Posted on: March 3, 2022 | By: M Vaseem Sheikh Head, Treasury Sales Federal Bank
1. What is LIBOR?
LIBOR stands for London Interbank Offered Rate and is published by the Intercontinental Exchange (ICE) Benchmark Association, UK. It is currently the accepted key benchmark interest rate for borrowing between banks in the international market. LIBOR is also the basis for FCY loans in countries around the world, thus impacting consumers as much as Financial Institutions. LIBOR is published for major currencies in different tenors (overnight, 1-week, 1- month, 3-months, 6-months, 1-year). The 3-months term is most common.
LIBOR is used worldwide in a variety of financial products including:
2. Why are regulators vouching for the markets to stop using LIBOR?
LIBOR was subject to a lot of criticism due to its susceptibility to manipulations. Regulators had concerns about the long-term sustainability of the benchmark and therefore decided to pre-empt any further possible deterioration by switching to other reference rates.
3. As from when will LIBOR no longer be published?
LIBOR for Sterling, Euro, Yen and Swiss franc will cease to be published on 31st December 2021, while US Dollar LIBOR will cease on 30th June 2023.
4. Which rates are likely to replace LIBOR?
Regulators want market participants to use rates based on overnight, virtually risk-free rates. The following ARRs (Alternative Reference Rates) have been identified by various jurisdictions for their respective local currency:
|Currency||Approved ARR||Published by|
|US Dollar||SOFR (Secured Overnight Funding Rate)||Federal Reserve Bank of New York|
|Sterling||SONIA (Secured Overnight Index Average)||Bank of England|
|Euro||€STR (Euro Short-Term Rate)||European Central Bank|
|SARON (Swiss Average Rate Overnight)||SIX Swiss Exchange|
|Yen||TONAR (Tokyo Overnight Average Rate)||Bank of Japan|
5. What are ARRs and how do they differ from LIBOR?
|Overnight Deposits||Interbank Offered Rates overnight to 1 year|
|Calculated in arrears / backward looking||Forward looking|
|Risk Free or nearly Risk Free||Incorporates Credit Risk|
|Transaction based||Submission or partly transaction based|
|Future cash flow based on compounding in arrears||Term Rate, certain future cash flows set by each tenor|
6. What the market participants need to do?
First of all, assess the entire portfolio (Assets & Liabilities) which is benchmarked to LIBOR currently and filter the impacted ones basis the currency-wise cessation dates. All the Deposits, Loans & Derivatives need to be taken in account for the assessment.
7. What will happen to existing impacted trades?
All the impacted trades (deposits, loans, derivatives) need to be moved to respective ARRs post the cessation date. The counterparties for deposits & loans need to mutually decide on adopting new ARRs/spreads. The transition to new ARRs for derivatives will be guided by ISDA (International Swaps & Derivatives Association).
8. What should be the preparedness for adopting the new ARR regime?
Majorly it’s to build the required IT infrastructural capabilities to take care of the ARR world. As the benchmark is daily rates, compounding of daily rate, calculating in arrears, adoption of calculation methodology (lookback/lockout) are key features. Building of risk management solutions to take care of valuations is also an important development which needs to be taken care of. Fresh legal contracts/addendum needs to be executed.
9. Whether I can take new LIBOR exposures as for USD, the expiry is June, 2023? Various regulators have advised not to take any fresh LIBOR exposures as the extension in cessation (specially for USD) is provided mainly to take care of legacy trades. Hence fresh exposures to be referenced to ARRs. Term ARRs also have been developed to provide ease to some of the products (specially trade finance).
10. What are the changes envisaged on Indian landscape on this space?
Reserve Bank of India (RBI) has already urged the market participants to prepare themselves to move away from LIBOR. Indian Bank Association (IBA) is spearheading this development for Indian markets. The products like Trade Credit and ECB which has an all-in-cost regulatory ceiling, will require a fresh guidance from RBI. At the same time a unified approach for interest calculation methodology for various loan products is also warranted. Trade Finance products are recommended to use Term Rates instead of overnight ARRs due to its inherent product demand. Modified MIFOR (Mumbai Interbank Forward Outright Rate) will be the benchmark for derivatives on ARRs, whereas Adjusted MIFOR will support the legacy trades slated for transition to ARRs.