LIBOR – Rest In Peace, What Next
The author can be reached at ptsmurthy@yahoo.com and eboard@icai.in.
1. Introduction, Global Scope & India’s External Debt Exposure
Reserve Bank of India also set up committee and entrusted the job to Indian Banks Association to evolve strategies to move swiftly to the new regime of Alternate Benchmark Rates. This article explores the LIBOR, the issue, various benchmark rates globally being proposed, the role of RBI sofar and the consequences and constraints. This article is useful for the accounting fraternity to properly guide their clients how they can easily, promptly, and effectively shift to the new regime.
Beyond the end of 2021, the Financial Conduct Authority (FCA), UK will not mandate Banks to poll LIBOR, the benchmark which has been used by all Banks/Financial Institutions in the world for financial foreign exchange contracts. These include derivate transactions, bonds, loan agreements both retail and corporate loans. The rate ruled the world for almost five decades. Unfortunately, this rate was found manipulated during the year 2012 by individuals at various financial institutions. As a corrective action, the FCA had decided to leave the LIBOR.
Scale of Global and Indian Exposures:
The quantum of LIBOR linked exposures globally is estimated to be around USD 240 trillion. At the end of June 2021, India’s external debt was placed at USD 571.3 bn. The External Commercial Borrowings is the largest component of external debt (37.4%) followed by Non Resident Deposits (24.8%). Short-term debt on residual maturity basis (i.e., debt obligations that include long-term debt by original maturity falling due over the next twelve months and short-term debt by original maturity) constituted 44.7 per cent of total external debt at end-June 2021.
Residual Maturity of Outstanding External Debt (as at end of June 2021)
| Residual Maturity | Amount in USD billion |
|---|---|
| Short term upto one year | 255.60 |
| 1 to 2 years | 54.30 |
| 2 to 3 years | 53.50 |
| More than 3 years | 207.80 |
| Total | 571.30 |
(Source: RBI press release dated 30.9.2021 on India’s External Debt as at the end of June 2021)
2. What is LIBOR & The Manipulation Scandal
What is LIBOR
London Inter-Bank Offered Rate is the average interest rate global banks base for their lending and borrowing from one another. The rate is calculated for five currencies namely, USD, Euro, British Pound, JPY and Swiss Franc for seven different maturities. They are overnight/spot, one week, one, two, three, six and twelve months. Thus, the total number of rates quoted on daily basis are five currencies multiplied by seven periods are 35. USD LIBOR is the most used floating interest rate globally.
It is calculated daily by ICE (InterContinental Exchange) by obtaining rates from Global banks how much they will charge for short term loans. They take the trimmed average meaning the highest and the lowest rates are trimmed, and the average of the remaining rates are taken for deciding the daily LIBOR rate.
Once they are finalized, these rates are announced every day at 11.55 am London time by the ICE Benchmark Administration. The methodology is well documented and unbiased. A panel consisting of 16 major banks active in the London market provide the rates.
LIBOR Issue
During the year 2012, a scandal came to light in quoting the rates by several major banks in collusion. It was reported that such events were taking place since 2003. The investigation showed that the traders were openly asking each other to set rates at a specified amount so that the positions based on inflated LIBOR rate will be profitable to them. Banks in the USA and UK who were involved in this scandal were fined to the tune of USD 9 billion.
What are Transitional Rates
After the scandal came to light several parties quoting their floating rates based on LIBOR, lost confidence in the rate. Finally, the ICE took over the supervision of the Rate from the British Bankers Association (BBA) and the rate quoted now is called ICE LIBOR.
Now each country is looking for bringing out an Alternate Reference Rate (ARR) for both short term and long-term contracts in the money market, derivative markets, bond markets or repo market and basing the mortgage and other loan agreements once the LIBOR is not available as a benchmark rate. A reference rate is a benchmark interest used to determine other interest rates.
