From deciding the alternative reference rates to designing products based on these, there are many hurdles
By Tasneem Chherawala
For the past three-and-half decades, LIBOR has ruled as the key reference interest rate for financial products. But, as per the diktat of the Financial Conduct Authority (FCA), the UK, it is set to retire on December 31. Why is LIBOR dying? How will the world be without LIBOR? What will be the transitional requirements and costs?
A number of developments have reduced regulatory confidence in the LIBOR. The global financial crisis in 2007 saw LIBOR diverging widely from other short-term risk-free rates like treasury yields and Overnight Index Swap (OIS) rates due to heightened perception of credit and liquidity risk. During the crisis, the significantly higher LIBOR volatility vis-à-vis other funding rates also became a matter of concern.
A number of LIBOR related scandals came to the fore post the crisis, involving global banks that had deliberately manipulated their quotes to either project financial soundness or to explicitly benefit from better valuations of their own exposures. Recently, as the interbank term borrowing volumes have shrunk, the LIBOR’s foundation on actual market transactions has also been questioned. Faced with its imminent death, the international financial markets are gearing up to phase it out and switch to alternative reference rates (ARRs). This is going to have major repercussions on close to $400 trillion of financial contracts outstanding as of 2021, whose pricing, valuation, accounting and risk management is currently linked to LIBOR.
RBI too has recently advised banks and FIs to ensure a smooth LIBOR transition. This is easier said than done. The first issue will be choosing the appropriate benchmarks to replace LIBOR. Working groups across jurisdictions have constructed and recommended multiple ARRs in different currencies—SOFR in the US, SONIA in the UK, TONAR in Japan and ESTR in Europe. Some of these are finding traction in financial deals, but nowhere near LIBOR’s. Financial Benchmarks India Ltd. (FBIL), the administrator of financial market rates in India, has started publishing the Adjusted and Modified MIFOR rates derived from SOFR. These will become the appropriate reference rates for relevant interest rate swaps post USD LIBOR cessation. However, for cash and derivative securities directly linked to LIBOR, the ARR choice will require careful consideration.
Another issue is identifying the current exposures to be impacted directly or indirectly by LIBOR replacement. RBI data shows that, as of December 2020, India’s total external debt was $563.5 billion and there was more than $2.5 trillion notional amount of FX and interest rate derivatives outstanding as of March 2020. It can be presumed that a substantial proportion of these are LIBOR linked exposures like external commercial borrowings, private and public bilateral and multilateral borrowings, FCNR (B) deposits raised by banks, currency interest rate swaps, etc. For those legacy deals and incremental exposures outstanding beyond the transition date, there will be legal issues of contract renegotiation.
This will entail not just agreeing to the appropriate fallback rates but adjustments to these rates, given that, term LIBOR has built-in credit, tenor and liquidity premiums whereas ARRs are purely risk-free overnight rates.
Banks will also have to quickly design products that reference ARRs, in line with regulatory expectations and market protocols, to use for new deals. Only a handful of the large Indian banks have taken an initiative with dollar-transactions linked to SOFR—viz, ICICI Bank and SBI for interbank money market deals; SBI for arranging an ECB for IOCL; and Axis Bank for a derivative trade.
The other focus will be with respect to modifications to internal models, processes and systems for valuation and risk management. Yield curves will need to be remodeled; spreads over ARRs will have to be re-estimated; historical rate volatilities used in Value-at-Risk models will have to be tweaked. The accounting and taxation impacts of these changes will need to be assessed.
The LIBOR transition will not be a cakewalk. The on-ground progress made by Indian entities that have substantial LIBOR exposure is not clear. The challenges involved in ensuring the regime transition are humungous and can lead to market disruptions unless adequate planning is done.
Assistant professor, National Institute of Bank Management