The end of Libor and the birth of Sonia

    Canary Wharf and the City of London financial district are seen from an aerial view in London. Banks face large costs for adapting systems and educating thousands of relationship managers on the merits of Sonia over Libor. (Reuters Photo)
    Canary Wharf and the City of London financial district are seen from an aerial view in London. Banks face large costs for adapting systems and educating thousands of relationship managers on the merits of Sonia over Libor. (Reuters Photo)

    By Sinead Cruise and Lawrence White

    LONDON – On June 30, British bank NatWest sent out an arcane-sounding press release – bus operator National Express had become the first company to take out a loan based on Sonia, a replacement for scandal-hit interest rate benchmark Libor.

    It was billed as the first switch of thousands that British firms would make by end-2021, when the benchmark is set to be decommissioned.

    Four months on, NatWest’s trailblazing Sonia switch has been followed by only one other loan, when the bank struck a deal with utility South West Water on Oct. 2.

    The slow progress highlights the challenge banks and borrowers face as regulators attempt to end the use of Libor, a benchmark embedded in as much as $340 trillion financial contracts worldwide from home loans to complicated derivatives.

    Libor, once dubbed the world’s most important number, was discredited after the 2008 financial crisis when authorities in the United States and Britain found traders had manipulated it to make a profit.

    But replacing Libor is proving expensive and tricky with concerns that, if mishandled, it could trigger credit market confusion and waves of lawsuits, finance industry sources said.

    With no obvious alternative, some countries are adopting their own benchmarks. The United States is leading the way with a booming trade in derivatives linked to its new Sofr rate, while the European Central Bank started publishing Estr, its new interest rate benchmark, earlier this month.

    In Britain, professional investors such as hedge funds and pension insurance clients are also already writing and trading derivatives contracts linked to Sonia. But companies which make up the so-called Libor “cash” market of sterling-denominated loans are dragging their feet or are even not aware of the shift.

    At least two banks in Britain have shifted staff from teams preparing for Brexit to specialist Libor taskforces in the past quarter as the issue becomes more pressing, industry sources said.

    “Part of the market is very educated and smart on this and part of the market is not even aware that Libor is going,” said Phil Lloyd, head of market structure & regulatory customer engagement at NatWest Markets.

    Lloyd said banks like NatWest are battling to allay concerns among corporate borrowers that the Sonia benchmark will make it harder for them to know how much interest they owe because the rate is backward looking.

    Sonia, the sterling overnight index average, is based on the average of interest rates banks pay to borrow sterling from one another outside market hours, and is published at 0800 GMT daily, after the transactions have been vetted by the Bank of England.

    Borrowers taking out Sonia loans will in effect not know exactly how much interest they owe until they are required to pay.

    In contrast, loans linked to Libor can have forward-looking term rates, meaning borrowers have greater certainty over their future liabilities and can manage cash flows more easily.

    Bankers and consultants said the market was exploring a forward-looking Sonia term rate by mid-2020 to appease borrowers but not everyone is in favor.

    The overnight Sonia rate, based on actual transactions, is seen as more robust and less vulnerable to the kind of manipulation that affected Libor, which was based on rates submitted by banks.

    The Libor rigging scandal saw billions of dollars in fines levied on major banks and jail sentences for traders convicted of manipulating the benchmark for profit.

    Some banks and lawyers fear the creation of a Sonia term rate, which would likely be based on forward-looking estimates from banks as opposed to past transactions, could undermine the security of the benchmark and even spawn legal dangers for banks.

    Murray Longton, a consultant at Capco who advises financial firms on Libor transition, said banks were fearful of lawsuits, as the proliferation of alternative Sonia term rates offered by different lenders could spark allegations of misselling.

    “If you get this wrong, this is PPI for investment banking- if you haven’t communicated properly and you move a customer (on to Sonia) and benefit, there could be a case where this gets reviewed and you owe your client a lot,” he said. – Reuters