The Role and Impact of Base Interest Rates (LIBOR and SONIA) on Corporates and Individuals
Central banks such as the Federal Reserve mainly use a base rate interest to control borrowing rates and encourage or discourage spending. Base rate interests are defined as interest rates that a central Bank charges commercial banks for loans (Manjoo & Zaman, 2021). Although regular commercial banks can set their interest rates for the borrowed loans, the base rate normally dictates the interest rates.
Central banks use the base rate interests to control money circulation within a system depending on the prevailing economic circumstances (Manjoo & Zaman, 2021). The London Interbank Offered Rate (LIBOR) is a dominant base interest rate that controls short-term financial borrowing and lending among the key global markets (Manjoo & Zaman, 2021). It ensures that the central bank has control over the financial market.
Despite the recent scandals surrounding LIBOR, it remains a global benchmark that controls borrowing costs and is listed daily by the intercontinental exchange. However, there are speculations that the rate shall be discontinued towards the end of 2023 (Manjoo & Zaman, 2021). Corporates and individuals find the base interest rates relevant or useful, and they guide them on the best investment areas. Businesses invest in interest-bearing bank accounts to make more money upon the increase in interest rates.
SONIA (Sterling Overnight Index Average): Nature and Daily Calculation
SONIA is the widely known abbreviation for the Sterling Overnight Index Average. SONIA has been documented as the most effective interest rate paid by banks in the event of unsecured transactions within Britain’s sterling market. It is an overnight interest rate used in overnight funds for businesses conducted in the late hours (Manjoo & Zaman, 2021). SONIA rates offer traders and their respective financial institutions an alternative short-term interest rate to the LIBOR, or the other competitors offer rates by the London Interbank.
The Bank of England publishes SONIA every morning at nine after analyzing and measuring the results of unsecured night loans borrowed by the traders. SONIA is calculated as a trimmed mean, further rounded to four decimal places of the interest rates that have already been paid back on all eligible transactions (Manjoo & Zaman, 2021). The trim mean is the total volume-weighted mean rate of more than half of the volume-weighted distribution rates.
The bank considers all the following metrics before a transaction can be considered eligible. The value of the transaction should be more or equal in value to £25 million (Manjoo & Zaman, 2021). The transaction should occur between 00:00 and 18:00 formal U.K. time and be repaid on the same day (Manjoo & Zaman, 2021). The loan should be unsecured and reported to the Bank of England money market for data collection.
The Transition from LIBOR to SONIA as a Financial Benchmark
SONIA is replacing LIBOR because of SONIA’s sustainability and promising future, considering its volume evident in transactions. LIBOR SONIA has no associated term bank credit risk components; hence, it is chosen for its interest rate levels (Manjoo & Zaman, 2021). Another reason for the transition towards the predominant use of SONIA is its compounded ability to be used in term contracts (Manjoo & Zaman, 2021). A compounded SONIA makes it more liquid and predictable, making it the best choice in short-term trades.
References
Manjoo, F. A., & Zaman, A. (2021). Implications of the regulatory shift from the LIBOR to the SONIA benchmark for the Islamic banking industry in the U.K. In F. A. Manjoo & A. Zaman Benchmarking Islamic finance (pp. 181-196). Routledge.