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SONIA sets the tone for new Libor

18 October 2017 by Other Recessionary Indicators

On Monday, the Bank of England (BoE) announced the details for the newly reformed SONIA (Sterling Over Night Index Average) overnight reference rate to be introduced next year; replacing the previous overnight benchmark, also known as SONIA.

At TwentyFour, whilst we have been keen in this low interest rate environment to position our portfolios with relatively short duration risk, overnight rates are a little short even for us, and normally this would be something we would heed, but without analyzing the detail too deeply as we don’t really operate in the money market arena. However, in this ever changing world of regulatory and policymaker action, the details of this change could give us some insight into how amendments to other more relevant benchmarks might be implemented in the future. Let’s not forget that Libor, the term benchmark rate for periods out to one year, is due to be replaced in 2021 and that 1-month and 3-month Libor are currently the benchmarks for almost all Floating Rate Notes (FRNs) issued in the capital markets, and that almost the entirety of the European ABS markets are issued in FRN format.

So what are the big changes to SONIA?

  • Well firstly the BoE will take on the administration, calculation and publication of the index, which is interesting as hitherto these indices have always been calculated by third party associations/organisations. This clearly shows that the authorities are determined to rule out any possibility of any future scandals, by having control themselves.
  • One of the cornerstones of the reformed indices is that the authorities would like them to be based on actual trades taking place in the market. The new SONIA will also include any bilateral trades between counterparties as well as those arranged via money-brokers which are already part of the current index.
  • The averaging methodology will become volume-weighted as well as trimming any outliers, and finally the publication timing will move to 9am the following day, rather than in the afternoon on the same day.
  • The BoE has been monitoring the new methodology and over the last 6 months has seen average daily volumes of approx. £46bn, which is about three times the amount seen under the old methodology. They have also observed that the new SONIA is about 1.3bps below the existing rate.

So what does this mean for Libor? In the short term, very little, but in the medium term it should give us some good clues as to the direction of travel for the upcoming reform of Libor.

We know that the authorities want to remove the “bank credit” element of the current term benchmarks which is contained in the bank rate contribution mechanism that is currently employed. Ideally they would like this new term benchmark (it almost certainly won’t be called Libor) to also be trade-based like SONIA, but unlike the overnight market there are currently not enough trades happening in the term market to create a credible index every day.

Therefore they need to find a new way to build the term structure that allows flexibility for changes in the shape of the curve as the market anticipates future changes in rates. We still await their thoughts on how this might be achieved, but a move to a treasury-linked rate such as the one proposed in the US or an extension of the SONIA rate out along the term curve (how this might be done is unknown, as clearly a fixed margin would not work) are both ideas that have been mooted.

Unfortunately there isn’t really a liquid trading market in Treasury bills, and the BoE doesn’t currently issue bills with a 3-month term, so that could rule the Treasury route out.

And what level might the new benchmarks come out at relative to the existing ones? The 1.3bps difference between new and old SONIA is a fairly small amount, but what if the new term rates, 3-months as the most common term for example, differ by a larger amount? If overnight can differ by more than 1bp then there is no reason that the 3-month rate might not differ by 10bps or more – and that is a significant difference. A generic 3-month Treasury bill, would currently trade around 10bps tighter than the current 3-month Libor rate.

The big issue here is that Libor is used as a benchmark for the coupon setting mechanism for trillions of £/€/$ etc. worth of bonds and swaps, plus as the reversion rate for billions of pounds of other non-capital markets instruments such as mortgages and loans.

How will investors and issuers react to that? If the new rate is 10bps lower, then naturally, issuers of FRNs may want the new indices to move seamlessly from the old ones – that will save them a fortune. Equally, investors will be keen that there is no cliff-effect at the changeover, and that going forward they continue to get rewarded for the credit risk they take on a commensurate basis.

The changes to SONIA, have taken place in full consultation with the market. For Libor, industry associations and participants are already engaging with issuers, investors and policymakers to discuss what solutions can be constructed and the aim will of course be to engineer as smooth a changeover as possible – think back to the introduction of the euro and the redenomination of the founding nations’ currencies – interest rates from different nations across Europe with vastly different rate structures gradually converged until the final cut-off date, when the changeover exchange rates were set.

We look forward to ongoing dialogue with the authorities to help achieve a similar outcome for Libor, although where the convergence point will be is still very much unknown.

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