3. Global Alternate Reference Rates (ARRs) Across Major Markets
The list below provides various Alternate Reference Rates (ARR) being devised by several countries:
| Particulars | USA | UK | EU | Switzerland | Japan |
|---|---|---|---|---|---|
| ARR | Secured Overnight Financing Rate (SOFR) | Sterling Overnight Interbank Average Rate (SONIA) | Euro Short Term Rate (ESTR) | Swiss Average Rate Overnight (SARON) | Tokyo Overnight Average Rate (TONAR or TONA) |
| Secured | Yes | No | No | Yes | No |
| Tenor | Overnight | Overnight | Overnight | Overnight | Overnight |
| Counterparties | Banks and non-banks | Banks and non-banks | Banks and non-banks | Banks only | Banks and non-banks |
(Source: The article “Libor: the Rise and the Fall – RBI Bulletin Nov 2020”)
USA – SOFR
This rate has been recommended by the Alternative Reference Rates Committee as a benchmark replacement to LIBOR. It measures the cost of borrowing monies from US treasuries against collaterals (Like our Repo Rate in India). Many major Banks in the USA such as Wells Fargo, JP Morgan, Citigroup have conducted transactions with this benchmark rate. It is reported that around USD 37 trillion in Futures, USD 700 billion in Swaps have already been concluded based on this rate.
UK – SONIA
These rates are chosen by a working group on Sterling Risk-Free Reference Rates as an alternate to LIBOR. It reflects the average interest rates that Banks pay to transact sterling currency in overnight markets from other financial institutions. Contracts to the tune of GBP 5.7 trillions were already traded in Futures markets based on this bench market rate.
EURO – ESTR
The euro short-term rate (€STR) reflects the wholesale euro unsecured overnight borrowing costs of banks located in the euro area. The €STR is published on each TARGET2 business day based on transactions conducted and settled on the previous TARGET2 business day (the reporting date “T”) with a maturity date of T+1 which are deemed to have been executed at arm’s length and thus reflect market rates in an unbiased way.
SWITZERLAND – SARON
It represents the overnight interest rate of the secured funding market for the Swiss Franc (CHF). (Swiss Average Rate Overnight) is an overnight interest rates average referencing the Swiss Franc CHF. It is based on transactions and quotes posted in the Swiss repo market.
JAPAN – TONAR
It is a risk-free rate (“RFR”) based on the uncollateralized overnight Call rate. In 2019, the Cross-Industry Committee on Japanese Yen Interest Rate Benchmarks, together with the Bank of Japan, held a public consultation on the choice of alternative benchmarks to JPY LIBOR, the results of which revealed an industry preference for two alternatives: the Tokyo Interbank Offered Rate (“TIBOR”) and the Tokyo Overnight Average Rate (“TONAR”).
4. Present Status of Transition & Comparative Analysis: LIBOR vs. SOFR
Dominance of the Greenback (USD):
The Greenback (USD) is the most traded currency in the world forex markets. 88% of global transactions include USD on one side of the transaction. The next comes EURO with 32.28% and JPY with 16.80%. US dollar denominated debt remained the largest component of India’s external debt, with a share of 52.4 per cent at end-June 2021.
The USD based contracts will shift to Secured Overnight Financing Rate (SOFR) once the LIBOR is eased out. The major differences in these rates are as under:
| LIBOR | SOFR |
|---|---|
| Bank to Bank Lending Rate including credit risk component. | Risk-free rate – base rate. Credit risk is not taken into consideration. |
| Forward-looking rate published daily from one day to one year. | Overnight – secured repo rate. Published on daily basis by Federal Reserve Bank of New York. |
| Term structure – available for seven periods. | No term structure (as of now). Based on overnight borrowing and lending in the US Treasury Repo market. |
| Based on the panel of Banks submissions and expert judgement. | Transaction based. |
| Based on roughly USD 1 Bn transaction per day. | Based on roughly USD One Trillion per day. |
| The rate is based partially on market data and expert judgement by the panel. | Relies entirely on transaction data. Calculated as a volume weighted median of transaction level data observed over the course of a business day, around 8 am Eastern Time. There is an option to republish the data in case errors are found. |
Multilateral Adoption & Derivative Protocols (ISDA 2020)
All financial institutions including Asian Development Bank have already worked out strategies for the transaction of their loan books linked to LIBOR to different benchmarks for the respective currencies.
