Why Are Financial Regulators Transitioning From LIBOR?
Context:
The RBI reported on May 12 that several banks and financial institutions had not yet enabled a complete move away from the benchmark London Interbank Offered Rate (LIBOR).
A global benchmark interest rate known as LIBOR combines the various rates at which banks believe they may borrow money from one another (for a specific amount of time) on the London interbank market.
The Secured Overnight Financing Rate (SOFR) was introduced by the US Federal Reserve as a preferred substitute in 2017.
What is LIBOR?
A benchmark interest rate used as a standard for many different financial products and transactions around the world is called LIBOR (London Interbank Offered Rate).
The average interest rate that banks on the London interbank market can borrow money from one another is represented by the LIBOR.
The banks that make up the LIBOR panel send Thomson Reuters, a provider of news and financial data, their borrowing rates every day before 11 a.m. London time.
The LIBOR panel consists of important banks such as J.P. Morgan Chase, Lloyds Bank, Bank of America, Royal Bank of Canada, and UBS AG, among others.
For particular periods (such as overnight, one month, three months, etc.), each bank on the panel offers the rate at which it believes it may borrow money from other banks.
The provided rates are ranked, and to prevent the outcome from being skewed, the highest and lowest rates (extreme quartiles) are not included in the calculation.
The LIBOR rate is calculated for any particular maturity or tenor by averaging the rates that fall between the middle quartiles.
The goal is to find a representative rate that matches the median range of bank borrowing rates.
The LIBOR serves as a benchmark rate for settling contracts in futures, options, swaps, and other derivative financial instruments in over-the-counter (OTC) markets and on exchanges worldwide. It is normally issued at about 11:55 a.m. London time.
The LIBOR is also used as a benchmark rate for consumer lending products like mortgages, credit cards, and student loans, among others.
The reduction in interbank lending and worries about the LIBOR’s dependability should not be overlooked. As a result, it was decided to phase out the LIBOR by the end of 2021 and replace it with other reference rates, such as the Secured Overnight Financing Rate (SOFR) in the US.
What was the controversy around it?
The process for reporting rates was fundamentally flawed because it placed a great deal of reliance on banks’ integrity.
It would not be advantageous for banks to emphasise the drawbacks of getting cash to prospective and existing customers when the rates were made public.
Banks manipulated the rates during the financial crisis of 2008 by artificially lowering submissions.
For their role in rate rigging, Barclays acknowledged to misconduct in 2012 and consented to pay a $160 million fine to the U.S. Department of Justice.
In May 2008, The Wall Street Journal revealed that some panellists were paying borrowing costs that were much lower than other market indicators showed, pointing to widespread manipulation.
To increase their profits, banks often modified their rate submissions based on the derivative positions of their trading units.
Because rates were made public, banks had the motivation to alter their submissions to offer a more favourable image or further their trading activity.
Overall, the process had a serious problem because it depended on banks’ honesty in reporting rates, as well as their economic interests and the possibility of manipulation.
Way Forward
The Secured Overnight Financing Rate (SOFR) was introduced by the US Federal Reserve as a preferred substitute in 2017. As a result, new transactions in India were to be carried out using the SOFR and the Modified Mumbai Interbank Forward Outright Rate (MMIFOR), which would take the place of MIFOR.
It is based on observable repo rates, or the cost of borrowing money overnight, according to the International Finance Corporation (IFC), and is secured by U.S. Treasury securities.
Making it a prevalent transaction-based rate, it moves away from LIBOR’s demand for an expert judgement. This might make it less susceptible to market manipulation.
