All you wanted to know about Sterling Overnight Interbank Average Rate(SONIA)

No, we aren’t talking about the beleaguered boss of the Grand Old Party of India. Rather, this SONIA is one of the major alternatives to LIBOR (London Interbank Offered Rate), the predominant global interest rate benchmark that will say its last hurrah in 2021.

SONIA is short for Sterling Overnight Interbank Average Rate. Since the 1990s, it is the weighted average overnight rate paid by banks for unsecured transactions in the British sterling market. In April 2017, the Bank of England selected SONIA as its preferred alternative to LIBOR.

But why is LIBOR — to which gazillions of dollars of loans and derivatives have been benchmarked for decades — on its way out? First, interbank borrowing, based on which LIBOR is calculated, has been on the decline since the 2008 global financial crisis. Second, LIBOR is based on estimates, not actual transactions, of surveyed global banks. Third, many of these participating banks took their jobs quite literally — in 2012, they were caught lying about the data, spawning cutting criticism about how LIBOR became ‘LieBOR’.

Thus began the search for more viable and robust replacements, and SONIA has emerged as one. It is based on actual transactions and vetted by the Bank of England, giving it a greater credibility. Over the past year, British bank NatWest has effected the transition of some of its customers to SONIA. Many savvy financial investors have also started moving on to SONIA. It’s early days still, but many more institutions and their clients are expected to follow suit over the next couple of years.

It’s a mammoth task though. A large part of the market is still unaware of the impending end of LIBOR. The shift will call for a great deal of co-ordination among regulators, banks and their clients, especially given that many contracts will be maturing after 2021. Significant costs are expected to be incurred on training, legal expenses and on ensuring proper accounting and documentation. Besides, many customers seem reluctant to shift — not knowing their exact cost due to the lack (so far) of forward-looking SONIA term rates, unlike those in place for LIBOR. These concerns have to be addressed.

Unlike LIBOR though, SONIA is not the only show in town – there is competition from the SOFR (US), ESTR (European Union) and TONAR (Japan). On a lighter note, sometime in the future, there may be an Indian benchmark too, and we could name it MODI – Mumbai Overnight Derivatives and Interest rate.

Finance is the lifeblood of business, and well-oiled global debt and derivative markets are a key part of the financial system. These, in turn, need trustworthy, widely-accepted benchmarks. SONIA, along with other benchmarks, will likely play a key role here.

The Indian government isn’t a big borrower abroad (it shelved a plan to issue sovereign dollar bonds recently), but Indian businesses love dollar borrowings in the form of external commercial borrowings (ECBs). The interest costs on these borrowings are usually linked to LIBOR. In fact, RBI’s regulations on ECBs also use LIBOR to calculate the cost of loans. All these borrowers will need to shift to other benchmarks sooner or later. Also, the MIFOR (Mumbai Interbank Forward Offer Rate) that is currently linked to LIBOR will see a change.

It is said that a butterfly flapping its wings in one part of the world can cause a hurricane in the other part. Given the inter-connected world we live in, a major change in financial benchmarks — from LIBOR to SONIA or others — can certainly make its impact felt. For starters, if you have invested in companies that borrow or have derivative transactions abroad, you will do well to understand how this change will impact their debt servicing costs. If you plan to borrow abroad, know the interest rate peg you’re committing to.

To replace LIBOR, SONIA will have to beat many other benchmarks. But the change is not so far off.

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