Transitioning from LIBOR

Context: 

The RBI stated that some banks and financial institutions were yet to facilitate an absolute transition away from the London Interbank Offered Rate (LIBOR) benchmark.

Both LIBOR and MIFOR (Mumbai Interbank Forward Outright Rate) would cease to be a representative benchmark from June 30 this year.

About LIBOR: 

• LIBOR is a global benchmark interest rate that combines individual rates at which banks opine they may borrow from each other (for a particular period of time) at the London interbank market. 
• It is used as a benchmark to settle trades in futures, options, swaps and other derivative financial instruments in over the counter markets (participants engaging directly without using an exchange) and on exchanges globally. 
• Consumer lending products including mortgages, credit cards and student loans, among others, too use it as a benchmark rate. 
• Every business day before 11 a.m. (London time), banks on the LIBOR panel make their submissions to news and financial data company Thomson Reuters.
• Following the submission, the contributed rates are ranked. Extreme quartiles, on the top and bottom, are excluded and the middle quartiles are averaged to derive the LIBOR. The idea is to be as close to the median as possible.

What was the controversy around it? 

• The central flaw in the mechanism was that it relied heavily on banks to be honest with their reporting disregarding their commercial interests.
• The phenomenon was particularly on display during the 2008 financial crisis when submissions were artificially lowered amid the crisis
• The Wall Street Journal too had studied in 2008 that several panellists were paying significantly lower borrowing costs than what other market measures were suggesting.
• Another observed phenomenon was the tendency to alter (higher or lower) the submission as per the entities’ trading units’ derivative positions to acquire more profits.

Alternative to LIBOR: 

• In 2017, the U.S. The Federal Reserve announced the Secured Overnight Financing Rate (SOFR) as a preferred alternative. 
• Accordingly, in India, new transactions were to be undertaken using the SOFR and the Modified Mumbai Interbank Forward Outright Rate (MMIFOR), replacing MIFOR.
• As stated by the International Finance Corporation (IFC), it is based on observable repo rates, or the cost of borrowing cash overnight, which is collateralised by the U.S. Treasury securities. 
• Thus, making it a prevailing transaction based rate and drifting away from the requirement of an expertise judgement as in LIBOR. 
• This would make it potentially less prone to market manipulation.

India’s Response:

• RBI had asked banks to assess their LIBOR exposures and prepare for the adoption of alternative reference rates. 
• Contracts entered after (or before, if possible) December 31, 2021, were not to use the LIBOR as reference rate. 

 News Source: The Hindu