmark and is encouraging a switch from LIBOR to SONIA.  However, most banks in the London market have adopted a policy of ‘wait and see’ before committing to a replacement, and SONIA will never be a simple, straight substitution for LIBOR.

SONIA

SONIA, or the Sterling Overnight Index Average has been around since 1997 and tracks the rates of overnight funding deals on the wholesale money markets and, unlike LIBOR, does not rely on submitters. SONIA is based on actual transactions and reflects the average of the interest rates that banks pay to borrow sterling overnight from other financial institutions.

Rating agency Moody’s has published a report arguing that overnight rates such as SONIA or the dollar-denominated Secured Overnight Financing Rate (SOFR) were less volatile in stressed situations and are less exposed to credit and liquidity risk than LIBOR.

Challenges

SONIA differs to LIBOR in several key respects:

• Backward looking: unlike LIBOR which is a forward looking rate based on offers for lending for particular durations in particular currencies, SONIA is a backward looking overnight rate and is based on actual transaction data
• Credit risk: LIBOR rates reflect the perceived future credit risk of banks being lent to, whereas SONIA does not
• Longer dated funds: unlike LIBOR, SONIA does not include a premium (or discount) for longer term funding

When substituting SONIA for LIBOR in a loan agreement this will mean borrowers potentially lose the certainty of knowing what their interest rate for the next interest period will be (allowing them to plan cash flows accordingly), as SONIA would be calculated at the end of an interest period rather than LIBOR being calculated at the start. Market practice to overcome this is still developing, with the ‘standard’ drafting of loan agreements changing rapidly.

While it is clear that LIBOR is on the way out, and SONIA is the front runner to succeed it, a simple switch is far from certain.  Regulators are putting pressure on the banks and other financial institutions they regulate to prepare for the post-LIBOR world but while most loan agreements with a LIBOR based interest rate provide a mechanism to replace LIBOR, most stop short of actually setting out what the replacement will be.