Financial regulators transitioning from LIBOR

Financial regulators transitioning from LIBOR

Why in news:

• Recently, the RBI stated that some banks and financial institutions were yet to facilitate an absolute transition away from the London Interbank Offered Rate (LIBOR) benchmark.

• They had not inserted fallback clauses into all their financial contracts that reference U.S.$ LIBOR or the corresponding domestic Mumbai Interbank Forward Outright Rate (MIFOR).
• Both LIBOR and MIFOR would cease to be a representative benchmark from June 30 this year.

What is LIBOR?

• LIBOR is a global benchmark interest rate that combines individual rates at which banks opine they may borrow from each other (for a particular period of time) at the London interbank market.
• It is used as a benchmark to settle trades in futures, options, swaps and other derivative financial instruments in over­the­counter markets (participants engaging directly without using an exchange) and on exchanges globally.
• Further, consumer lending products including mortgages, credit cards and student loans, among others, too use it as a benchmark rate.

What was the controversy around it?

• The central flaw in the mechanism was that it relied heavily on banks to be honest with their reporting disregarding their commercial interests.
• It must be noted that the rates were made public.
• Therefore, it would not be particularly useful to impress upon potential and current customers the various disadvantages in obtaining funds.
• The phenomenon was particularly on display during the 2008 financial crisis when submissions were artificially lowered (amid the crisis).

Do we have an alternative in place?

• Yes, in 2017, the U.S. Federal Reserve announced the Secured Overnight Financing Rate (SOFR) as a preferred alternative.
• Accordingly, in India, new transactions were to be undertaken using the SOFR and the Modified Mumbai Interbank Forward Outright Rate (MMIFOR), replacing MIFOR.
• As stated by the International Finance Corporation (IFC), it is based on observable repo rates, or the cost of borrowing cash overnight, which is collateralised by U.S. Treasury securities.
• Thus, making it a prevailing transaction­based rate and drifting away from the requirement of an expertise judgement as in LIBOR.
• This would make it potentially less prone to market manipulation.

Syllabus: Prelims