Transition from LIBOR to … …

The London Interbank Offered Rate (LIBOR) was originally considered as a very systematic and well-managed international benchmark interest rate for a large volume and variety of financial products and contracts including derivative products, syndicated corporate loans, sovereign bonds, etc.

LIBOR was earlier calculated by adopting a polling method. At a specified time quotations were gathered by the Intercontinental Exchange (ICE) from about 16 to 18 major banks that have a significant role in the London market for their charge rates if they were to lend money in five major currencies—US dollar, Euro, British pound, Japanese yen, and Swiss franc—for seven different maturities: overnight/spot next, one week, and one, two, three, six and 12 months. The extreme rates were removed and the remaining rates were averaged to determine a median borrowing rate. This was announced each morning as LIBOR, at around 11.55 am by the ICE Benchmark Administration.

This procedure went on well for quite some time. But with the eruption of the LIBOR scandal of 2012 that sent shockwaves across the global financial markets, the flaw in arriving at the LIBOR rate came to light. It was revealed that major bank players—Citi Bank, HSBC, Barclays Bank, Deutsch Bank, and JP Morgan— colluded amongst themselves for garnering benefit by quoting mutually decided rates to the market officials. Once this manipulation came to light, market-participants lost their confidence in this widely used benchmark rate.

This string of LIBOR-related scandals made market players feel like going for a new alternative benchmark rate. But replacing LIBOR turned out to be not that easy, for almost all of the then-existing loans were benchmarked against LIBOR. However, in 2017, the US Federal Reserve introduced the Secured Overnight Financing Rate (SOFR) as an alternative to LIBOR. In the same year, the LIBOR regulator announced that LIBOR would be discontinued by December 2021. As a sequel to this, the Reserve Bank of India issued instructions to banks and other RBI-regulated entities to stop entering into new contracts that use LIBOR as a reference rate (as soon as possible) and latest by December 31, 2021.

This had, of course, created a lot of commotion in the market. For, this entailed two challenges: one, it called for banks to ensure that existing contracts in which LIBOR was the reference rate and the contracts fall due after the date on which LIBOR ceases to be effective contain Fall-back Clauses; and two, in the event of its absence banks to ensure that a new benchmark rate is identified, financial risks thereof are mapped along with identification of legal risks involved post the adoption of the new benchmark. Coming to the new contracts, banks have by and large adopted SOFR—a benchmark interest rate for dollar-denominated derivatives and loans arrived at based on observable repo rates—as a replacement for LIBOR.

Simultaneously, the use of LIBOR-based Mumbai Interbank Forward Offer Rate (MIFOR) was restricted to certain specific purposes such as transactions executed to support risk-management activities such as hedging, market-making in support of client activities, etc. They were also to assess the risk emanating out of LIBOR-linked contracts and place a framework in force to handle risks arising from such exposures. Banks are also required to create the necessary infrastructure to offer financial products linked to ARR. All this is a real challenge, which the banks are navigating through with the advisories offered by RBI.

Against this backdrop, and expecting that banks have developed the necessary wherewithal to manage the complete transition away from LIBOR, RBI issued a circular on May 12 asking banks and other financial institutions “to ensure that no new transaction undertaken by them or their customers rely on or are priced using the US $ LIBOR or the Mumbai Interbank Forward Outright Rate (MIFOR)” from July 1, 2023. They were also advised “to take all necessary steps to ensure insertion of fallbacks in all remaining legacy financial contracts that reference US$ LIBOR (including transactions that reference MIFOR)”.  

This complete move to alternative benchmark rates from LIBOR will take a while for banks to settle on the alternatives. Although SOFR is less likely to be manipulated since the treasury repo market is one of the most liquid markets, it is “backward-looking”. Secondly, there is an argument against Term SOFR that it lags in a rising rate environment. Of course, it is also true that the reverse happens in a decreasing rate environment and thus some argue that over a period of a few years, this difference might average out. Nevertheless, navigating through these nuances is a big challenge for Indian banks.

 

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