The derivative transactions are governed by the guidelines issued by the International Swaps and Derivatives Association (ISDA). The counterparties to a derivative transaction need to execute an ISDA document that has listed guidelines regarding interest payments and the structure of the derivative transaction. ISDA 2020 IBOR (Interbank Offered Rate) Fallback Protocol had already set the guidelines w.e.f. 25.1.2021.
The method of interest calculation is also different in LIBOR and SOFR. In the case of LIBOR based financing, the benchmark rate is fixed in advance and the interest and principal amount are paid at the end of the period. The borrower will know his outgo of interest payment. In the case of SOFR based borrowing, the SOFR is not determined until the end of the periods as the SOFR to be applied is on day to day basis. In addition to the rate, credit risk premium need to be loaded to the rate.
5. Measures in India & FBIL Benchmark Framework
Reserve Bank of India appointed a committee in June 2013 headed by Shri P. Vijaya Bhaskar to review the financial benchmarks in India. Based on the committee’s recommendations, The Financial Benchmarks India Pvt Ltd. (FBIL) was set up to act as administrator for providing benchmarks in India in debt, interest rates and forex markets. The benchmarks pronounced by them are also used for the valuation of investment portfolios of the banks periodically.
| BENCHMARK | BASIS | DECLARATION |
|---|---|---|
| Overnight MIBOR | Based on Call money transactions | Daily basis. Announced at 10.45 am |
| Market Repo Overnight Rate (FBIL -MROR) | Based on basket repo trades | Daily at 10.45 am |
| Term MIBOR | Based on Pooling based submission by market participants | Daily basis at 11.45 am. Three tenors 14 days, 1 and 3 months |
| Reference Rate | USD/INR, EURO/INR, GBP/INR, JPY/INR | Daily at 1.30 pm |
| Forward Premia curve | USD-INR | Daily at Overnight, 1 to 12 months tenor. |
| MIFOR curve | USD LIBOR | Daily at Overnight, 1 to 12 months tenor at 4.15 pm |
In addition to the above benchmark rates, FBIL also announces benchmark rates for Treasury Bills, CDs, MIBOR-OIS, FC-Rupee Options Volatility Matrix and G-Sec valuations.
IBA Preparedness Workstreams
The IBA has since formed three workstreams on:
- (i) LIBOR transition arrangements
- (ii) Rates and methodology
- (iii) Outreach to market participants
IBA has also circulated a guidance note among its member banks to enable them to assess their preparedness for LIBOR transition on various parameters, viz., exposure assessment and assessment of the accounting, tax, information technology (IT) related implications. They have already communicated to the FICCI, CII and ASSOCHAM to advise their members to prepare for the transition.
Regulatory Ceilings Under Existing RBI Guidelines:
- External Commercial Borrowings (ECBs): Linked to LIBOR (maximum borrowing costs Benchmark rate + 450 bps) with Minimum Average Maturity Period ranging from 1 to 10 years.
- Trade Credits (Buyers’ Credit and Suppliers’ Credit): Benchmark rate plus 250 bps maturity ranging up to 3 years.
- FCNR Deposits: Interest Rate on FCNR deposits linked to LIBOR plus 200/300 bps.
- Interest Rate Derivatives: Several Interest Rate Derivative transactions would also be based on benchmark rates.
