Straight and Narrow: Why SONIA’s Shift Towards Bank Rate Matters
In the world of finance, there are often quiet signals that tell us more than the loud headlines. One of those signals is SONIA, the Sterling Overnight Index Average. SONIA is not a household name like the Bank of England’s Bank Rate, but for those who work in markets, it is just as important. In fact, SONIA is the reference point for trillions of pounds worth of contracts.
Since early 2025, something subtle but significant has been happening. The difference between SONIA and Bank Rate has narrowed to around three basis points, compared with five basis points in 2024. At first glance, that might look like a small technical change. But in reality, it tells us a lot about how monetary policy is working, how liquid the financial system is, and how markets are adjusting to a new era of lower reserves.
To understand why this matters, let us start at the beginning.
What exactly is SONIA?
SONIA is the average interest rate paid on unsecured overnight borrowing in sterling markets. In simple terms, it measures how much banks and financial institutions charge each other to borrow cash for just one night, without pledging any collateral.
It is called a risk free benchmark rate because it is based on actual transactions, not quotes or estimates. Since its reform in April 2018, SONIA has replaced LIBOR in most sterling markets, becoming the backbone of the United Kingdom’s financial system.
SONIA is not just for traders. It has a direct link to the wider economy:
Derivatives and swaps worth trillions are priced using SONIA. These instruments help banks and companies manage interest rate risk.
Loans and mortgages increasingly reference SONIA, particularly in corporate lending where floating rate structures are common.
Government debt and bonds are influenced by SONIA because investors use it as the base level for pricing risk.
When SONIA shifts, the effect ripples outward into the cost of borrowing for businesses, households, and ultimately the wider economy.
Why does SONIA usually sit below Bank Rate?
Bank Rate is the rate set by the Bank of England for reserves held at the central bank. Because reserves are risk free and remunerated at Bank Rate, overnight money market rates like SONIA tend to trade slightly below that level.
Why below? Because some lenders in the market, such as money market funds or non bank institutions, do not have direct access to deposit at Bank Rate with the Bank of England. They therefore accept a slightly lower rate in order to place their cash with banks that do have access. This creates a small but persistent spread.
In recent years, that spread has typically been around five basis points. But in 2025 it has narrowed to three. Understanding why is important for anyone following monetary policy.
What is driving the narrowing gap?
There are three main reasons.
Shrinking reserves
Reserves in the banking system have been falling. This is a result of quantitative tightening, as the Bank of England reduces the size of its balance sheet, and because of repayments on government and central bank schemes. With fewer reserves circulating, competition for short term funding has increased. That pushes SONIA higher relative to Bank Rate.
Think of reserves as the oil in an engine. When there is plenty of oil, everything runs smoothly with little friction. When there is less oil, the moving parts work harder, and the pressure rises. The narrowing spread between SONIA and Bank Rate is the financial equivalent of that rising pressure.
Repo market dynamics
The secured market, known as the repo market, has also played a role. In repo transactions, banks borrow cash in exchange for collateral such as government bonds. Repo rates have stayed close to Bank Rate, partly because the Bank of England offers its own repo facilities. These operations act as a stabiliser, preventing market rates from moving too far above Bank Rate.
Because repo is so closely linked to Bank Rate, unsecured rates like SONIA are constrained. They can rise as reserves shrink, but they cannot drift too far, because banks always have the option of borrowing through the Bank’s facilities.
A familiar pattern
This is not the first time we have seen such behaviour. During mid 2020, when reserves were shifting during the pandemic response, the spread between SONIA and Bank Rate also tightened. The current episode is consistent with the historical pattern that as reserves decline, SONIA edges closer to Bank Rate.
Why does this matter?
At first, three basis points might not sound like much. But in markets, it matters a great deal.
Transmission of monetary policy
The Bank of England raises or lowers Bank Rate to influence borrowing costs across the economy. For that policy to work, market rates like SONIA must respond in a predictable way. The tighter the link between Bank Rate and SONIA, the stronger and clearer the transmission mechanism. That means businesses and households feel the effect of monetary policy more directly.
Market stability
The fact that SONIA has moved closer to Bank Rate while repo markets remain stable suggests the system is functioning well. Even as reserves decline, there has been no sign of disorderly moves or volatility in overnight funding markets. That provides reassurance that the financial system can adapt to lower levels of central bank reserves.
A new normal
The Bank of England has made clear that it is learning from these developments. The current environment is uncharted territory compared with the years of abundant reserves after the global financial crisis and the pandemic. Monitoring the relationship between SONIA and Bank Rate is one way of judging whether the system is adjusting smoothly.
Real world impact
So how does this affect ordinary people?
For homeowners, mortgage rates are influenced by swap rates, which are linked to SONIA. A closer alignment with Bank Rate means that when the Bank of England adjusts policy, the change should feed more reliably into mortgage costs.
For businesses, loans priced off SONIA will also reflect policy changes more consistently. That helps companies manage their borrowing costs with more certainty.
For investors, SONIA is a benchmark for returns in sterling assets. A stable relationship with Bank Rate gives confidence that markets are functioning efficiently.
Final takeaway
The recent narrowing of the gap between SONIA and Bank Rate is not just a footnote in financial data. It is a signal that the Bank of England’s monetary policy is transmitting effectively, even as reserves decline. It shows that markets are adapting to a new normal of tighter liquidity conditions without instability.
SONIA may be a behind the scenes rate, but its behaviour is crucial for the wider economy. The closer it tracks Bank Rate, the more predictable and stable the financial environment becomes. And in a world where confidence and clarity are everything, that is good news for everyone.
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