[Answered] Describe the role of the London Interbank Offered Rate (LIBOR) in global finance. What led to the decision to move away from LIBOR? Also, highlight the key features of the Secured Overnight Financing Rate (SOFR) that make it a preferred alternative to LIBOR?

Introduction: Provide a contextual introduction of LIBOR
Body: Write 3-4 points on the importance of the role played by London Interbank Offered Rate (LIBOR) in global finance. Write 2-3 reasons behind moving away from LIBOR. Write 2-3 points on significance of SOFR over LIBOR.
Conclusion: Provide a neutral conclusion that suggest a way forward for India.

LIBOR is a global benchmark interest rate that combines individual rates of banks so that the individual banks may borrow from each other on the London interbank market.

Role in global finance:

  • As a benchmark, LIBOR is used to settle trades in futures, options, swaps, and other derivative financial instruments in both over-the-counter markets in which there is direct transactions without the use of an exchange and on exchanges around the world.
  • LIBOR is used as a benchmark rate for consumer lending products such as mortgages, credit cards, and student loans, among others.
  • Banks and private companies would use LIBOR as benchmark interest rate to obtain funds from abroad.

Why do financial regulators want banks to move away from LIBOR?

  • RBI has asked banks to move away from London Interbank Offered Rate (LIBOR) and Mumbai Interbank Forward Outright Rate (MIFOR) and adopt a more widely accepted Alternative Reference Rate, such as the Secured Overnight Financing Rate (SOFR) by July 1, 2023.
  • It is also believed that LIBOR played a big role in worsening the effects of the 2008 Financial Crisis.
  • The Financial Conduct Authority of the UK also suggested that LIBOR settings (interest rates) would cease to be operative after allegations of malpractice by paneled banks. It was found that banks had indulged in financial misconduct like significantly lowering the borrowing costs and tendency to alter trading units’ positions to maximize profits.
  • Indian banks are adding fallback clause to their existing foreign loan arrangements for ensuring smooth transition away from LIBOR.
  • Finally, the main flaw was that the arrangement relied on banks to be completely transparent about their interest rates reporting which was against their commercial interest to derive maximum profits.

Key features of the Secured Overnight Financing Rate (SOFR):

  • S. Federal Reserve in 2017 announced the Secured Overnight Financing Rate (SOFR) as a preferred alternative to LIBOR.
  • SOFR is considered a more credible alternative as it is based on repo rates or cost of money borrowed overnight which is backed by US Treasury assets.
  • SOFR is based on the prevailing transaction-based rate which makes it less susceptible to market volatility.

Conclusion

It is necessary on part of RBI to act as financial regulator and oversee stability of the banking system while at the same time maintaining credibility of Indian banking system overseas.

 

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