The London Inter-Bank Offered Rate (LIBOR) is the most common bench-mark interest rate index used for Corporate and Government Bonds, mortgages, student loans, credit cards, derivatives and other Financial Products. It serves for maturities from Overnight to 1 year and on each day there are 35 different LIBOR rates published by British Bankers Association (BBA).
The BBA officially adopted LIBOR in 1986 and established a governance system where traders at banks were asked to estimate the rate at which they could borrow funds. It then became a standard benchmark in the derivatives market.
LIBOR is presently administered by ICE Benchmark Administration (IBA) and is regulated by the UK’s Financial Conduct Authority (FCA).
A total of $ 400 trillion of financial products are presently exposed to LIBOR. In India we have about $532 billion of external loans which are exposed to LIBOR. Of this $400 trillion, at least $52 trillion of financial products will still be exposed to LIBOR after December 31, 2021.
In July 2017 Governor of Bank of England Andrew Bailey announced that by end of 2021 FCA would no longer seek to compel or persuade panel Banks to submit quotes for LIBOR, making it clear that reliance on LIBOR could no longer be assured beyond this date.
LIBOR’s limitations
Susceptibility to manipulations: The LIBOR rate setting system was tainted by the rate-rigging scandals where panel banks submissions were alleged to be inaccurate or manipulated to project market strength and for other proprietary purposes which led to breach of market trust. Following the 2012 Wheatley Review, a number of reforms were introduced aimed at reducing subjective input and making LIBOR a transaction based benchmark. IBA became LIBOR’s administrator and FCA the supervisory authority for IBA.
Illiquidity: Despite the reforms introduced the number of transactions in the short term wholesale Funding Market reduced over time, as financial institutions became more reluctant to lend on unsecured basis for terms longer than overnight. Thus LIBOR became more vulnerable to short-term market illiquidity and amplification of price moves. This could cause systemic risks.
Challenges to LIBOR as a risk free rate: Financial transactions are better suited to reference rates that are close to risk free.
The FCA confirmed on March 5, 2021 that 26 LIBOR settings will end on December 31, 2021 while June 30, 2023 is the last date for overnight, 1, 3, 6 and 12 Month US Dollar Libor settings. The extended publishing of certain LIBOR settings on a synthetic basis will provide relief only for certain types of tough legacy contracts that are difficult to renegotiate or amend or where there is no suitable alternative. These cannot be used for any new contracts. These announcements bring the markets one step closer to the cessation of the LIBOR.
Alternative reference rates
The new Benchmarks are: (1) USD - SOFR; (2) CHF - SARON; (3) EUR - ESTER; (4) GBP - SONIA (Already in use since March 31, 2021); (5) JPY - TONA.
All these benchmarks are having an overnight tenor as opposed to LIBOR which had a tenor from overnight to 1 year. While LIBOR, which is administered by ICE Benchmarks Administration, is an unsecured reference rate submitted by panel banks with different maturities and built in credit risk, SOFR is an overnight secured reference rate administered by the New York Fed that broadly measures the borrowing cash overnight with US treasuries as collateral. SOFR is transaction based, collateralized and representative of wholesale borrowing.
There are certain limitations to SOFR. Since it is based upon the repurchase repo markets it is at the repo markets mercy. In September 2019 a spike in repo rates resulted in SOFR soaring from 2.14 per cent to 5.25 per cent in a single day. Fed intervention helped to smoothen out spikes.
Also there is no forward curve to SOFR as opposed to LIBOR which offered a full forward curve which gave the market an ability to borrow at term rates for various time increments like 1, 3 and 6 months while SOFR is an overnight rate offering no term rates of any kind.
LIBORs and ARRs are calculated using separate methodologies and therefore there may be differences between the published rates of the two benchmarks. While LIBOR has three components: (a) Credit risk Premium, (b) Term Premium, (c) Risk Free Rate ARRs are considered as risk free and do not incorporate the other two.
Managing transition
The transition from LIBOR is by the market and RBI has issued two circulars giving the road map to the transition and arrangements to be made for the same.
There are multiple complexities involved in the shifting from one regime (LIBOR) to another regime (ARR) and there could be a lot of volatility in the financial markets as we approach the deadline. Companies/Organisations are required to be ready for this transition so that they do not have to face the music at the last moment.
The writer is Head of Treasury, Finrex Treasury Advisors. Inputs by V Thiagrajan, CEO Quantum Trends