It’s finally curtains down on the scandal-hit though ubiquitous LIBOR (London interbank offered rate), the benchmark rate used in determining the pricing of transactions worth 100s of trillions of dollars. 

From Monday, January 3, the first working day of the year for global financial markets, all new floating rate transactions in loans, bonds and derivatives will be priced with reference to alternative reference rates (ARRs) developed by regulators in the US, the UK, the EU, Japan and Switzerland.

The ARRs that have emerged are the Secured Overnight Finance Rate (SOFR) in the US, the Sterling Overnight Interbank Average rate (SONIA) in the UK, the Euro Short Term Rate (ESTR) in the EU, the Tokyo Overnight Average Rate (TONAR) in Japan, and the Swiss Average Rate Overnight (SARON) in Switzerland.

In India, the Reserve Bank of India (RBI), while directing the banks to stop using LIBOR based pricing from January 1, has allowed use of any widely accepted/alternate reference rate in the currency concerned for pricing of bonds and derivatives.

Simultaneously, the Mumbai Interbank Forward Outright Rate (MIFOR), published by the Financial Benchmarks India Private Limited (FBIL) with LIBOR as one of its components, too ceases to be used for new transactions.

State Bank of India (SBI) has proactively modified its systems and processes to embrace the change to ARRs from LIBOR, its managing director (international banking, technology and subsidiaries) Ashwini Kumar Tewari said.

SBI has already started offering ARR-based products to customers through its domestic as well as foreign branches. 

There is a key difference between ARRs and LIBOR. ARRs are overnight rates without a term structure and a credit risk component. The now ceased LIBOR, on the other hand, was a combination of credit risk premia, term premia and liquidity premia for fixed terms – overnight, one week, one month, two months, three months, six months and 12 months. Further, SOFR and SARON are secured rates, while Japan, the UK and Euro ARRs are unsecured. LIBOR was an unsecured reference rate.

To overcome the challenges in transitioning to ARRs, development of term rates to serve as reference rates and development of liquid financial markets linked to the ARRs is essential.

LIBOR had become increasingly unprovable with the banks participating in the daily survey-based polling themselves having considerable exposures in the very markets. The year 2012 was significant in shaking up the global financial markets as the benchmark used to price the floating rate loans, bonds and derivatives was found to have been manipulated, for almost a decade.

It took nearly a decade for the global financial market to phase out the scandal-ridden benchmark, which was first formally introduced on January 1, 1986. The winding down of LIBOR began in 2017 with the announcement of the UK Financial Conduct Authority that from the end of 2021 it would no longer legally mandate publication of LIBOR.

Most of the loans, bonds and financial instruments that were to outlive the cessation of LIBOR did not have fallback arrangements. These are expected to have been individually renegotiated and fall back clauses inserted. In the derivatives markets, conventions for adoption of fallbacks are more standardised due to actions by bodies such as the International Swaps and Derivatives Association (ISDA).

The tax authorities in the US have published guidance on issues that could arise on account of the transition. The Financial Accounting Standards Board too has issued guidance on certain accounting aspects that could arise from the renegotiation of LIBOR referenced contracts.

In India, exposures to LIBOR arise from external commercial borrowings, FCNR(B) deposits, derivatives. In November 2020, RBI had said preliminary estimates suggest that about $50 billion of debt contracts in the form ECB/FCCBs and $281 billion of derivative contracts will expire beyond 2021. These exposures may have increased as new contracts with LIBOR as the reference were signed subsequently.

In addition, the government has exposures linked to LIBOR. These include LIBOR-referenced loans availed from multilateral / bilateral agencies and lines of credit offered to other countries.

The Reserve Bank of India (RBI) has increased the spread above the reference rate it allowed to for borrowings as well foreign currency deposits by 50 basis points to provide room for adjustments given that there were bound to be transition issues.