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Libor to SONIA: an update

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Following our note on Libor in August, there have been some developments.

We responded to the Bank of England’s whitepaper SONIA as the RFR and approaches to adoption raising a number of concerns about the potential replacement of LIBOR with SONIA that are likely to affect our clients.  This will help to ensure they start to be placed on the agenda of the Bank of England’s working group.

The Bank of England’s working group on sterling risk-free reference rates has set up a sub-group to focus on term SONIA reference rates, an area we highlighted in our response to whitepaper in September. There are a number of alternative approaches to generating a term fixing however, we still favour the use of the short-term OIS market to generate these fixings.

The need for a term SONIA reference rate arises from the backwards-looking nature of SONIA, which is likely to create operational challenges for borrowers and lenders alike. The fact is that the current infrastructure of many lenders does not cater for a daily-compounded average SONIA rate. Leaving aside the necessary overhaul of IT, from 23 April 2017 SONIA will be published on the next business day. The agent of a loan will only be able to start calculating and preparing loan interest reset notices the day after the interest period has ended, meaning that, at best, the payment of interest will occur three business days after the interest period. 

There have been two notable market developments regarding derivative instruments that reference SONIA the risk-free reference rate chosen by the Bank of England:

1. At the end of October, ICE announced it will launch a new one-month SONIA future starting from 1 December 2017. The contract will be available up to maturities of 24 months and will operate much as I described in my podcast with Derivsource. It will be settled in arrears based on the average SONIA rate during the delivery month and can be traded up to the last business day of the delivery month before being settled on the next business day. The Bank of England working group is still considering different approaches to the futures market so we may see competing futures products in due course.

2. As we highlighted in our note in August, there are concerted efforts to extend the range of tenors of OIS that will be clearable by LCH. We understand that LCH has now completed the necessary internal approvals for extending clearing of OIS out to 50 years and is aiming to launch the change by the end of 2017. This is an extremely welcome development, as it will help encourage more liquidity in these contracts going forward. 

Finally, the Bank of England has now published a summary of the responses to their whitepaper. It is clear from responses that there is broad agreement on the choice of SONIA as the new risk free reference rate and that the challenge now is the transition from LIBOR.





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