Phasing Out of LIBOR

1. Historical Evolution and Determination of LIBOR

In 1984 the British Bankers Association (BBA) developed the BBAIRS (BBA Interest Rate Settlement Rates) upon request by the member banks for a reliable benchmark to be used for derivative transactions. Over a period of time this rate became London Inter Bank Offered Rate (LIBOR).

From January 1986 LIBOR started officially publishing rates for three currencies: USD, JPY and GBP. Through passage of time, two more currencies and further maturities were added. Currently rates are quoted for five currencies: USD, GBP, JPY, EUR and CHF.

LIBOR is the reference rate at which the panel banks indicate that they can borrow short term wholesale funds from each other. LIBOR is thus an interbank unsecured rate. The rationale for wide usage of LIBOR in the financial world is due to the fact that it represents the terms at which the world’s largest and financially sound institutions are able to obtain funds on a short-term basis.

Determination Process

LIBOR is determined daily through a process in which the member banks in the panel submit quotes at 11 AM (London time) in the morning for different currencies and maturities ranging from 1 day to 12 months, and an average of these rates so submitted is taken and published after certain adjustments.

The rates thus published are used as reference for a wide variety of financial transactions across the globe. It is estimated that an amount of USD 300 – 350 trillion of financial instruments in corporate debt, mortgages, variable rate loans, consumer loans, municipal debt and other derivative products across the globe are linked to LIBOR as the reference rate. LIBOR has become so important that it is sometimes referred to as the financial world’s most important number.

2. Rate Rigging Scandal, Regulatory Investigations & Loss of Trust

In 2010 the British Financial Services Authority (FSA) launched an investigation into allegations of manipulative practices followed by the member banks for determining LIBOR. The Department of Justice (DOJ) of the US and the UK Serious Fraud Office (SFO) investigated the member banks. A lot of US financial instruments are linked to USD LIBOR rate and hence the US had the authority to prosecute the member banks.

The investigations revealed that derivatives traders and employees of the member banks discussed and provided artificial rates that would benefit the traders instead of the rates that the bank would actually quote to borrow money. Banks also coordinated with other banks, something akin to a cartel, to alter the rates as well. This made the benchmark rate vary based entirely on the trader’s positions sometimes.

Further, during the global financial crisis of 2007-08, banks artificially quoted lower rates to appear that they can borrow money at lower rates to make the bank appear less risky and insulate itself from the global phenomenon. The investigation revealed facts which shocked the financial world as to the scale of wrongdoings and the benefits the member banks got by rigging the benchmark rate. It also shattered the trust the financial system had in the benchmark rates. Reports revealed manipulation could be traced as far back as 2003. There were no proper checks in place in determination of the rates and the conduct of the member banks, and the process relied on a self-policing mechanism left to the banks themselves.

3. Global Phase-Out Roadmap & Emergence of Alternate Reference Rates (ARRs)

In July 2017, the UK Financial Conduct Authority (FCA) announced that LIBOR would be phased out by the end of 2021. In April 2017, the Bank of England, as a part of its wider interest rate benchmark reform process, selected a risk-free Alternate Reference Rate (ARR) for GBP financial contracts and derivatives based on the Sterling Over Night Index Average (SONIA).

Over a period of time, various other Alternate Reference Rates (ARRs) have been developed by central banks across the globe. Each of the five LIBOR currency jurisdictions is working on the new rates and addressing the transition-related issues that crop up.

ARRs fundamentally differ from LIBOR:

• Transaction-Based vs. Subjective Judgment: ARRs are anchored in actual, observable overnight market transactions (either secured or unsecured), whereas LIBOR relied heavily on subjective hypothetical quotes and the judgment of panel banks.
• Risk-Free vs. Credit Premium: ARRs are designed to be near risk-free without any term premium or embedded bank credit risk, whereas LIBOR reflected the unsecured interbank credit risk of commercial banks.
• Tenor Structure: ARRs are predominantly overnight rates, lacking the pre-determined forward-looking term yield curve (1M, 3M, 6M, 12M) traditionally offered by LIBOR.

4. In-Depth Comparative Study: SONIA and SOFR vs. LIBOR

Sterling Over Night Index Average (SONIA)

This is the longest in existence of all the ARRs identified. Though this rate was in existence for more than two decades, it was not normally used as a benchmark. However, in 2017 it was selected as an alternate preferred risk-free rate as a replacement for LIBOR. The selection was made primarily because it is based on an active liquid underlying market; average daily volume in January 2020 was around GBP 150 Billion. The rate is administered by the Bank of England (BoE). This is an unsecured overnight rate produced by the BoE and is calculated based on actual transactions that banks pay to borrow pound sterling overnight from other financial institutions.

Though both LIBOR and SONIA are overnight rates, there are certain limitations for the latter. SONIA is based on past data and is backward-looking, whereas LIBOR was based on expected rates and forward-looking. The other major difference or drawback is that LIBOR is available across a range of maturities like 1 month, 3 months, 6 months and 1 year, etc. SONIA currently does not have any term rates except for the overnight rate. Work is currently underway to arrive at term rates of SONIA for different maturities and these rates are expected to be available in Q3 2020. This coincides with the timeline that FCA has set, that no new LIBOR referenced loans can be issued after Q3, 2020.