Government Sovereign & Multilateral Borrowings
The Government of India borrows from several international agencies and Countries such as Asian Development Bank, World Bank, International Development Association, International Bank for Reconstruction and Development, International Fund for Agricultural Development and IMF based on bench market rates. As of 31st December 2020, the total bilateral debt India owes is USD 30.5 Bn and multilateral debt of USD 67.9 bn. If these borrowings are based on benchmark rates, they need to be relooked into.
A shift away from LIBOR will necessitate a distinct set of risks affecting external commercial borrowings including trade credits, cross-currency swaps, LIBOR-linked interest rate swaps, corporate bonds, credit default swaps and even the LIBOR-based Mumbai Interbank Forward Offer Rate (MIFOR) contracts, FCNR deposit rates and the government borrowings for foreign counterparties.
6. Constraints, Operational Complexities & Accounting Standards Impact
The change in benchmark rates from LIBOR to other currency specific benchmark rates may not be a smooth transition. While new contracts entered into on new Alternate Reference Rate after ceasing to exit from LIBOR will yet to test the waters on its implications, where transition of existing contracts based on LIBOR to new ARRs are likely to have impact on Risk assessment, Tax implications, Control mechanism, change in protocols and preparedness of the present IT systems in the Banks to smoothly move to the new Bench mark rates.
Accounting and Legal Hurdles (US GAAP, IFRS & IND AS):
The accounting Authorities must come out what accounting methods to be amended either in US GAAP & IFRS as well in IND AS. It may also pose new interest rate risks and whether the financial institutions and the Banks and their counterparties are prepared for probable losses is yet be foreseen. The constraints are also foreseen in redrafting the ISDA agreement and redoing the entire exercise of the contracts which have been executed and likely to continue beyond 2021.
Portfolio Readjustment & Credit Rating Requirements
The corporates need to readjust their portfolios as they may have to hedge the additional exposures and meet the increased costs in lending after shifting to new benchmark rates. They must individually evaluate the transition process by understanding various contracts they have executed, legalities involved in renegotiating the rate and the contracts, measure the additional burden that may arise on costs. Banks must equally scan through their entire portfolios which were based on LIBOR benchmark rates and initiate discussions with the counterparties well in advance to mitigate any hiccups in transition.
The ICAI may also investigate the impact of these transitions on the accounting standards. Since the new alternate benchmarks have not considered the credit risk as component in basing the rate, a fresh credit rating may have to be undertaken by the corporates from International Agencies which are not only time consuming but also involving huge costs.
7. Reserve Bank of India (RBI) Directives & Action Plan
RBI Guidelines (Circular Dated 8th July 2021)
Reserve Bank of India vide circular dated 8th July 2021 had given the following steps to be taken by all the concerned such as Banks and financial institutions:
- (1) Cessation of New Contracts: They should cease entering into new financial contracts with LIBOR benchmark rates by December 31, 2021.
- (ii) Robust Fallback Clauses: They must include robust fallback clauses in all financial contracts that reference LIBOR and the maturity of which is after the announced cessation date of the LIBOR settings.
- (iv) Cessation of MIFOR: Banks have also been advised to cease using the Mumbai Interbank Forward Outright Rate (MIFOR), a benchmark which references the LIBOR, as soon as practicable and in any event by December 31, 2021.
- (v) Risk Management Restrictions: Contracts referencing LIBOR / MIFOR may generally be undertaken after December 31, 2021 only for the purpose of managing risks arising out of LIBOR / MIFOR referenced contracts undertaken on or before December 31, 2021.
8. Conclusion
The shift away from LIBOR is not as simple as it appears. All the stakeholders namely, Corporates, Financial Institutions, Banks, Regulators, Accounting Standard Authorities, Government need to address the issue fast and make them aware of the implications.
“Someone compared this transition as vital as the ‘Y2K’ transition which happened two decades ago. The time is ticking fast. The saying that ‘Cross the bridge once we come to it’ may not jell well in this situation.”
References
- (1) LIBOR: The Rise and the Fall – Article in RBI Bulletin November 2020.