What is SONIA? Greg Readings greadings@arlingclose.com

A few months ago I wrote about the transition away from LIBOR as the principle interest rate benchmark in global financial markets, a process which continues towards its end-of-2021 ‘deadline’. I mentioned that in the UK the main replacement reference rate is SONIA – well, what exactly is SONIA? This is a question that has been asked by a couple of clients recently so hopefully worthy of a few more column inches.

SONIA is the Sterling Overnight Index Average. If we dig down into the definition of SONIA, it is made up of two elements, or ‘statements’, as the Bank of England refers to them:

Firstly the ‘statement of underlying interest’:

“SONIA is a measure of the rate at which interest is paid on sterling short-term wholesale funds in circumstances where credit, liquidity and other risks are minimal.”

Then the ‘statement of methodology’:

“On each London business day, SONIA is measured as the trimmed mean, rounded to four decimal places, of interest rates paid on eligible sterling denominated deposit transactions.

The trimmed mean is calculated as the volume-weighted mean rate, based on the central 50% of the volume-weighted distribution of rates.

Eligible transactions are:

  • Reported to the BoE’s Sterling Money Market daily data collection
  • Unsecured and of one business day maturity
  • Executed between 00:00 hours and 18:00 hours UK time and settled that same-day
  • Greater than or equal to £25 million in value.”

A long-winded way of saying SONIA is the average interest rate of large unsecured overnight borrowing/lending transactions being undertaken in pounds sterling.

Although it may not be as familiar as the rate it looks set to replace, SONIA has been around since 1997 and is used to value roughly £30 trillion of assets each year. It’s administered by the Bank of England, who took charge of it in 2016 and overhauled its calculation in 2018.

As you’ll have noted above, SONIA is designed to be a rate that excludes credit and other risks, which is why the LIBOR replacement rates are also referred to as ‘risk free reference rates’. This is a key difference between SONIA and LIBOR (which includes bank credit risk) and means that SONIA is generally a lower number than LIBOR.

This is important because a straight switch between the two rates could make one side of a transaction significantly better off (e.g. lower borrowing costs) and the other much worse off (e.g. lower investment returns). To get around this a ‘spread adjustment’ will need to be agreed that considers this difference between the two rates.

Another key difference is in the name; SONIA is an overnight rate only whereas LIBOR is set for a variety of different tenors (3, 6, 12 months etc.). Closely linked to this is the fact that LIBOR is set for those periods in advance, e.g. 3 month LIBOR represents the rate to borrow or lend for three months starting from today (‘forward-looking’), while SONIA is based on past transactions (‘backward-looking’).

This means that to know the SONIA-linked rate you are either paying or receiving over any particular period, daily SONIA data must be recorded and then compounded to calculate the overall rate at the end of the period. So, counterparties will not know the exact cash flows from these transactions in advance as was the case with LIBOR. There has been talk of developing forward-looking SONIA but the standard compounded version looks set to be the market default option.

LIBOR looks set to disappear and new investment, borrowing and hedging products, such as interest rate swaps, are already being based on SONIA, so a good understanding of the rate is necessary.