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Working Group outlines possible replacement of LIBOR with SONIA

A group set up by the Bank of England has outlined ways in which the Sterling Overnight Index Average (SONIA) benchmark could be referenced in new contracts, ahead of the likely phase-out of the London Inter-bank Offered Rate (LIBOR) over the next few years.28 Mar 2019

The Working Group on Sterling Risk-Free Reference Rates, which was initiated by the Bank of England in 2015, identified SONIA as the preferred risk-free reference rate to replace LIBOR. The Working Group seeks to facilitate transition to SONIA by the end of 2021, but SONIA is currently only an overnight rate whereas LIBOR is produced over a range of periods of up to a year. 

The Working Group's latest discussion paper (14 page / 235KB PDF) is aimed at helping companies looking at referencing SONIA in new contracts.

The Working Group's paper says that greater clarity and awareness of market conventions could encourage the wider adoption of SONIA and help reduce risks of fragmented liquidity. Better clarity would also minimise unnecessary mismatches between products; and allow system changes to be applied consistently across markets and products, said the paper.

The Working Group said that SONIA’s use in financial markets instruments was increasing quickly across different asset classes, such as in sterling-denominated overnight index swaps, but there were segments such as the loan market where its use was much rarer.

The paper looked at how to use SONIA to calculate interest for terms that are greater than overnight, and compared compounding and simple averaging. It also discussed margin treatment for SONIA referencing products.

The Working Group noted it would be helpful if a third party published a standard SONIA rate calculator or a SONIA screen rate for a given period, adding that this was a priority for future infrastructure development.

The paper highlighted the need for market participants to align themselves with well-established SONIA referencing markets, particularly for those in both the bond and loan markets and the derivatives market. The paper also highlighted the need for Market participants to have “robust contractual fallbacks” for SONIA, in accordance with the EU Benchmarks Regulation and IOSCO Statement on Matters to Consider in the Use of Financial Benchmarks.

However, the paper stops short of making recommendations or providing guidance, and focuses only on ways to reference SONIA directly in its form as an overnight rate.

Financial regulation expert Charlotte Pope-Williams of Pinsent Masons, the law firm behind Out-Law.com, said the paper was designed to complement the development of conventions for referencing SONIA in new contracts in the market, although the paper appeared to be aimed more at the wholesale sell-side banking industry rather than other market participants.

The Working Group said it would welcome feedback by 30 April 2019 on referencing SONIA in new contracts.

In 2017 Financial Conduct Authority chief executive Andrew Bailey said the market for unsecured interbank lending, on which LIBOR is based, was "no longer sufficiently active" for the rate to be based on actual transaction data, raising "a serious question" about the sustainability of the rate.

The panel banks whose submissions inform LIBOR are expected to support the rate until 2021.