A Guide to SONIA/EURONIA and OVERNIGHT INDEXED SWAPS

The WMBA provides indices that benchmark the cost of funds in the overnight sterling and euro markets. With the backing of the British Bankers’ Association, SONIA was introduced by the WMBA in March 1997 and EURONIA in January 1999. Their development is intended to stimulate the market in Overnight Indexed Swaps in the money markets.

Data is available from the following sources:

What are SONIA/EURONIA?
They are the Sterling Overnight Index Average (SONIA) and the Euro Overnight Index Average (EURONIA). These indices track actual market overnight funding rates. The indices help product developments which reduce risk and increase transparency.

SONIA is the weighted average rate to four decimal places of all unsecured sterling overnight cash transactions brokered in London by WMBA member firms between midnight and 4.15pm with all counterparties in a minimum deal size of £25 million. EURONIA is the weighted average rate to four decimal places of all unsecured euro overnight cash transactions brokered in London by WMBA member firms between midnight and 4.00pm London time, with all counterparties.

The indices are weighted average overnight deposit rates for each business day. Each rate in the average is weighted by the principal amount of deposits which were taken on that day.

Which trades are eligible for SONIA/EURONIA?

Eligible trades are those arranged between 0000hrs and 1615hrs (SONIA) and 0000hrs and 1600hrs (EURONIA) London time on settlement day, where repayment is made on the following business day. Both indices are published at 1700hrs each day.

What are the key features of these benchmarks?
They are credible and transparent, and mirror actual overnight funding.

What is an Overnight Indexed Swap (OIS)?
An OIS is a fixed rate interest rate swap against a floating rate index, e.g. SONIA or EURONIA. It replicates a mismatched deposit position through either -

• a short-term loan funded by an overnight deposit, or
• an overnight loan funded by a short-term deposit

In this way, OIS allow banks to manage their liquidity requirements more effectively.

What are the steps in an OIS trade?
The two parties to an OIS contract agree to exchange the difference between the interest accrued at an agreed fixed interest rate for a fixed period – say 3 months – on an agreed notional amount, and the interest accrued on the same amount, by compounding an index daily over the term of the swap. Settlement is made net at an agreed date after maturity (in the sterling market settlement is on the maturity date) so the principal never changes hands.

How important are OIS?
The importance of OIS stem from their impact on activity at the overnight end of the yield curve. This means that overnight interest rate risk can be managed off-balance sheet, thereby allowing money market participants -

• reduced credit risk
• reduced capital charges
• enhanced liquidity and gearing
• reduced use of credit lines
• lower transaction costs

Importantly, the ability to separate interest rate decisions from balance sheet decisions increases banks’ flexibility.

How will the indices benefit risk managers?
OIS allow the interest rate risk profile of a portfolio to be changed as if by the addition of a cash asset or borrowing, but with no use of cash and with minimal use of credit. These features allow much better risk management and allow active trading or market-making of OIS as a derivative instrument. They can increase liquidity along the money market curve and reduce systemic risk relative to the cash alternatives.

Do OIS improve liquidity?
Liquidity requirements can be managed more effectively with OIS. They allow term deposits to be raised thus improving liquidity ratios but without locking in the term interest rate. This procedure involves paying the fixed rate on the term funds and then, through an OIS, receiving the overnight floating rate.

Do OIS trades help the repo book?
OIS can simplify the risk management in the repo book. An overnight or open repo allows collateral to be changed daily, whilst an OIS fixes the rate for a term (although a basis risk still exists). Collateral can be changed overnight, but a fixed interest rate can be maintained; or a term repo can be indexed to overnight rates.

What other benefits will the indices have for the derivatives markets?
An OIS provides more accurate forward-forward rates with which to quantify market expectations about future rates and produce a clearer forward curve. As OIS are derivatives, they are likely to be more liquid than cash and will therefore trade at narrower spreads.

Will fund managers benefit?
Having an internal benchmark against which to manage interest rate risk in short-term portfolios will benefit fund managers. Often, the sharper the overnight rise, the less sustainable it is seen to be, and the less it is reflected in the futures. This makes futures a poor hedge for funding risk. By contrast, paying fixed and receiving floating in an OIS exactly compensates for rises in overnight rates.

What type of formal documentation is required?
Currently, most OIS structures are completed using International Swaps and Derivatives Association (ISDA) documentation.

How large is the OIS market and what are the dealing spreads?
Current sterling OIS volume is estimated at £3 billion x 3 month equivalent per day (or £9 billion x 1 month equivalent, etc). Volume in euro OIS in London is estimated at 100-150 billion x 3 month equivalent per day. Much of this volume stems from the interbank market as the product is particularly suitable for financial institutions’ asset and liability management operations in the money market. It is anticipated that OIS will become more popular with non-bank treasury teams looking for more flexible ways of interest rate management at the short end of the yield curve.

Spreads for both sterling and euro OIS are normally quoted three points wide in all maturities, narrowing to one or two points if a dealing interest is shown. In general, there is a liquid market out to two years and quotes are available to 10 years.

Are OIS good for positioning?
OIS are an excellent positioning tool for putting on carry trades or expressing a directional view. Since the floating leg exactly follows overnight rates, central bank rate reductions or increases can be directly exploited.

How do sterling OIS trades affect money market funds?
With the development of both the gilt repo market and SONIA, sterling overnight rates have stabilised and led to the growth of money market funds. In the past, the lack of a benchmark and the lack of investments of short enough duration impeded money market fund progress. SONIA’s development, together with the growth in OIS trades, has helped to neutralise these problems.

Why are OIS better than term deposits?
Investment institutions prefer using OIS funding because of its flexibility. Aside from flexibility gains, OIS can have cost benefits if the forward curve is considered too steep. Term deposits of any maturity available can be taken and restructured to the desired maturity using OIS. Overall, institutions can gain from credit, liquidity, capital and cost drawbacks that arise from on-balance sheet interest rate management.

Is there a standard confirmation?
The BBA is working to develop a standard confirmation which is compatible with ISDA documentation.

Historical data is available by clicking SONIA EURONIA.