Secured Over Night Financing Rate (SOFR)

In 2014 the US Federal Reserve Board of Governors convened the Alternative Reference Rates Committee (ARRC) to identify an ARR to USD LIBOR. In 2017 the ARRC selected SOFR from various alternative rates and worked on an implementation plan for the adoption of SOFR in all financial products that reference LIBOR.

SOFR is based on overnight transactions in the USD Treasury repurchase (repo) market. The rate is produced by the Federal Reserve Bank of New York (FRBNY), and is based on an active, well-defined market where daily trading volumes are in the tune of USD 700 – 800 Billion. It is an exceptionally transparent rate based on actual observable transactions.

As in the case of SONIA in the UK, there are major differences between LIBOR and SOFR which cause difficulties in transition for contracts extending after LIBOR phase-out:

• Transaction vs. Expert Estimation: SOFR is entirely based on actual repo transaction data, whereas LIBOR reflected speculative quotes and expert projections of future funding costs.
• Single Overnight Rate vs. Seven Tenors: SOFR is a daily overnight rate, compared to LIBOR’s seven distinct term structures from overnight to one year.
• Credit-Free Treasury Risk vs. Bank Credit Risk: SOFR carries zero bank credit risk because it is secured by US Treasury collateral, whereas LIBOR incorporated an inherent bank credit-risk spread.
• Money Market Spikes: Being based on repo market liquidity, SOFR can be subject to quarter-end volatility and short-term liquidity spikes in the money market.

SOFR also currently lacks forward-looking term rates across various maturities. The ARRC proposed that FRBNY could construct a forward-looking term rate based on SOFR derivatives markets once trading in SOFR futures and swaps matures and achieves sufficient liquidity depth.

5. The Transition Challenge: Legacy Contracts & Market Depth

The transition from LIBOR to the ARRs will be a herculean task and will require coordination across all areas of financial and regulatory environments. The transition will have far-reaching implications across the globe, impacting accounting, reporting, regulatory compliance, taxation, corporate finance, and risk management.

Contracts based on LIBOR stretch far into the future beyond the discontinuation date. Market estimates indicate that contracts to the extent of USD 900 Billion will mature beyond 2021. There are also instruments with maturities stretching beyond 2030, and certain hybrid capital bonds are perpetual with no fixed maturity date.

Financial institutions and corporate borrowers must actively review legacy contracts extending past 2021 and incorporate robust fall-back clauses referring to the new ARRs, ensuring contracts can seamlessly transition beyond the sunset period.

Furthermore, fundamental structural problems arise from a liquidity and market depth perspective. Because LIBOR was a mandated benchmark, panel banks were legally obligated to submit daily quotes across all maturities. Conversely, because ARRs rely entirely on observable market transactions, certain longer-dated tenors may suffer on days when no actual transactions take place, creating severe liquidity handicaps.

6. Accounting, Valuation, and Financial Reporting Considerations

Financial Instruments Modification vs. Derecognition (IFRS 9 / Ind AS 109)

There are numerous accounting considerations that have to be taken care of around financial instruments. Amending a contract from LIBOR to a new ARR changes contractual cash flows and must be tested to evaluate whether the modified terms are substantially different from the original terms. This determines whether the change is treated as an amortized contractual modification or requires complete derecognition of the existing asset/liability and recognition of a new financial instrument.

Hedge Accounting & Discontinuation Risks (IFRS 9, IAS 39 & Ind AS 109)

Where debt exposures are hedged with interest rate swaps, hedge documentation must be updated to reflect the new benchmark rate. Entities must evaluate whether the economic relationship remains effective or whether the hedging relationship must be discontinued, which would trigger the recycling of accumulated gains/losses in Other Comprehensive Income (OCI) into the profit and loss statement.

Debt covenants must also be closely monitored to ensure that variations in interest benchmarks do not trigger involuntary covenant breaches, requiring advance negotiations with lenders to secure adequate covenant headroom.

Discount Rates in Valuation Models

LIBOR is a foundational component for constructing discount rates in valuation models across corporate finance, including impairment testing of goodwill and intangibles, fair value measurements of financial assets and liabilities, and pension obligation discounting. Existing models will require systematic recalibration once LIBOR ceases publication.

7. Indian Legal & Regulatory Dimensions: Transfer Pricing, FEMA, ECB, and MIFOR

Transfer Pricing and CBDT Safe Harbour Rules

Over a period of time and across numerous judicial rulings, Indian tax tribunals and courts have accepted LIBOR as an arm’s length benchmark for intragroup cross-border financial loans and corporate guarantees. Phasing out LIBOR introduces immediate ambiguity into transfer pricing determinations.

