Sterling Overnight Interbank Average rate (SONIA) definition

What is the SONIA interest rate benchmark?

The Sterling Overnight Interbank Average rate (SONIA) is the effective overnight interest rate paid by banks for unsecured transactions in British sterling – these are loans that are not backed by collateral. It is the overnight funding charge for trades that occur in off-market hours and represents the amount of overnight business in the marketplace.

The benchmark is commonly used by traders and investors to get an idea of which direction interest rates are going.

The SONIA rate was established in 1997 but wasn’t administered by the Bank of England (BoE) until 2016. In 2018, SONIA was reformed and proposed as the alternative benchmark rate to the London inter-bank offered rate (LIBOR).

How does SONIA work?

SONIA works using a strict process that is monitored by the BoE and International Organisation of Securities Commissions (IOSCO) best practices.

First, they gather data from banks across the UK on the transactions that were completed on the previous trading day. So, if you’d been looking at the SONIA rate on a Friday, what you would actually be seeing is the transaction data from the Thursday.

Next, the BoE runs the data through its algorithm to ensure that there are no unusual patterns interfering with the quality of the data. Once this is done, the SONIA rate is calculated by taking a weighted average of all unsecured overnight sterling transactions of a minimum size of £25 million. The top 25% and bottom 25% are removed, and the mean of the central 50% is presented and rounded to four decimal places.

At 9am, the SONIA rate is sent to the BoE’s licensees and users can then access the data from Bloomberg or Reuters.

SONIA vs LIBOR

Before SONIA, the UK used LIBOR as a benchmark for daily interest rates on loans and financial contracts. It was calculated by asking 35 banks around the world to answer a survey on the rates at which they would offer each other short-term loans. The average number of the central 50% of these answers was given as the LIBOR daily figure.

While SONIA is a UK-focused index, LIBOR was a global benchmark. It was calculated in five different currencies: the US dollar, euro, British pound, Japanese yen and Swiss franc.

However, in 2012, bank employees were found to be manipulating the rates for financial gain. This led to much stricter rules and regulations being put in place that made sure all interest rate benchmarks were based on data. It also meant that the countries previously involved in LIBOR created their own replacement indices – such as SOFR for the US and ESTR for the EU.

Pros and cons of SONIA

Pros of SONIA

Unlike LIBOR, the SONIA benchmark is calculated using actual transactions, rather than survey results. This means that it not only reflects the average rate of transactions, but that there is less risk of the rate being manipulated. SONIA will help to provide transparency within the market.

Cons of SONIA

The transition from LIBOR to SONIA was a huge undertaking, as the previous system covered sterling deals to a notional value of $30 trillion. The concerns about the change were that it would be difficult to establish feasible and trusted alternatives, as well as liquid markets, and that – for a while – the old and new benchmarks would have to work side by side.

Another concern raised about SONIA, or rather the transition away from LIBOR, is that the group of five currencies will not be fully aligned. However, the benchmarks will have to conform to international regulations which will go someway to creating global unity between the rates.