Whether you are a lender or a borrower, you may have to make sure you are seated before reading through the documentation for a SONIA-based loan.
If you fast-forward to the pages dealing with interest calculations (in fact, it would be quicker to start at the back of the document, since an entire schedule has been devoted to these), the formulas you will see resemble the insides of a mechanical watch: fascinatingly beautiful, but hardly approachable.
A problem presents itself: you have been told to familiarise yourself with these formulas from now on, or at least until the next benchmark replacement arrives – potentially decades away. You will promptly realise what is required of you: to skilfully run all those formulas for every business day (253 times per year on average) for each of your loans.
Scandal-ridden LIBOR was not ideal, but it was user-friendly. SONIA has certainly been around for a reassuringly long time – and so the idea of using it to replace LIBOR seems totally sensible. (Even those who dislike the idea of compound interest can take comfort that Einstein reportedly referred to it as the eighth wonder of the world.)
Today’s SONIA documentation – and the clockwork-like formulas defined within them – are the result of a quest for razor-sharp precision, a desire to address every possible future rates path and to accommodate the most demanding lender requirements, all in one place. It still awaits some consideration for user experience.
Complex formulas do not need to be rolled out, nor should they become everyone’s problem. When drafting a loan documentation, one can easily refer to an index.
Since August 2020, the Bank of England started publishing an index, which grows daily alongside the publication of the SONIA rate. They do the complex calculations for everyone, and all market participants have to do is observe the progression of the index during a specific period to know the coupon at the end of that period.
More recently, the ICE Benchmark Administration (IBA) announced that from April 2021, a range of indexes will be published to provide further flexibility and to satisfy the needs of lenders and borrowers seeking specific observation lags or shifts depending on their preferences.
The purpose of an index is to replace this type of formula:
with this one:
With an index, you need only two data points per coupon period – one at the beginning and one at the end. The ratio of these two numbers will give you enough information to know your coupon. For reporting accrued interests, you do the same but observe the second index data point on the day of reporting.
Here’s where it becomes truly amazing: if it wasn’t for the loan margin, there would be no need to use a day-count fraction. The immediate benefits of this method – compared with handling 253 data points per year – include a fantastic gain in efficiency, clarity in terms of both the method and its outcome, reduced scope for error and greater control when it comes to loan drafting. Indeed, loan drafting would amount to just a one-line placeholder for the commercially agreed index and its definition.
A closer look into the details of the current standard reveals a small but ferociously stinging detail: each daily benchmark rate is floored at 0%, resulting in your selling 253 compounded floors per year.
Those daily compounded floors are deemed so exotic that options traders don’t even have them off the shelf, which means you won’t be able to hedge them. Or if you do, you will need to use proxy hedges and accept some degree of hedge ineffectiveness.
To be clear, daily compounded floors are not meant to protect lenders against the possibility of negative rates (periodic floors are meant for that), but against the ‘noise’ that may arise should SONIA randomly fix positive some days and negative on other days within a specific coupon period. They are also meant to bring comfort to a subsection of those times when ‘noise’ is happening, in case you repay your loan in the middle of a coupon period, so that your accrued interest cannot be accidentally negative either. And for those sorts of exception you are asked to permanently threaten hedge accounting effectiveness.
With current formulas, daily compounded floors are so embedded that even waiving them on commercial grounds would require input from the finest lawyers. Once the index method has become standard, it will be easier to switch from a floored index to a non-floored index, and to apply any necessary floor to the coupon period instead, as it was done previously within the definition of interest – with the caveat that the floor would still apply to shortened periods.
As all paths lead to the index method, we have an opportunity to make SONIA almost simpler to use than LIBOR was. And as far as daily compounded floors are concerned, such specifics should not come in the way of hedging against risks of far greater amplitude such as the volatility of rates.
So, in order to square things up and put a lid on unnecessary complexity, let’s have current loan standards translated to use the index method and thereby free precious time for businesses. After all, far greater challenges await.
François Jarrosson is director, derivatives and hedging advisory at Rothschild & Co. He has more than 20 years of corporate finance experience and advises companies on risk management and the use of financial derivatives. He is also a non-executive director of the London Capital Credit Union