Interest Rates: Making the Switch from Libor to SONIA

There are a few big differences when it comes to the new rate benchmark.

Over the last several months, the lending world has embarked on a huge shift in how it sets the cost of borrowing.

At the end of 2021, the London Interbank Offered Rate – LIBOR – was formally phased out as the preferred standard for setting interest rates, following a high-profile rate-fixing scandal. No new loans or financial products are supposed to reference LIBOR.

For decades, LIBOR was one of the standards of the global economy, helping set the cost of borrowing for everything from car loans to corporate debt. (It goes back to 1969, when lenders were trying to figure out how to price an $80 million loan to the Shah of Iran.)

Though LIBOR grew to be widely used, the scandal undermined its credibility so badly that policymakers and lenders looked for a new reference point.

In the UK, that new standard is the Sterling Overnight Index Average, aka SONIA, which promises to be more resistant to manipulation. The United States, meanwhile, is using a different standard, the Secured Overnight Financing Rate (SOFR).

There are a few significant differences in how SONIA operates compared to LIBOR, which businesses should understand as they manage their borrowing.

How SONIA is calculated

Every business day, the Bank of England calculates SONIA based on deposit transaction data from the previous day. Specifically, SONIA looks at the interest that was paid for borrowing at least £25 million in unsecured, sterling, short-term wholesale funds for one day, which sets the new day’s rate.

SONIA is a risk-free rate. Essentially, it measures the cost of credit in a situation where lending risk is minimal. As a result, SONIA is as close as possible to the “true” cost of borrowing funds, including only the most basic margin that a lender would charge for funding the transaction.

Compared to LIBOR, SONIA was designed to be less susceptible to manipulation.

That’s because LIBOR was based on estimates from several leading banks on how much it would cost for them to borrow from another bank. Following the 2008 financial crisis, it was discovered that several lenders were engineering their estimates to boost profits or appear to be in better financial health than they actually were. The resulting scandal led to the end of LIBOR.

SONIA is seen to be more reliable because it’s based on how much borrowers actually paid in interest.

3 big differences between SONIA and LIBOR

1. SONIA uses a different window of time

Technically, SONIA measures the cost of borrowing only for a single day, where LIBOR would calculate the cost for terms of varying lengths, up to a year.

To borrow money over multiple days, weeks or months, a SONIA rate must be collected and compounded for each of the included days at the end of the loan.

2. LIBOR looked ahead, SONIA looks backward

With LIBOR, businesses knew upfront how much they would be paying in interest. Because of how SONIA is calculated, the exact costs of borrowing are usually not known until the end of each interest period.

A lender might use a shifted “look-back window” that calculates interest based on a period of time from five days before the interest period started to five days before it ends. That way, the borrower has five days’ notice of how much will be due.

There are some situations where a forward-looking rate is necessary, so a Term SONIA rate — based on an average of recent SONIA values — has been developed. Policymakers have stated that Term SONIA should only be used in limited cases.

3. Lenders may need to adjust for the cost difference between SONIA and LIBOR

At first glance, SONIA may appear to cost less than LIBOR. That’s because, as a risk-free rate, SONIA is looking at the cost of lending in a risk-free situation. It doesn’t include the extra cost that a lender would charge for a riskier loan over a longer period of time.

That’s not a big problem for new loans. Lenders still have the ability to set their own rates and price in the cost of additional risk. This is called a credit adjustment spread.

This has been used by lenders that needed to update older contracts to switch from LIBOR to SONIA. They’ve had to incorporate the credit adjustment spread to ensure that SONIA’s new cost is roughly comparable to what was agreed upon under LIBOR. One method to calculate the adjustment is to find the median difference between LIBOR and SONIA over the previous five years.

The bottom line

Under SONIA, the UK’s new preferred benchmark for interest rates, businesses will need to adapt to a new method of calculating interest due. But the move should make lending fairer and more trustworthy for business borrowers going forward.