Bank Reference Rates: Transition to LIBOR to SOFR & SONIA


Risk free rates (RFRs) represent the cost of borrowing that a borrower would incur without the lender taking into consideration the counterparty risk level of the borrower. They indicate the return that investors should get on zero risk investments and are used by the financial markets as a benchmark upon with risk premiums are added. Previously, London Inter-Bank Offered Rate (LIBOR) would be used as an RFR benchmark rate but due to the recent scandals and its inability to represent actual interbank transactions the world continues to shift towards alternative reference rates such as Secured Overnight Financing Rate (SOFR) and Sterling Overnight Interbank Average (SONIA). Additionally, due to how it was computed, LIBOR represents the credit risk that financial institutions were perceived to have. LIBOR is a representation of the cost of funding that financial institutions would incur if they were to borrow on a short-term basis from one another. The main difference between the reference rates and LIBOR is that they are based on actual overnight transactions in their respective currencies and hence are backward looking and to some level immune from outright manipulation.

Secured Overnight Financing Rate SOFR

In 2014, the New York fed and the Federal Reserve Board formed the Alternative Reference Rate Committee (ARRC) that was tasked with coming up with an alternative reference rate that could be used instead of LIBOR. Regulators such as the Financial Stability Board had identified the weak points and risks of continuing to use LIBOR and hence ARRC came up with SOFR in 2017. They not only recommended this new reference rate SOFR but also developed a plan that would help in guiding the transition from LIBOR to SOFR including steps and timelines in a plan called the Paced Transition Plan. Later in 2018 ARRC was reconstituted to help in implementing the Paced Transition Plan as it was evident that LIBOR may not exist beyond 2021.

SOFR is one of three treasury repo reference rates that is published by the New York Fed together with the US Department of the Treasury’s Office of Financial Research (OFR). These reference rates are based on transactions that take place in the US treasury repo market. Repo market is where financial institutions exchange quick liquidity (cash) in exchange for treasury securities and vice versa. One firm sells securities to another and agrees to buy them back at a later date for a higher price and typically these transactions occur overnight. In summary, it is a market for short term loans collateralized using US treasury securities and provides crucial funding for the financial industry of about USD 3 trillion every day. To compute SOFR, the volume-weighted median of the 50th percentile of the dollar volume is calculated. During the computation transactions not considered at arm’s length or erroneous are not considered, a judgement call made by the New York fed.  The fed publishes SOFR one business day following the negotiation of overnight trades. They also publish SOFR compounded averages rates of 30-, 90- and 180- day tenors that are published on their value date as well as a SOFR index for computing averages rates of any time period. These averages and indexes are published daily at approximately 8:00 AM Eastern Time.

Sterling Overnight Interbank Average SONIA

In 2017, the Bank of England’s (BOE) working group on sterling risk-free reference rates recommended SONIA as a benchmark interest rate in line with recommendations made by the Financial Stability Board (FSB) regarding the developing of alternative risk-free rates that are anchored in transactions. SONIA has been in existence from 1997 established by the Wholesale Markets Brokers’ Association (WMBA) who were aiming to bring in stability in the overnight interest rates. However, from 2016 the Bank of England took over the administration of SONIA. SONIA represents the rate at which interest is paid on sterling short-term wholesale borrowing (between banks) if credit, liquidity, market and others risks are at minimum levels.

In 2018 numerous changes were made to SONIA by BOE to make it more robust and effective in being relied on as an index for financial transactions. They expanded it to include overnight unsecured transactions that were bilateral in nature as well as those that used brokers. Additionally, BOE took over the calculation of SONIA from the Financial Conduct Authority (FCA) who regulate the Wholesale Markets by employing a volume-weighted trimmed mean approach rounded to four decimal places. It is the volume weighted mean of the 50th percentile calculated on each London business day. Transactions that are included within the computation are greater than or equal to 25 Million Euros, unsecured and mature in one business day and are executed between 12:00 AM and 6:00 PM UK time and settled that same day. SONIA is published every London business day at 9:00 AM UK time and represents sterling denominated short-term bank to bank funding that took place the previous day.

Author: David Kageenu