From LIBOR to SOFR: A Complete Transition

 

The Reserve Bank of India (RBI) has declared that various alternative reference tax rates will completely replace LIBOR. LIBOR (London Interbank Offered Rate) is the benchmark or reference rate which is used to determine other rates. It is calculated for seven maturities (overnight, 1 month, 2 months, 3 months, 6 months, and 12 months) and for five different currencies (US Dollar, Pound Sterling, Euro, Swiss Franc, and Japanese Yen). As a result, 35 rates were computed every business day using these. LIBOR plays a critical role in the global market since it was the benchmark rate for financial instruments like derivatives (forwards, futures, swaps, and options). For External Commercial Borrowings (ECB), it was specifically employed.

The RBI has asked banks and other financial institutions to discontinue using LIBOR and switch to a widely used alternative reference rate, such as the Secured Overnight Financing Rate (SOFR), by July 1, 2023. They are urged to make sure that none of their upcoming transactions, or those of their clients, depend on or are valued using the USS London Interbank Offered Rate. Additionally, MIFOR (Mumbai Interbank Forward Outright Rate), which is based on LIBOR published by Financial Benchmark India Pvt Ltd (FBIL), is not to be used by banks any longer. Commercial banks in India used MIFOR as a benchmark rate for specific financial contracts. Prices for forward rate agreements and derivatives are set using it. It combines a forward premium obtained from the Indian Foreign Exchange Market with the London Interbank Offered Rate. The USD LIBOR and the USD/INR forward premium were used to create a synthetic term Rupee rate. Additionally, banks and financial institutions are urged to take all necessary measures to ensure that fallbacks are inserted as soon as possible in any remaining legacy financial contracts that reference USD LIBOR, including MIFOR-referencing transactions. They must also have created the procedures and systems necessary to oversee the full move away from LIBOR. After June 30, 2023, The Financial Benchmark India Pvt Ltd. will stop publishing MIFOR. From June 30 of current year, LIBOR and MIFOR will both no longer be considered representative benchmarks.

RBI advised the banks to take this action because LIBOR is based on hypothetical figures set by international banks rather than actual transactions, i.e., the rate-setting banks present their estimates of the interest rates they would pay if they had to borrow money from another bank on the Interbank Lending Market in London each day. They may therefore be able to influence these rates to their advantage. A controversy involving big international banks manipulating LIBOR for their needs surfaced in 2012. Thus, LIBOR is being phased out as a result of rate-setting institutions' manipulations and its contribution to the worsening of the 2008 financial crisis. The benchmark or reference rate used by India to determine the rate for external commercial borrowings and other types of loans will be the SOFR as of July 1, 2023. The Secured Overnight Financing Rate is a general indicator of how much it costs to borrow money overnight when it is secured by US Treasury Securities. The Federal Reserve Bank of New York releases the SOFR, a transparent rate that accurately indicates the general financing circumstances in the overnight treasury repo market. It displays the financial costs associated with borrowing and lending for the vast range of market players who are active in the market. Of all the accessible treasury repo rates, it has the broadest coverage in terms of transactions The volume of transactions behind the Secured Offered Financing Rate eclipses the volume underpinning the London Interbank Offered Rate and is far larger than transactions in any other US money market. It is regarded as a more precise and secure price benchmark because it is based on actual transactions. So, SOFR and MMIFOR (Modified MIFOR) will be mostly used for the new transactions. There are several other alternatives to London Interbank Offered Rate.

1.     Secured Overnight Financing Rate (SOFR) for US Dollar

2.     Sterling Overnight Index Average (SONIA) for Pound Sterling

3.     Euro Short-Term Rate (ESTER) for Euro

4.     Swiss Average Rate Overnight (SARON)

5.     Tokyo Overnight Average Rate (TONAR) for Japanese Yen

These risk-free rates are based on active market transactions ie, the transactions that happen in the market, which provide a barrier against manipulations. Alternative rates are published at different times and are also currency-specific against LIBOR ie, if Federal Reserve is releasing it then it is especially for the US Dollar and if Switzerland is releasing it then it is especially for the Swiss Franc.

 Ms. Rajashree. V, Assistant Professor of Commerce, Al Shifa College of Arts and Science, Kizhattoor, Perinthalmanna.