The Bank of England published proposals on Tuesday for tailoring its overnight interest rate benchmark to plug a gap in the market and speed up the replacement of Libor. After banks were fined billions of pounds for trying to rig Libor, which measures borrowing costs between lenders, Britain's regulators set an end-of-2021 deadline for switching to the BoE's SONIA overnight rate for pricing contracts like derivatives and ending the reliance on sterling Libor.
Libor is denominated in three-, six- and 12-month "terms", but SONIA is a purely overnight rate, making it of little use for pricing some contracts that stretch into the future. The BoE said its working group of market participants has set out how SONIA could be adapted to plug this gap and cover terms of up to a year. The group believes that "term" rates for SONIA could be available in the second half of 2019.
"In a significant majority of cases where sterling Libor is used, an overnight rate like SONIA will meet users' needs," the BoE said in its consultation paper.
"However, outreach has identified operational challenges which could inhibit the use of an overnight rate by users in loan and debt capital markets." It said that "firm quotes" for terms up to a year based on SONIA-linked swaps offered the "most feasible and robust data sources in the near term" for plugging the "term" gap.
"These provide a high degree of transparency and a strong link to transaction data, but with the benefit of ongoing availability even where transaction volumes are low." But safeguards were needed to ensure that quotes were sourced in a transparent and verifiable way, based on actual transactions, where possible.
The BoE said the most reliable quotes may only be available currently under subscription, and even these may only be indicative, rather than firm.
There was a need to shift telephone-based trading of SONIA-based swaps to electronic platforms where such quotes and transactions can be tracked, the BoE said. "The majority of working group members believe that overnight rates offer compelling benefits in many applications, and that most users will, over time, adapt to referencing SONIA directly in their financial contracts," the BoE said.