The core challenge lies in calculating the appropriate spread over the ARR, which must factor in customer credit risk, maturity period risk, and liquidity premiums. In the initial years, thin transaction volumes may make these spreads contentious and prone to litigation. Assessees must renegotiate intercompany loan agreements to include transition mechanisms.

On 20 May 2020, the Central Board of Direct Taxes (CBDT) notified the Safe Harbour Rules for AY 2019-20, which explicitly reference LIBOR plus a credit-rating spread. As new contracts shift to SOFR and SONIA, the CBDT must urgently issue modified Safe Harbour Rules for 2020-21 with calibrated spreads tailored to risk-free ARRs.

RBI FEMA Regulations: External Commercial Borrowings (ECBs)

Under the Reserve Bank of India (RBI) Master Direction on External Commercial Borrowings, ceiling limits on All-in-Cost (AIC) are capped at 450 basis points over the benchmark rate (defined as 6-Month LIBOR or equivalent interbank rate).

In the revised scenario, the RBI will need to:

1. Formally recognize new ARRs (such as SOFR) and determine specific revised AIC spreads to account for the gap between risk-free rates and historical credit-inclusive LIBOR;
2. Address currencies where the chosen ARR lacks a pre-determined 6-month term rate; and
3. Grandfather existing legacy ECBs maturing beyond 2021 so that borrowings compliant when contracted under the LIBOR framework do not involuntarily fall into non-compliance upon benchmark cessation.

Mumbai Inter Bank Forward Rate (MIFOR)

MIFOR is published by Financial Benchmarks India Pvt Ltd (FBIL) under RBI authorization and serves as the core benchmark for pricing currency swaps and forward rate agreements in Indian financial markets. MIFOR is calculated by compounding the overnight USD LIBOR rate with the domestic foreign exchange forward premium.

Discontinuing USD LIBOR directly undermines MIFOR. The domestic derivatives market must formulate an alternate benchmark (such as Modified MIFOR linking SOFR with forward premiums) to avert systemic disruption in foreign exchange hedging.

Indian Corporate Exposure & IBA Working Group

In 2019, the Indian Banks’ Association (IBA) constituted a dedicated working group to prepare an operational transition roadmap and guidance notes for banks and corporate borrowers.

Market estimates indicate that cross-border financing contracts totaling approximately USD 500 Billion are negotiated between Indian companies and offshore lenders. Sectors heavily reliant on long-term foreign currency borrowings—particularly infrastructure and housing finance—face acute exposure and must prioritize contract remediation.

8. Conclusion: The Financial World’s Y2K Moment

Every change is hard to overcome; the phasing out of LIBOR—which has been the benchmark and considered the gold standard of the global financial framework for decades—will be even more challenging. The transition from LIBOR to ARRs will be a challenge of daunting proportions. This is the Y2K problem of the financial world, only this time the deadline is 31 December 2021.

The stakes are exceptionally high, and transition planning must be highly effective to prevent market chaos and legal paralysis. In the limited time available, the COVID-19 crisis diverted significant attention of both regulators and financial institutions. However, despite the pandemic, the FCA and Bank of England reiterated in March 2020 that the 31 December 2021 sunset date remains unchanged.

Despite administrative restructuring and enhanced controls around LIBOR after the rate-rigging scandals, these measures could not reverse the erosion of market trust. The death of the benchmark is inevitable. All stakeholders—banks, corporate treasuries, borrowers, auditors, and regulators—must proactively execute their transition roadmaps. While some degree of turbulence is unavoidable, meticulous preparation will mitigate hardships and ensure financial stability.

References & Regulatory Documentation

1. United States Department of Justice (DOJ) Enforcement Press Release: Five Major Banks Agree to Parent-Level Guilty Pleas in Rigging of Foreign Exchange and Benchmark Rates – https://www.justice.gov/opa/pr/five-major-banks-agree-parent-level-guilty-pleas
2. UK Financial Conduct Authority (FCA) Policy Statements on LIBOR Transition and Ceasing Publication Post-2021 (Andrew Bailey Speech, July 2017)
3. Bank of England (BoE) Working Group on Sterling Risk-Free Reference Rates: Technical Specifications for SONIA Compounded Indices and Term Rates
4. Federal Reserve Bank of New York (FRBNY) & Alternative Reference Rates Committee (ARRC): SOFR User Guide and Implementation Plan for Cash Products
5. International Accounting Standards Board (IASB): Interest Rate Benchmark Reform – Amendments to IFRS 9, IAS 39 and IFRS 7 (Phase 1 & Phase 2)
6. Central Board of Direct Taxes (CBDT), Ministry of Finance, Government of India: Safe Harbour Rules Notification dated 20 May 2020 for Assessment Year 2019-20
7. Reserve Bank of India (RBI): Master Direction – External Commercial Borrowings, Trade Credits and Structured Obligations (FED Master Direction No.5/2018-19)
8. Financial Benchmarks India Pvt. Ltd. (FBIL): Computation Methodology and Governance Architecture for Mumbai Inter Bank Forward Rate (MIFOR)