Bank of England Seeks to Accelerate Libor Reform

The UK has upped the ante again in driving interest rate benchmark reform away from Libor to risk free rates with the Bank of England unveiling two new initiatives aimed at further supporting the transition.

The BoE and the UK regulator the Financial Conduct Authority (FCA) are working closely with market participants to support the use of Sonia – the Sterling Overnight Index Average – as the predominant interest rate benchmark in sterling financial markets as markets transition away from Libor.

In order to accelerate the adoption of Sonia as a reference rate in sterling markets, the Boe has published a discussion paper and is seeking views from sterling market participants on plans unveiled this week by executive director of Markets at the Old Lady, Andrew Hauser, to publish a daily Sonia Compounded Index, intended to support its use in a wide range of financial products by simplifying the calculation of compounded interest rates.

The Bank is also considering publishing a simple set of compounded Sonia Period Averages, which would give users easy access to Sonia interest rates compounded over a range of set time periods. As the set periods used to generate such averages cannot always align with those currently applied in products referencing Sonia, the Bank says it is seeking to establish whether there is market consensus on how to define the relevant time periods. Once it has comments on the options presented in the paper, the BoE says it will decide whether it would be helpful to publish such averages.

Sonia reflects the average of interest rates that banks pay to borrow overnight, unsecured sterling cash on a given day. It plays a critical role in sterling markets and is widely used as a reference rate to determine the interest payable on a range of floating rate instruments. For instance, it underpins the Overnight Indexed Swap (OIS) market, with a notional value of outstanding contracts exceeding £13 trillion, and is used as the basis for valuation of a wide range of other products.

Products that currently use Sonia as a reference rate typically pay interest on a periodic basis , with the interest due calculated as a ‘compound average’ of the individual overnight Sonia rates across the period. The resulting interest rate is equivalent to a rolling overnight loan over the same period of time, but without the operational overhead of daily cash flows, the Bank says, adding that this calculation is long established as the basis for the OIS market, but requires a large number of data points and may not be familiar to some non-financial end users, including many corporates. Market participants also point out that many corporations like the certainty of cash flow and cost of funding and would prefer not to use a “look back” calculation such as that proposed by the Bank of England.

In its proposal the Bank says it intends to provide a simple means for users to work out the compound interest due on products without performing calculations using each day’s underlying Sonia rate. It will also publish a Sonia Compounded Index, which is a number representing the returns from a rolling investment earning interest each day at the Sonia rate. It adds that the change in this index between any two dates could be used to calculate the interest rate payable on a Sonia product over that period, noting that this approach is consistent with that taken by the Federal Reserve Bank of New York and the forthcoming publication of its SOFR Index.

Subject to feedback, publication of the SONIA Compounded Index is anticipated to commence by end-July 2020, with a more precise date to be communicated in 2020 Q2, the Bank says.

In addition to the Compounded Index, the Bank says it is also considering whether – and, if so, how – to publish daily a simple set of Sonia Period Averages. These could directly provide the interest rate payable over specific periods of time. It notes that this approach has the merit of further reducing the calculations that most users will have to perform, making it an even simpler way of getting compound rates than using the Sonia Compounded Index, however, that convenience comes at a cost. Specifically, it is not possible to generate a simple set of period averages that will always reflect precisely the same time periods as currently used in products which reference Sonia. “These small differences in how time periods are defined would lead to differences in the calculation of interest,” the paper states. “For example, a loan referencing a period average and an OIS hedge paying coupons on the same frequency will not always have identical interest period, reducing the effectiveness of the hedge.”

In seeking feedback from sterling market participants on the potential usefulness of publishing these rates and on preferred conventions for calculating them if taken forward, the BoE stresses that in particular, participants should consider whether they are willing to accept such a trade-off between the added simplicity of an easily accessible set of period averages; and the potential inconsistency if they also use products that have adopted different approaches.

“Were the Bank to publish a set of period averages, we would require a market consensus on how to define the relevant time periods,” it warns. “The Bank’s current view is that failure to reach consensus on such conventions would undermine the potential benefits of publishing Sonia Period Averages, and is therefore likely to lead it to opt not to publish such averages.”

Responses to the questions posed in this paper are invited by 9 April 2020.

The BoE also issued a Market Notice, which laid out plans to progressively increase the haircut on Libor-linked collateral. It says that the haircut add-on will be 10 percentage points from 1 October 2020, 40 percentage points from 1 June 2021 and 100 percentage points from 31 December 2021. “For the avoidance of doubt, haircuts will be capped at 100 per cent,” the Notice states.

In respect of loan portfolios containing both Libor-linked loans and other loans, Sterling Monetary Framework (SMF) participants may choose to either remove the Libor-linked loans from the portfolios, or alternatively split them subject to them meeting the Bank’s standard collateral eligibility requirements.

The Notice further advises that from 1 October 2020, all securities issued on or after that date and maturing after 31 December 2021, where the coupon pays a rate of interest calculated by reference to Libor, will be ineligible for use in the SMF, as will all securities issued on or after that date and maturing after 31 December 2021, where embedded swap payments are calculated by reference to Libor, and where one or more loans in the portfolio is a Libor-linked loan.

From 1 October 2020, all Libor-linked loans issued on or after that date, will be ineligible for use in the SMF and from 31 December 2021, all Libor-linked collateral, regardless of the issuance or origination date, will be ineligible for use in the SMF.

Colin Lambert

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