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Source: This post is created based on the article “Why are financial regulators transitioning from LIBOR?” published in The Hindu on 18th May 2023.
Syllabus Topic: GS Paper 3 – Indian Economy – Financial Market
News: The Reserve Bank of India (RBI) said on May 12 that some banks haven’t completely stopped using the London Interbank Offered Rate (LIBOR).
In 2020, RBI had asked banks to analyse their LIBOR exposures and prepare for the adoption of alternative references rates like Secured Overnight Financing Rate (SOFR) and Modified Mumbai Interbank Forward Outright Rate (MMIFOR).
RBI has announced that Contracts entered after (or before, if possible) December 31, 2021, were not to use the LIBOR as reference rate.
What is LIBOR?
LIBOR is a global benchmark interest rate. It combines individual rates collected from banks at which they may borrow from each other (for a particular period of time) at the London interbank market.
LIBOR is used as a benchmark to settle trades in futures, options, swaps and other derivative financial instruments in over-the-counter markets.
How is LIBOR decided?
Banks on the LIBOR panel submit their suggested interest rate at 11 AM on every business day to news and financial data company, Thomson Reuters.
The company then averages the middle quartiles to derive the LIBOR. It excludes the Extreme quartiles, on the top and bottom.
What is the controversy in the methodology of LIBOR?
This mechanism is heavily dependent upon the banks in the panel to be honest in the interest rate suggestions.
The phenomenon of dishonest submissions was on display during the 2008 financial crisis when submissions were artificially lowered.
In 2012, Barclays admitted to the misconduct and agreed to pay $160 million in penalties to the U.S. Dept of Justice.
Another observation was the banks were changing the submission to acquire more profits.
What alternatives are available to LIBOR?
Therefore, an alternative was announced in 2017 by the U.S. Federal Reserve, which was Secured Overnight Financing Rate (SOFR).
India also announced the use of SOFR and the Modified Mumbai Interbank Forward Outright Rate (MMIFOR), instead of MIFOR, for all new transactions.
Indian banks use the Mumbai Interbank Forward Offer Rate as a standard for pricing forward-rate contracts and securities. MIFOR rate is tied to Dollar LIBOR.
SOFR comprises the weighted averages of the rates charged in these repo transactions. It is collateralised by U.S. Treasury securities. Therefore, it is a transaction-based rate and does not require any expert calculation. It also makes it less prone to manipulation.