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.
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.