What is the Sterling Overnight Interbank Average Rate (SONIA)?
Sterling Overnight Interbank Average Rate (SONIA) is an unsecured overnight rate for wholesale funds for all sterling-denominated unsecured overnight funding deals in the British sterling market. SONIA facilitates the direct use of overnight funding deals in financial contracts across the sterling bond, loan, and derivative markets.
To traders, SONIA is an alternative benchmark interest rate for financial contracts since it does not incorporate any credit risk associated with the London Interbank Offered Rate (LIBOR). LIBOR acts as a reference rate in broad wholesale and retail financial products, as well as in various adjacent processes such as valuation and accounting models.
- Sterling Overnight Interbank Average Rate (SONIA) is used in wholesale cash and derivative markets as an actual overnight interest rate.
- SONIA benchmark gauges the rate at which interest is paid in sterling wholesale and retail funds when risks are minimal.
- The Bank of England has imposed several reforms to SONIA, making it the best benchmark for British sterling markets.
Sterling Overnight Interbank Average Rate Explained
SONIA was first launched in March 1997 by the Wholesale Market Brokers’ Association (WMBA). It was designed to track the rate of actual overnight funding transactions. SONIA fixing is computed as a transaction-to-volume weighted average interest in British sterling markets brokered by WMBA-member firms in London. The minimum trading size for all counterparties is GBP25 million.
SONIA was widely used in the UK markets before its selection by the Bank of England (BoE) in April 2016 as a critical benchmark for the sterling financial markets. The benchmark is based on actual transactions and factors in the actual interest rates charged for overnight borrowings.
Furthermore, it measures overnight interest rates in a way that is considered free from systematic risks. As of August 3, 2020, the BoE started calculating and publishing SONIA every day on any London business day that is not a holiday. Since its creation, there has been stability in the overnight rates on the British financial market.
From LIBOR to SONIA
SONIA has effectively replaced LIBOR in most parts as the benchmark rate. The position is reinforced by the lack of activity that questions LIBOR’s robustness as a benchmark rate. Secured interbank borrowing, which is the basis of LIBOR among financial institutions, has also declined considerably. The trend has also been reinforced by the post-crisis liquidity status, which labels interbank borrowing as unstable.
Sterling Overnight Interbank Average Rate is already used as the benchmark for discounting sterling rates and Sterling Overnight Indexed Swaps (OIS). The Bank of England’s series of changes has strengthened SONIA as a critical benchmark for financial contracts on sterling markets. Unlike in LIBOR, where the actual values are based on a market for brokered transactions whose transaction volume is limited, SONIA is anchored on actual transactions.
SONIA now reflects a wide range of scope of unsecured deposits. In line with the reformed methodology, the Bank of England estimates that the new benchmark accounts for about GBP50 billion worth of financial transactions per day. The amount is three times as much as financial contracts recorded by LIBOR.
In general, interbank markets enable banks to provide lending and deposit facilities by pooling, managing, and redistributing funds. The overnight market is considered one of the most important interbank markets.
By providing safety valves, the market plays an important role in a country’s monetary and payment system. Banks with insufficient cash flow to balance their position at the end of a trading period are forced to borrow. On the other hand, banks with abundant cash reserves at the end of a trading period can lend money to other banks with insufficient cash flows.
Borrowing from the central banks is usually considered a last resort since it comes with a significant penalty compared to borrowing from the market. The interest rate in the overnight markets serves important functions such as shaping the monetary policy, as well as a key short-term indicator for traders.
Changes to SONIA
SONIA has been administered by the Bank of England since April 2016 and is the selected risk-free rate (RFR). In such a case, RFR refers to a rate of return on investment with zero risks of financial loss. The Financial Conduct Authority (FCA) oversees the computation and publication of different benchmarks through WMBA. The following changes have been affected regarding SONIA:
- It includes bilaterally negotiated transactions, as well as brokered financial transactions.
- It includes a volume-weighted average interest rate for computing the rate.
- SONIA rate is reported on the business day and published at 9:00 a.m. The arrangement is meant to give financial institutions enough time to account for a higher volume of activities.
Banks are encouraged to adopt SONIA as an alternative to LIBOR. The call is based on the premise that SONIA is a near-risk free interest rate. Such a change has impacted British sterling derivatives and other similar financial transactions. It has also replaced the dominant LIBOR as the best option, resulting in an alternative interest rate.
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