Industry group backs wider use of term Sonia in derivatives

Swaps used to hedge tough legacy products and some new loans could reference a forward rate

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Forward-looking term Sonia rates should be available for use in derivatives that hedge so-called tough legacy products as well as certain new loan deals, according to an influential industry group representing around 40 of the UK’s largest fixed income dealers, issuers and investors.

The FICC Market Standards Board (FMSB) published its draft use-case and governance proposals for term Sonia rates on March 24, just a week before firms are expected to ditch Libor in new lending agreements.

The group identified trade finance, working capital products, and Islamic finance as the primary use cases for term Sonia. Other segments such as corporate and private banking, retail lending, export finance and emerging markets loans are also mentioned as areas where there may be a rationale for term Sonia.

But, in a departure from existing guidance, the FMSB’s draft use cases also include end-user-facing derivatives that hedge “cash products which reference term Sonia” and “tough legacy products which reference synthetic Libor”, as well as derivatives used to “manage such hedges”.

UK regulators have sought to encourage the adoption of backward-looking compounded-in-arrears rates for derivatives and most cash products. The UK’s Financial Conduct Authority (FCA) has said forward-looking term Sonia rates, which offer visibility on interest payments, should only be used for around 10% of sterling loans by volume. A June 2020 paper on term Sonia use cases from the sterling risk-free rate (RFR) working group also omitted derivatives, noting that large notionals “need to be built on more robust overnight RFRs to ensure financial stability.”

The FMSB has taken a different line, saying there may be “a robust rationale” for employing term Sonia in derivatives used to hedge cash products linked to forward-looking benchmarks.

Chris Rich, general counsel at the FMSB, says the paper aims to build on the original RFR working group conclusions and reflects the broader view of FMSB members. “We’re at a different point in transition, where 15 months after [the sterling RFR working group’s original paper], it is deemed helpful to produce a comprehensive standard that looks at both cash and derivatives, given the interconnectedness.”

The decision to use term Sonia in derivatives should not be taken lightly, the group added, given “the reduced systemic risks associated with a broad-based adoption of overnight risk-free rates as well as the potentially heightened conduct risks of excessive usage of term Sonia”. The FMSB also called for comprehensive risk disclosures and robust contractual fallback arrangements when term Sonia is used.  

This neither slams the door shut nor opens the floodgates for term Sonia, but puts a very clear onus of responsibility on participants

Martin Pluves, FMSB

“This neither slams the door shut nor opens the floodgates for term Sonia, but puts a very clear onus of responsibility on participants for assessing the rationale and recognising the various risks for selection of the most appropriate product,” says Martin Pluves, chief executive of the FMSB.

One industry consultant says the inclusion is critical for the management and mitigation of basis risk, and agrees there is no significant departure. “The spirit of the paper is still ‘limited and justified use cases’, which is in line with the principal messaging of the original paper,” he says.

In a statement, the Bank of England, the FCA and the RFR working group all welcomed the paper, saying the proposals were “broadly consistent” with the working group’s January 2020 conclusions.

Synthetic life

The FCA is formulating plans to compel publication of a synthetic Libor rate for legacy contracts that cannot be re-hitched to compounded-in-arrears Sonia. The methodology is expected to comprise a term Sonia rate with a fixed spread adjustment to reflect the difference between Libor – which embeds a credit premium – and Sonia. All inputs for the synthetic Libor rate, including the term Sonia benchmark, will be selected by the FCA.

“The introduction of a synthetic Libor based on a term Sonia means there is quite a legitimate use case in hedging existing exposures, which can be quite large. Once you take that into account, and combine it with the cash market guidance, the use cases for a term benchmark are probably [beyond] earlier expectations,” says one benchmarks expert.

In January, Ice Benchmark Administration and Refinitiv began publishing live term Sonia settings for one- to 12-month tenors.

The two rates are almost indistinguishable in their construction. Both are built from firm Sonia swap prices streamed to electronic order books. In the absence of ample, firm swaps data, a waterfall of safety-net inputs sees the rates turn to negotiable dealer-to-client quotes from Tradeweb. IBA includes an additional layer of Sonia futures data.

A third term Sonia provider, FTSE Russell, dropped out of the running after its parent, London Stock Exchange Group, completed its merger with Refinitiv.

As administrator of Libor, IBA would also be the official guardian of the synthetic versions. But there is no guarantee that the FCA will choose its term Sonia benchmark as the primary input for the new rate, which would underpin billions of pounds’ worth of legacy contracts and potentially the derivatives used to hedge them. Another industry source describes it as a “win-win” for the selected provider of term Sonia inputs.

The market is already gearing up for the April 1 deadline for banks to stop writing new Libor business. Refinitiv confirms it has issued the first licences to clients seeking to use its term Sonia rate in contracts. The first deals are expected to be in trade finance. These privately negotiated transactions are not reported, meaning even benchmark providers themselves are unaware whether the rate has been directly referenced once a licence is agreed.

“Term Sonia adoption is encouraging. We’ve had more than 600 clients access the rates almost 90,000 times, which is great if we think about the size of the market,” says Jacob Rank-Broadley, global head of Libor transition at Refinitiv. “Clients are quite communicative in discussing with us how they want to use it, but when it comes to actually embedding it in contracts, we have limited transparency.”

A spokesperson for IBA says the vendor does not track or publish comparable usage figures.

Beyond the hedging recognition, a specific nod to trade finance, which relies heavily on term rates for discounting future cashflows, was welcomed by market participants. But some are calling for greater clarity on the client segments for which a term rate would be available and on the breadth of products that would be swept up by a synthetic Libor. 

“At a macro level, if you think about Brexit, trade finance is going to be a growing area for the UK and term Sonia needs to play a part, so there needs to be conduct rules around that,” says Navin Rauniar, partner for Libor transition at consultancy TCS.

“It’s good that the paper gives guidance but scope is very important, and a lot of corporate clients aren’t ready for overnight Sonia. Coronavirus and Brexit has distracted them – many are still in recovery mode and Libor transition is the least of their problems.”

Self control

FMSB members, including 21 large banks and major issuers such as BP, Royal Dutch Shell and Vodafone, are expected to adopt all standards and principles set out by the group through statements of commitment. Refinitiv and its new parent, LSEG, are also members.

The industry-led effort is seen as the main control mechanism for managing how term Sonia will be used in practice. The term benchmarks from IBA and Refinitiv comply with standards set out by the International Organization of Securities Commissions and can be used in any contracts under UK and European Union benchmarks regulations.

While the FCA can curb usage by UK financials that fall under its supervision, it lacks the clout to impose similar limitations on corporate users and international banks.

Six of the largest US banks, including Goldman Sachs and JP Morgan, are also FMSB members.

The FMSB’s draft use-case and governance proposals for term Sonia are open for comment until May 28.