From LIBOR to SONIA

FROM LIBOR TO SONIA

By Vasilios Kyriacou

June 2012 saw one of the largest financial scams ever, with an MIT professor commenting that ‘it dwarfs by order of magnitude any financial scam in the history of the markets’. This is referring to the LIBOR scandal, which saw a series of fraudulent actions of traders colluding with other divisions in the Bank to report false interest rates on inter-bank loans in an attempt to increase profit. The London Inter-Bank Offered Rate (LIBOR) is the average interest rate calculated through submissions of interest rates of major banks across the world. LIBOR is enormously influential due to its use in the valuations of financial products worth trillion of dollars and as such, manipulation LIBOR will have massive consequences as its used as a benchmark for: mortgages, student loans, financial derivatives and countless other financial instruments.

LIBOR is enormously influential due to its use in the valuations of financial products worth trillion of dollars and as such, manipulation LIBOR will have massive consequences as its used as a benchmark for: mortgages, student loans, financial derivatives and countless other financial instruments.

The entire US derivative market is based on LIBOR and an attempt to manipulate LIBOR is an attempt to manipulate the US derivative market. However, this isn’t new as this is thought to have been common since 1991, but the 2012 scandal brought all the inefficiencies and short-comings of the model to light. Since then the Financial Conduct Authority (FCA) and Bank of England (BoE) has looked into alternative risk-free rates (RFR) and as such, starting from the 2nd of March 2020, the BoE will transition from the LIBOR to the Sterling Overnight Index Average (SONIA). The implications of the transition from LIBOR to SONIA will be huge, and marks a shift in the way in which the financial markets operate. Since the financial crash in 2008, more and more regulations have been added on such as the Markets in Financial Instruments Directive (MiFID) in 2008 and the revised version brought out in 2018. LIBOR was established in 1986 by the British Banking Association and is defined as ‘the rate at which a Contributor Panel bank could borrow funds and then the accepting inter-bank offer in reasonable market size, prior to 11:00[am] (London time)’. The Contributor Panel (Banks chosen by the BBA) makes a blind submission and a complier (Thomas Reuters) averages the second and third quartiles. LIBOR soon became the fundamental interest rate because of three main characteristics: (a) it was viewed as a measure of the borrowing cost in the inter-bank market, (b) before the 2008 financial crisis it was interpreted as risk free and (c) lastly, it’s a sign of the health for the credit market. As it stands now the current system for calculating LIBOR cannot continue, so question arises – do you reform or replace LIBOR? The UK has decided to replace LIBOR in favour for SONIA, however, this transition won’t be an easy one and will require a great deal of finesse to pull off, especially in wake of the UK’s separation from the EU. This begs the question, did the UK make the right choice? The Wheatly Review, authored by Martin Wheatly the CEO of the FCA, suggests that reform is most advantageous option. The review stipulated that transaction data should be used explicitly to support LIBOR and that market participants should continue to play a major role in the oversight and production. To prevent history repeating itself, the report urged for an increase in oversight and enforcement, with the administration and submission of LIBOR to become regulated under the Financial Services and Market Act 2000. There’s a strong emphasis on sanctions in order to ensure compliance among the banks. The review outlined that three areas that are failing the current LIBOR model and explained the path reform. Firstly, there was an ‘insufficient independence from governance structure’, relying too heavily on participating banks and their own industry organisation. The review postulated that LIBOR should be a market-led benchmark led by a private organisation rather than a public body. Subsequently, this would curb the other two shot-comings, the lack of transparency and inadequacies that comes with the government organisations.

There is still a lot of hesitations surrounding the potential of reform as many claimed it would not make a significant difference. A great deal of resources has been put into reforming LIBOR after the 2012 yet there has been no noticeable change and is still riddled with problems.

