Sonia Is Too Complex: Q & A With A Creator Of The Libor Replacement

AS BANKS PREPARE to move away from the scandal-tainted London interbank offered rate, few in the city of London will be watching more closely than William Porter.

- Emma Haslett

Now head of European credit strategy at Credit Suisse Group AG, Porter was working on J.P. Morgan’s short-term interest rate and strategy team in the mid-1990s as it searched for a way to hedge short-term floating-rate risks against European currencies.

Their solution was the sterling overnight index average, or Sonia. Earlier this year, the benchmark, which is considered impossible 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 the perfect 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 replicate overnight swaps that existed in France. There were two swaps traded against the average overnight rate that the Bank of France observed, known as TAM. Effectively, French market participants were hedging short-term, floating-rate risks and funding risks using those swaps.

We were trading a lot of foreign exchange forwards, which have two short-term interest-rate risks, at the time. Everything, by convention, goes back to the dollar. So you’ve got the underlying currency, and you’ve got the dollar, and we wanted a way to strip that out. We were looking at ways to do it using futures, but nothing really worked because of the funding element, and we had the brain wave of starting to trade on [the] Fed funds effective [rate] the way they were used to trading in France on this TAM rate. We just started doing that, so that started the dollar overnight index swap market in London.