SONIA to replace LIBOR
The end of the London Interbank Offered Rate (LIBOR) is approaching, since this rate will only be used until the end of 2021. The Bank of England, the UK’s central bank, is introducing the Sterling Overnight Index Average (SONIA), as lost confidence in LIBOR led to a search for alternatives. SONIA linked to overnight transactions has proven the best choice. How will these two reference rates differ? What does this transition mean for the world of finance and transfer pricing?
Interest rates applied to loans and borrowings are usually tied to reference interbank rates plus the debtor’s risk margin. The current system of deriving interbank rates has shown a weakness, as banks have been informing the regulator about the price they were willing to offer for financing in the market and not about the price of actual transactions. A scandal around LIBOR in 2012 revealed the manipulation practices of some banks. The resulting loss of trust in LIBOR led to a search for alternatives. SONIA linked to overnight transactions has proven the best choice as it is based on overnight transactions that really take place and that therefore cannot be manipulated.
The result of calculating SONIA is one overnight rate only. Three-month or other longer rates are derived mathematically using compound interest. So is there a catch?
Paradoxically, SONIA’s strength is also its weakness: it derives from the past, and not from expectations; therefore, differences to LIBOR arise, which is only logical. It can thus be expected that the transition from one reference rate to the other while maintaining the same risk margin will not result in the same total aggregate rate for group financial transactions.
How to best incorporate this difference into calculations and plan the most suitable transition strategy? We recommend mapping in advance the financial transactions that refer to LIBOR and that should also exist after 2021 (similarly for EURIBOR and the year of 2022). Contracts and documentation should be updated beforehand to refer to SONIA, the new reference rate. In addition, contracting parties should agree on how they will deal with the expected variance from LIBOR. Ideally, no party should make a profit or suffer a loss as a result of the new rate, which is how transition success will actually be measured. The change will also affect the transfer pricing sphere, as interest within cash pooling may in the future be derived from SONIA. The SONIA rate is already known; it is therefore not necessary to wait until the end of LIBOR. SONIA can be implemented earlier, e.g. when negotiating appendices to existing contracts for other reasons.
A similar change is being implemented by the European Central Bank. At the end of 2022, the EONIA and EURIBOR rates should be replaced by €STR. In contrast, the Czech reference rate (PRIBOR) remains based on the existing principle of offered rates.