Technology needed to meet Sonia’s complexities
The end of March marked the deadline set by the Financial Conduct Authority (FCA) and the Bank of England (BoE) to end the issuance of new Libor contracts. In December, the IBA will stop publishing the Libor sterling as a representative rate and many companies are pushing to complete their transition to the risk-free rate (RFR), Sonia.
“As far as our customers are concerned, some have started modifying their contracts and migrating others to the Sterling Overnight Index Average (Sonia),” said John Byrne, CEO of Salmon Software. “Some plan to do it at the end of the third trimester. Almost everyone we talk to is getting ready to make sure everything is migrated before the end of the year.
The market is still far from having completed the transition to Sonia. Only 51% of the pound sterling OTC interest rate derivatives, used RFRs. One of the reasons the market has been slow to adopt Sonia is the perceived lack of liquidity.
“It’s hard to buy too much into the cash flow argument,” Byrne says. “Benchmark rates are not an option, they stem from a directive to halt Libor. There is no choice ”
“If you take out a new loan or swap and tie it to Libor for the rest of that period, to me that would be short-sighted. The new diet is coming, everyone will participate at this time next year. Difficult to envision a liquidity problem?
The FCA and other regulators pushed companies to adopt RFRs as soon as possible, they went so far as to say individual bonuses should be related to how a company moves away from Libor. This is part of an effort to both increase RFR liquidity and build confidence and understanding in how new RFRs are calculated.
“The mechanisms and calculations under Sonia are so seismic different from Libor,” Byrne explains.
“The Libor was a rate for a period, hit early on and you knew exactly what it was. Sonia is an entirely different proposition. It has 25 rates each month representing 25 mini periods including weekends. Also, the rate for a given day is not today’s rate. This is a rate of a few business days earlier, based on the “lag” period. In addition, each daily rate must be compounded.
With Sonia, the calculations are more complex than those used for Libor, which is why market players are eager for technological solutions to help with the transition.
“We have a number of customers who are actually starting to use our new module and were very anxious to get it because they thought they couldn’t migrate until they had a system in place,” explains Byrne.
“It was a big challenge for software companies like us. We have invested over two years of development to determine what is required.
He adds that for companies that manually calculated Libor rates using Excel, doing something similar for Sonia would require significantly more resources and lead to increased operational risk.
“You have to dial the rates daily. Round to 16 decimal places. Excel can store numbers from 1.79769313486232E308 to 2.2250738585072E-308; however, it can only do so with 15-digit precision.
For a 10-year loan referencing Libor, the interest would have to be recalculated 120 times, with Sonia getting close to 3,000.
“If you have a portfolio of swaps and loans, you can see that the volume itself is going to be difficult to maintain in Excel at first. And that’s before you get to the math, ”Byrne says.
“If there are additional complications in such a mid-period capital movement, interest margins, then the complexity increases. Or if you need to do a cross currency swap where one side refers to Sonia and the other to SOFR, you now have two sets of rates to manage, thus doubling the number of calculations you have to do.
Grab the nettle
To help ease the Libor market and further strengthen financial stability, the FCA recently opened a consultation period to determine whether an unrepresentative synthetic Libor rate is needed so that difficult legacy contracts can mature naturally.
“I believe if anything results from this, it will be a very short-term solution,” Byrne said. Synthetic Libor isn’t even really defined and there are always complexities associated with it.
A final decision and policy statement will be released in the third quarter. However, Byrne believes companies shouldn’t wait to see what synthetic Libor looks like.
“Businesses need to grab nettle.
“If there was an alternative, it would be available.
Ultimately, it will be a combination of technology providers and market players such as banks and central counterparties that will allow companies to move to RFRs.
“I suspect that many companies may rely on their banks or their counterparties to provide them with the calculations,” Byrne says. “The onus is on the system vendor to deliver elegant solutions. We’ve made sure our TMS, Salmon Treasurer delivers exactly that.