As banks prepare to move away from the scandal-tainted Londoninterbank offered rate (LIBOR), few in the city of London will bewatching more closely than William Porter. Now head of Europeancredit strategy at Credit Suisse Group AG, Porter was working onJ.P. Morgan's short-term interest rate and strategy team in themid-1990s as it searched for a way to hedge short-termfloating-rate risks against European currencies.

Their solution was the sterling overnight index average, orSONIA. Earlier this year, the benchmark, which is consideredimpossible to manipulate because it's based on actual transactions,was designated LIBOR's heir apparent by the Bank of England. Here,Porter describes how SONIA came to life and why it still isn't theperfect solution to measuring overnight lending rates.

EMMA HASLETT: Set the scene: It's 1996,you're working at J.P. Morgan. How does SONIA come about?

WILLIAM PORTER: It was a desire to replicateovernight swaps that existed in France. There were two swaps tradedagainst the average overnight rate that the Bank of Franceobserved, known as TAM. Effectively, French market participantswere hedging short-term, floating-rate risks and funding risksusing those swaps.

We were trading a lot of foreign exchange forwards, which havetwo short-term interest-rate risks, at the time. Everything, byconvention, goes back to the dollar. So you've got the underlyingcurrency, and you've got the dollar, and we wanted a way to stripthat out. We were looking at ways to do it using futures, butnothing really worked because of the funding element, and we hadthe brain wave of starting to trade on [the] fed funds effective[rate] the way they were used to trading in France on this TAMrate. We just started doing that, so that started the dollarovernight index swap market in London.

See also:

• Goldman Sachs Anticipates 'Really PainfulTransition' Away from LIBOR
• LIBOR's 2021 Demise Means More Work forTreasury
• Swaps Group Considers Cure for LIBOR'sDemise

We filled in gaps in the U.K. and in Japan by appealing to thebrokers with a new product to trade and by getting them to publishthe overnight average that they observed. So the Wholesale MarketBrokers' Association in the U.K. [now known as the European Venues& Intermediaries Association] started publishing its observedaverage overnight rate, which was SONIA—and the Bank of Englandkept a watchful eye. Fast-forward 20 years, and enhanced SONIA isgoing to be calculated by the bank.

EH: Was it hard to persuade other marketparticipants to get involved?

WP: They were initially skeptical, but therewas always some liquidity. As you know from the LIBOR fiasco, thesebooks are huge, some of them. So it didn't take much market shareto make it worth the brokers' while.

One of the tricks at the time was how volatile SONIA was. Therewas no benchmarking. The overnight sterling market was a dark art.That was one area of difficulty. It was difficult to persuadeauthorities that this was in the public interest. They eventuallycame round, but there was so much volatility in SONIA. I don'tthink they wanted to publicize it.

EH: You later joined the European BankingFederation's Euribor steering committee as the European Unionprepared to introduce the euro. What was your role?

WP: The euro was hoving into view, and Europewas seen as a major threat to the London markets. I was insertedinto the Euribor working group that led into the steeringcommittee. As Euribor ramped up, the London International FinancialFutures and Options Exchange observed liquidity was going to begreater, so they benchmarked their euro interest rate future toEuribor, not LIBOR, and traded it in London anyway. That was a hugedecision, very public, and seen as a disloyal threat in somecircles.

Part of the reason I was put into that committee was becausethere was no provision for overnight rates. So there we were,trading all these currencies that were going to be succeeded by theeuro overnight, and there was no provision for an overnightsuccessor rate, so that caused a bit of a panic. Eonia [the euroequivalent of SONIA] was how we put that right—we basically addedEonia to the Euribor structure and just basically mapped across theparticipants.

EH: Is its implementation being handledwell by the Bank of England?

WP: It's a difficult challenge. I've hadconcerns about the nature of fixings for a long time, and I thinkAndrew Bailey [chief executive officer of the Financial ConductAuthority, the U.K. financial markets watchdog] is right to pointto systemic issues that he wants to get rid of. Maybe there's somedetail in the implementation, but overall I think they're onabsolutely the right track.

EH: Could there be a cliff-edge scenario onthe date the Bank of England switches from LIBOR to SONIA, leavinginvestors who hold bonds that were pegged to LIBOR but mature afterthe transition in an awkward position?

WP: I don't think at the end of 2021 theworld's going to end, but it's a bit like Brexit: I don't think there's going to be acliff on 29 March 2019, but it would be imprudent in the extremenot to hedge against it. There's a date starting to emerge in thefuture when the way that we're doing things is going to change. Sothe most sensible thing to do is to start anticipating that.

EH: Twenty years on, do you have anyregrets?

WP: Its complexity is a regret. We regrettedthis early on. The daily compounding is, in my view, a mistake. Idon't think it's going to be changed now. It's analytically pure.We said at the time, Should we do it the other way? And withhindsight we should have just averaged it and then left people todeal with any complexity worries.

The logical thing to do is just to set up a site where you canput in two dates and get the compounding between them, and thenclick on the number and socialize the calculation rather thaneveryone doing it in-house, unverified. To have an external,verifiable source would be a good idea.

So that is one regret. We should have done just simpleaveraging.

From: Bloomberg

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