Sonia and SOFR Begin to Take Over From Libor as Reference Rate for Borrowings and Derivatives

From April 23, the UK's central bank took on the responsibility of overseeing Sonia (Sterling Over-Night Index Average), which is meant to eventually replace the decades-old Libor (London Interbank Offered Rate) as the benchmark for pricing derivatives and loans. The New York Federal Reserve started publishing SOFR (Secured Overnight Financing Rate) on April 3 to serve as alternative for Libor in pricing US-dollar financial instruments.

For now, Sonia and SOFR will co-exist with Libor, whose reputation was tarnished by alleged manipulation before and during the 2009 Global Financial Crisis. The two new benchmarks are transaction-based, whereas Libor is partly judgment-based. The UK's Financial Conduct Authority will stop requiring banks to submit Libor rates after 2021.

In March, the Alternative Reference Rate Committee comprising a group of large banks said Libor underpins some US$200 trillion in US dollar derivatives and loans, a number larger than previously assumed. Sterling transactions underpinned by Libor are estimated by consultancy Oliver Wyman at more than US$30 trillion.  

New risks

CFOs, treasurers, banks and other counterparties are expected to move cautiously in shifting away from Libor. "It is clear that SONIA and Libor are different so a simple switch may not be appropriate without some adjustment to the rate or margin," writes Ivan Harkins of financial risk management consultancy JCRA in a blog post.   

"It will be important that any transition takes place across both debt and derivative instruments in a similar fashion, and on a similar timetable to avoid introducing new risks that would be difficult to manage efficiently."

Harkins also warns about the impact on a company's hedge accounting. "A material amendment to an existing derivative could result in a requirement to de-designate an existing hedging relationship and re-designate a new one," he notes. "Even if the change of reference rate is the same on the debt and the derivative instrument, this could still lead to ineffectiveness as the re-designated hedging relationship may be off-market."

The situation becomes further complicated if the changes to the reference rate for the debt and the derivative are different, or occur at different points in time.