Do you know Sonia? You don’t recall anyone by that name? A brief fling perhaps you now refuse to remember? No?

Yet sooner or later she will tell you how much to pay for your mortgage, your credit card debts, your car loan, everything. At least when your financial affairs are denominated in pound sterling.

Because SONIA is the ‘Sterling Over Night Index Average’ as administered by the Bank of England. It is “the effective reference for overnight indexed swaps for unsecured transactions in the Sterling market”, the new standard interest rate benchmark for loans and bonds. It is meant to replace the disreputable LIBOR rates, which have been so scandalously manipulated by some of the biggest banks during the financial crisis.

It is a gargantuan undertaking: financial arrangements worth €370 trillion use LIBOR as a reference, contracts amounting to $300 billion per day. Many of these contracts are written with a time horizon exceeding 2021, the year in which the switchover should happen, and many agreements are such that the intended index replacement looks ill-suited to match the structure of many LIBOR-based deals.

Sonia is not alone. Regulators in the US and Europe want to replace LIBOR too. By SOFR for instance, the ‘secured overnight financing rate’ collateralised by Treasury securities and published daily by the Federal Reserve Bank of New York. Or EONIA, the ‘effective overnight reference rate for the euro’ and EURIBOR, the ‘rates for term deposits between banks’ as published by the European Money Market Institute, the umbrella group of Europe’s national banking associations. Financial authorities from Dubai to Tokyo, from Pakistan to Hong Kong are cloning LIBOR too and come up with ever more indices. Financial institutions, put to shame by their misdeeds, were initially open to change but are increasingly worried about the approaching mess.

LIBOR, the ‘London Interbank Offered Rate’, came to life in the 1980s when London became the pre-eminent hub for petro dollars. It was an English affair. Banks were called up in the morning and asked at what rates they think they could borrow from other banks. In various currencies, and over varying time horizons. The most outlandish claims were ignored and an average rate calculated and then published. As no one checked the veracity of these self-assessments or the actual pricing of underlying transactions, such arrangement was of course open to abuse.

The financial crisis of the years following the collapse of the US subprime market and the nuclear bankruptcy of Lehman Brothers brought to light two kinds of abuse: an interbank conspiracy to fleece clients and trick markets out of billions and, more benevolently, inventing theoretical borrowing costs when banks, all banks, could not borrow at all anymore. It was the desperate attempt to appear liquid when all liquidity had evaporated. Banks did this to avoid panic, a bank run, nationalisation, a taxpayers’ bailout or a combination of all the aforesaid. It was a white lie.

The concept of replacing an index which was essentially based on self-assessment with something more substantial, as for instance the weighted average of real, underlying transactions, is desirable and looks simple enough. But what to do if there are no real transactions taking place that day?

It was the desperate attempt to appear liquid when all liquidity had evaporated

One could roll forward the price fixing from the previous working day, as happens during bank holidays in London. But during the financial crisis the interbank market had seized to function at all. For days, months, even years banks refused to lend each other and deposited their cash with their respective central banks instead, such was the mistrust towards each other. Bankers after all were the first in the crisis queuing to empty their bank accounts.

Strictly speaking, the business of one bank lending to another has never really recovered. The idea of basing rates on ‘real’ transactions between financial intermediaries is therefore a nonstarter. Sonia’s American sibling SOFR is no less of a teratism. The index is based on overnight bank-to-bank lending collateralised by Treasury securities, which means that the credit element is completely missing. Rates collected in such a way are not only much more volatile, they are also tied to the issuance of such securities. They reflect much more the US government cost of borrowing rather than the banks’. And SOFR covers the overnight rate only – a less than satisfying replacement for the three-month-dollar LIBOR for instance.

The broadly used EURIBOR and its little brother EONIA are essentially based on the information submitted by Europe’s biggest banks. Not much difference to the LIBOR then, but quite alarming that the pool of informing banks is shrinking rapidly. It consists now of only 15 of Europe’s banks, showing a tendency towards zero.

We have all learned to appreciate the practicality of indexing. Our rental agreements are indexed to inflation. We would love our bitcoin trove to be indexed to the US dollar lately and we’d wish to index our summer holiday bookings to good weather reports. As we can see with the two examples above, it is crucial that both parties to a financial transaction can agree on the underlying index. For banks giving credit it is important that their loan income will not undershoot their actual cost of money. Debtors will not wish to be taken for a ride when the banks’ refinancing costs get cheaper. As savers we too want to get commensurate compensation for our deposits, when on the other hand the banks start charging us more for overdrafts.

The wonderful thing about LIBOR was that as an index it was appealing not only to very different counterparties, it was also applicable to a broad range of financial transactions, such as futures, swaps, options and other derivatives.

LIBOR was so ubiquitous that a suggestion to base a loan on anything else was viewed with suspicion. I once lent money to a business, suggesting three-month-treasury bills as a reference. The borrower was sure I wanted to trick him and declined with a canny smile. This was two years before the Great Recession and as it soon became apparent, he would have fared way better had he agreed.

It is widely assumed though that LIBOR has reached its sell-by date. The Bank of England has stopped “compelling banks to submit LIBOR rates” and is determined to phase it out as a benchmark. Lawyers are tasked to draft financial contracts which will remain valid for the time after LIBOR. Clauses are introduced to pre-agree a change to other rate references, and many banks and some supra-national bodies have started to issue bonds based on SONIA and SOFR. At the same time many financial actors are adamant to keep LIBOR alive. London’s banks are determined to continue submitting rates, no matter what. New contracts are signed using LIBOR, and many a market participant is happy to announce the index’s immortality. So long as such attempts will not be outlawed LIBOR could well live happily ever after.

Its mortality threatens from a completely different corner. While the US will continue to weaponise its currency and to attach too many strings to its use for the Eurodollar market to thrive, the EU exit of the UK will hasten the migration of euro markets to the continent and remove the raison d’être for the presence of foreign banks in London. In succession US banks will increasingly move back to the US, and euro-focused banks will be forced to decamp to Europe. The London Interbank Market may become a rather lonely place. And the LIBOR a citizen of nowhere.

Andreas Weitzer is an independent journalist based in Malta. He reports on the economy, politics and finance. The purpose of his column is to broaden readers’ general financial knowledge and it should not be interpreted as presenting investment advice or advice on the buying and selling of financial products.

andreas.weitzer@timesofmalta.com