New step towards Risk Free Rate transition: The BoE publishes a discussion paper on the SONIA compound index

In their discussion paper, the Bank, as administrator of SONIA, sets out their intention to publish a SONIA Compounded Index, with a known methodology and timing – similar to the publication of SONIA itself. 

SONIA reflects the average interest rates that banks pay to borrow overnight, unsecured sterling cash on a given day. SONIA is widely used as a reference rate to determine the interest payable on a range of floating rate instruments and, is used as the basis for valuation of a wide range of other products.

The products that use SONIA as a reference rate usually pay interest on a periodic basis which typically range between every 6 or 12 months. The interest is calculated as a compound average of each individual overnight SONIA rate during that period. This calculation is also commonly used in some loan hedging products (e.g. the Overnight Indexed Swap market). But, the Bank acknowledges that this compounded calculation methodology may not be familiar to some non-financial end users or corporates as there are numerous data points to calculate from.

To make it easier to adopt SONIA as the new reference rate for loans, the Bank wants to simplify the calculation of the compound interest by removing laborious daily SONIA rate calculations. To enable this, the Bank suggests publishing an official SONIA Compounded Index. The objective is for the change in this index between any two dates to be used to calculate the interest rate payable on a SONIA product over that period. This is also consistent with the approach taken by the Fed of New York and the forthcoming publication of its SOFR Index.

The Bank expects to start publication of this SONIA Compounded Index by end-July 2020. The publication would be the same as the current publication of SONIA and, Bloomberg and Refinitiv have already confirmed they could publish it also.

This proposal could be the latest piece of the jigsaw, which may solve the most challenging issues faced by the industry in respect of the market calculation and documentation.

The main benefits that could emerge:

• Consistency of calculation methodology: Institutions are preparing for the transition to SONIA by developing approaches on compounding and indexation using publicly available information. With limited guidance so far on how to incorporate such information, several alternate approaches are being developed by institutions, each using its own interpretation. Having both the SONIA Compound Index and the associated methodology published will help achieve greater harmonisation across market participants allowing comparability of the results.
• Providing a trusted third party validation for the calculations of interest payable: Loan market participants, and others such as trustees or calculation agents, need to use rate information from a trusted source rather than using an internal calculated rate – especially to avoid any legal and liability risk an internal estimate may trigger.
• Publishing screen rate for RFR based documentation: Many contractual documents for Floating Rate Notes or securitised products currently use LIBOR and refer to a specific place of publication of the reference rate. With this new Compound reference Index, changes can now be made to the documentation to normalise and finally initiate a smooth transition in the loan market, reducing/closing the gap with the derivatives market’s speed of transition.

The proposal would reduce the risk of disputes and mistakes, ease the implementation of SONIA into workflows, and provide certainty.

Importantly, the publication of the SONIA Compounded Index will simplify calculations for many participants.

In addition, the Bank is also considering (but has not yet worked out a methodology) to publish a daily simple set of “SONIA Period Averages”. These would provide the interest rate payable over specific periods of time (i.e. the compounded rate over the last X days or months). This would further help with performing calculations for compound rates – making it even easier, than using the SONIA compounded Index. But this also presents some challenges. For example, some instruments (such as a Swap) may be used to hedge products for which interests calculation would be based on the aforementioned SONIA Period Average), while the hedging instrument might not use the same period average. This could result in mismatch and increase ineffectiveness. The Bank is therefore seeking Sterling market participants’ feedback on the usefulness of these Period Average rates and, preferred defined relevant time periods.

Progress has been made by the Sterling Working Group and the Regulator, but there is still a long way to go to reduce the stock of LIBOR-linked products to zero in a timely way. So, the development of a fall-back language solution across markets is still needed, and especially in the very fragmented loan market.

The outcome of the consultation is to be followed: response expected by 9 April 2020.

Written by Anisse Yahoui, Manager, Financial Services Consulting