Inter-bank rates, including the London Inter-Bank Offer Rate (“LIBOR”) and the London Inter-Bank Bid Rate (“LIBID”), have played an important function in financial markets since their establishment in the 80s and have been used as the main reference rate for a countless number of financial products.

Over recent years however, it has become apparent that inter-bank rates have regrettably long passed their sell-by date. This is in part due to the way they are calculated. The LIBOR is calculated using the average rate at which a group of 20 leading banks lend to one another, however, since the financial crisis inter-bank lending is a rare occurrence as banks have moved to other sources of funding. Submissions made by banks to maintain the LIBOR rate are therefore often based (at least in part) on expert judgement rather than actual transactions, making it less representative of lending levels. Furthermore, as witnessed in 2012, LIBOR is vulnerable to manipulation.

The Financial Conduct Authority reviewed the appropriateness of inter-bank rates and concluded that they no longer comply with the principles for robust interest rate benchmarks. Consequently, it was announced, earlier this year, that inter-bank rates will cease to be published from 31 December 2021.

The Bank of England and most market participants, have already replaced, or will be replacing, inter-bank rates (as the interest rate used) with SONIA (the Sterling Overnight Interbank Average rate), an alternative reference rate that was introduced in the late 90s. SONIA doesn’t have the same drawbacks as inter-bank rates, as it is calculated using actual transactions, and reflects the interest rate that banks pay to borrow sterling overnight from other financial institutions and other institutional investors.

Inter-bank rates have been a main feature in the investments many pension schemes hold. A few of these, and the implications of the change, are discussed below.

Inter-bank rates were often used as a benchmark “cash” rate for cash funds, as well as multi-asset and diversified growth funds (which typically seek to generate a return of 3-5% per annum in excess of LIBOR). Recently, providers have replaced the “cash-rate” of LIBOR with SONIA.

As well as being used as one of the primary benchmarks for a range of investment types, the rates were regularly used as a reference rate for other solutions. This includes the underlying components of de-risking products, such as swaps and derivates that are used in Liability Driven Investment (“LDI”) and other insurance contracts, which are widely used by pension schemes. Such products can use leverage, which is effectively borrowing and has a cost associated with it (that references UK interest rates). Most providers have moved to replace the LIBOR reference rate with SONIA.

SONIA has historically been less volatile and also (usually) lower than the LIBOR/LIBID (as it is deemed a “risk-free rate”. Thus, one should be aware of the benefits and drawbacks of switching the reference rate for different asset types, including those mentioned above.

For investments that have performance targets that reference cash, future return targets may be marginally lower. This should be allowed for when considering the return that is required/expected on these types of investments.

Where cash is being borrowed, such as in a leveraged LDI solution, the cost of borrowing had been expected to decrease as SONIA has historically been lower than LIBOR. However, in practice this has not been the case, because markets began pricing in the assumed difference when the announcement was made.

From the 31 December, a difference may become more apparent as an explicit adjustment (known as the fall back spread, which is the average difference between SONIA and LIBOR over the previous 5 years) will be made to allow for the change, rather than relying on the assumed difference priced in by the market.

Whilst the cessation date is 31 December and the change is expected to have an impact on investments, the transition is already largely underway and much of this has been priced into markets already. Pension schemes should, however, be aware of the implications this change has for their investments, and ensure this is accounted for.

The cessation of interbank rates, and replacement with SONIA is expected to improve transparency and representativeness of cash/interest rates, which is positive.

Only time (and hindsight) will tell the true impact of the transition to SONIA, however, the extent to which market participants have prepared for it and priced in the change, points to a hopefully minimal degree of disruption for pension schemes and wider institutional investors.