However, that is not to say replacement will not be without its own issues. The replacement of LIBOR comes with three main issues for corporations; transitioning away from LIBOR to new contracts and dealing with existing legacy contracts. For new contracts, SONIA presents the problem of term structure, or the lack there of. The LIBOR index is published daily on various terms including one, two and six-month forward-looking period, whereas with SONIA is published first thing in the morning just as an overnight rate. So, loans with just SONIA referencing will require daily compounding. However, a possible solution to this could be a ‘term SONIA reference rate’, where the expected SONIA rate is used over a giver period (Schrimpf and Sushko, 2019). As of now, there is no ‘term product’ so it would require a set of agreed practices and what market data should be used and how. The other issue surrounded legacy contracts still remain, if the overhaul is too big or is not pulled off carefully with finesse then there could be significant legal complications to a lot of legacy obligations. Schrimpf and Sushko (2019) postulated that one potential solution for the legacy contracts could be to continue management and reporting of LIBOR until the contracts have matured or dissolved. However, this comes with a drawback, if LIBOR is still in the picture then the new reference rate might see stronger resistance.

As of now, there is no ‘term product’ so it would require a set of agreed practices and what market data should be used and how.

On the other hand, the resistance to the new reference rate such as SONIA may not be as strong as initially anticipated. Clear positive externalities will show itself once the transition to the new reference rate has taken place, as the advantages will be realised in the use of the same single rate. Adoption of a single reference rate will allow for greater liquidity and opportunities to trade and hedge against financial instruments that are tied to the rate; network effects suggest that the market participants benefit from in a non-linear fashion from the increase in total number of users (Hue and Skeje, 2014). As a result, the liquidity and market depth concerns would be eliminated, and such scale benefits could be harder to realise with a multi-reference regime. However, the risk diversification that comes with a multi-reference regime could prove to be advantageous, as it can mitigate or lessen any of the errors that can be found in the other rates. Another issue that presents itself it that of coordination. The transition from such a widely used and popular reference rate is likely to result in heavy path dependency (Hue and Skeie, 2014). Subsequently, policymakers will need to play a large role, in order to provide sufficient motivation for the private sector to adopt the new reference rate; the socially optimum outcome may not be fully realised and achieve critical mass if the adoption process if left solely to the private sector.

The transition of such a historical reference rate is a monumental task but so is the development of a new reference rate. Developing the new reference rate

is not easy and it may not be feasible to preserve all the desirable features of LIBOR, whilst simultaneously ensuring that the new rate is grounded in actual transactions in the liquid markets. The ideal reference rate would be something like a Swiss army knife – suitable for any situation. One of the most important characteristics for the new rate, is for it to be a robust and accurate representation of the interest rates in the core money markets. It’s widely accepted that in order to fulfil such feature, the rate would have to be grounded in actual transactions in active and liquid markets, this prevents the benchmark from being susceptible to manipulation. The new benchmark would also have to be a reference rate for financial contracts that extent beyond the money markets, such as the Overnight Index Swaps (OIS) contracts with different maturities, without much difficulty (Centrus, 2018). Lastly, as financial intermediaries are both lenders and borrowers, they require a lending benchmark, so the new reference rate will have to serve as a benchmark for lending and funding (Centrus, 018). For example, a bank may fund a long-term loan by drawing upon short-term funding instruments at a variable rate. LIBOR fulfils two of these important characteristics, only lacking in the area where its robust and accurate and not susceptible to manipulation. In a white paper by Centrus, they explained that there are four reasons that explain LIBOR’s failure in this aspect. The first one being its design flaw, as the rate relies on reports from various banks instead of actual transactions and secondly, sparse activity in the interbank deposit markets stands in the way of benchmarks based on interbank rates. Third, an increase in the dispersion of individual bank credit post-crisis has undermined the adequacy of benchmark that aim to capture common bank risk. Lastly, due to regulatory and market efforts to reduce counterparty risk in interbank exposures, banks have also tilted their funding mix towards less risky sources of wholesale funding. With these shortcomings in mind, there are proposals for repairing rather than replacing LIBOR. A possible option would be to convert LIBOR into a transaction-based rate and can be done by taking the weighted average of actual rates and calculate the fixing (Coulter, Shapiro and

Zimmerman, 2018). Supporters of this option view it as quick and low-cost method that will restore the integrity of the reference rate, whilst there those who oppose due to possibility of high volatility.

The ideal reference rate would be something like a Swiss army knife – suitable for any situation. One of the most important characteristics for the new rate, is for it to be a robust and accurate representation of the interest rates in the core money markets.

The BBA considered two main changes in for processing LIBOR. The first being an increase in the LIBOR panels and the second is an enhancement of governance by adding non-contributor banks to the FX and MM Committee and a Scrutiny Mechanism. The President of Euribor ACI proposed a solution in an open letter to the BBA, where an independent body should conduct periodic controls of the data submitted by member banks. So, the most effective way to ensure reliability is for the BBA to mandate and undertake periodic sampling of actual transactions. This provides several advantages, one of them being that it doesn’t change the formulation of LIBOR, which maintains the integrity of the financial contracts that’s its built upon (Wong, 2009). Secondly, it allows the LIBOR data to remain transparent and available to public review, something which the BBA highly favours, while improving the accuracy of LIBOR. Furthermore, the Scrutiny Mechanism and noncontributor panel banks are greatly enhanced by the ability to sample transaction data. They can compare the reported rates with those that actual rates that are sampled and in doing so, they detect and eliminate two herd behavioural circumstances that’s been troubling for LIBOR (Wong, 2009). The first being when all banks manipulate their data for fear of being singled out as in financial trouble; and second when a particular bank would skew its data to match the banks (Wong, 2009). Lastly, this solution can fit neatly into the BBA’s other changes, such as allowing the Scrutiny Mechanism to fulfil the role of sampling transactional data. To conclude, the transition from LIBOR to SONIA is going to be one of the largest finical overhauls in history, and will present many difficulties along the way, especially if not carried out carefully. The issues of existing financial contracts and legacy contracts will be a major factor in measuring the success of the transition; LIBOR underpins trillions of pounds worth of contracts and so will require a great deal of finesse. A possible solution for this will be to continue reporting on LIBOR until those contracts have dissolved or matured. In the meanwhile, there can be changes to LIBOR to help curb its current weakness of being susceptible to manipulation, which can be done through increased governance from through the Scrutiny Mechanism and addition of non-contributor banks. Furthermore, the BBA can implement the President of Euribor recommendation of undertaking periodic sampling of transactional data to ensure the validity of LIBOR. By continuing to report on LIBOR for existing contracts, this should provide enough time for corporations to prepare themselves and work on their transition to SONIA. Whilst the transition should be primarily market-led, the governing authorities should still be providing oversight and the necessary pressure to ensure a smooth and seamless move to SONIA.

References

Hou, David, and David R. Skeie. “LIBOR: origins, economics, crisis, scandal, and reform.” FRB of New York Staff Report 667 (2014). Wong, Justin T. “Libor left in limbo; a call for more reform.” NC Banking Inst. 13 (2009): 365.

Centurus: Market transition form LIBOR to SONIA (2018)

Tata Consultancy Services: The End of the Road for LIBOR: Handling the impact on the Financial World

Schrimpf, Andreas, and Vladyslav Sushko. “Beyond LIBOR: a primer on the new benchmark rates.” BIS Quarterly Review March (2019).

Coulter, Brian, Joel Shapiro, and Peter Zimmerman. “A mechanism for LIBOR.” Review of Finance 22, no. 2 (2018): 491-520.

Treasury, Her Majesty. “The Wheatley review of LIBOR.” (2012).

MacKenzie, Donald. “What’s in a number? The importance of LIBOR.” Real-world economics review 47, no. 3 (2008): 237-242.