The London Interbank Offer Rate (LIBOR) is one of the most common series of benchmark interest rates referenced by contracts measured in the trillions of dollars across global currencies. Regulators and industry bodies have proposed and agreed on the new interest rate benchmarks to replace LIBOR rates that are anticipated to no longer be published or supported past the end of 2021. These new alternative rates are likely to significantly impact corporates as users of LIBOR linked products, and replacing LIBOR will affect a significant number of financial agreements (within treasury, finance and across the organisation). It is imperative that corporates mobilise further to ensure that they are able to reliably communicate to key stakeholders the nature or their LIBOR exposures and the impact of LIBOR reform on their organisations.
LIBOR serves as a reference rate at which financial instruments can contract upon to establish the terms of agreement and also as a benchmark rate that reflects a relative performance measure for investment returns. LIBOR is used almost ubiquitously in global financial markets for a wide array of financial instruments in different kinds of loan and derivative products, thereby enabling non-rival consumption properties akin to a public good in terms of reducing complexity, increased standardisation, enhanced liquidity and lower transaction costs. Beyond the pricing of financial instruments, LIBOR is also extensively used for valuation and accounting purposes.
An Alternative Reference Rate (ARR) – one which retains the desirable features of LIBOR while ensuring that it is based on transactions in liquid markets – has to satisfy several key attributes; (a) it should provide a robust and accurate representation of interest rates in core money markets that is not susceptible to manipulation; (b) it should offer reference rates for financial contracts that extend beyond the money market; and (c) serve as a benchmark for term lending and funding (BIS, 2019). Jurisdictions across the world are eliminating IBOR rates and likely to adopt replacement rates as follows:
- The UK has recommended a reformed Sterling Overnight Index Average (SONIA) as the alternative unsecured risk-free rate for the Pound Sterling (GBP) LIBOR market.
- The Secured Overnight Financing Rate (SOFR) is expected to be the preferred alternative reference rate for US dollar financial products after 2021.
- The European Central Bank (ECB) recommended the Euro Short-Term Rate (€STR) unsecured rate to replace EONIA
- The Swiss National Bank selected the Swiss Average Rate Overnight (SARON), a secured reference rate based on data from the Swiss Franc repo market, as an alternative to CHF LIBOR.
- The Bank of Japan formed a working group that ultimately recommended the Tokyo Overnight Average Rate (TONAR) as an unsecured overnight rate replacement.
Why the transition matters?
- Contracts outside of treasury such as procurement, supply chain and revenue contacts referencing LIBOR will need to be identified and assessed for impact to determine actions needed prior to the LIBOR transition.
- The change from LIBOR may necessitate renegotiation of existing contracts that lack fallback language with customers and updated fallback language in contracts for new customers.
- Corporations that do not proactively manage their transition from LIBOR may find it increasingly difficult to mitigate potential adverse effects on their cashflows, systems and operations.
- Customers/clients may be less educated about the change in reference rates and may need to be educated as part of the renegotiation/amendment process.
- Some types of executory contracts (e.g. leases) are longer-term in nature and any new contracts entered into will extend beyond 2021 (or have the option to extend past 2021). The LIBOR transition should be considered when entering into these types of contracts so as to avoid additional costs that will be required to renegotiate contracts at a later date
- Valuation models, accounting and tax configuration, and data sourcing may need to be changed so that valuations, transfer pricing and accounting and tax records are accurate going forward.
- Internal processes such as transfer pricing and intercompany funding may require that new analyses and updated procedures are in place so that appropriate rates and spreads are applied across the company
- Challenges may arise with existing cross-currency basis risk management instruments that reference two floating rates.
- Institutions need to understand to-be curve construction and behavior to appropriately develop risk management strategies and transition plans
- LIBOR-based financial instruments may be more difficult to liquidate because market demand may decline as the end of 2021 approaches.
- Volatility in SONIA (especially at period end) and uncertainties around the availability of forward-looking tenor rates may increase settlement risk
The Indian Context
The use of benchmarks in the Indian financial system is not new. A range of foreign exchange and interest rate benchmarks have been in use, primarily by the banking sector, to price contracts and value assets and liabilities. In India, exposures to LIBOR arise from loan contracts (e.g. External Commercial Borrowings (ECBs)) linked to LIBOR; FCNR (B) deposits with floating rates of interest linked to LIBOR; and derivatives linked to LIBOR or to the MIFOR – a domestic benchmark based on LIBOR.
In addition, there are Government exposures linked to LIBOR. These include LIBOR-referenced loans availed by the Government from multilateral / bilateral agencies and Lines of Credit offered to other countries. A large number of trade contracts also reference LIBOR but most of these are short term and existing contracts may not continue after the cessation of LIBOR. The challenges for India and milestones for preparing for the cessation of LIBOR at the end of December 2021 are similar to those faced by other jurisdictions, especially those which are, in some sense, ‘LIBOR-takers’, i.e., they rely on LIBOR interest rates of major jurisdictions.
In India, MIFOR – which has LIBOR as one of its components – is a key benchmark used in the interest rate swap (IRS) markets. An alternate benchmark based on global ARRs will need to be developed in place of the MIFOR. At present, the Clearing Corporation of India Limited provides guaranteed settlement for IRS contracts that reference the MIFOR. The clearing and settlement arrangements will also need to be modified to provide for the alternate benchmark.
A scrutiny of existing loan/derivative contracts show that contractual fallback clauses catering to cessation of LIBOR are not available in existing contracts, which will continue beyond 2021. Fallback clauses customised to domestic markets but based on global practices will, therefore, need to be developed. These contracts may have to adopt the country specific ARR as a substitute once LIBOR ceases to exist, beyond 2021.
As we move closer to the transition date, all contracts which will continue after LIBOR cessation will need to be renegotiated and replaced. Critical for this will be the creation of adequate stakeholder awareness across all classes of financial market participants. Related accounting and tax issues will also need to be addressed. Existing regulations, which reference LIBOR will need to be amended to provide for contracts referencing ARRs. As is being planned in most jurisdictions globally, a cut-off date after which no new contracts can be entered using LIBOR will need to be notified. This will, of course, largely be dependent on development of liquid debt and derivative markets linked to ARR and the cut-off date announced by the advanced economies.
As is the case globally, financial contracts referencing LIBOR – both loan and derivative contract – which will outlive the cessation will need to be re-negotiated to ensure insertion of appropriate fallback language. Customer sensitisation and addressing of legal, taxation and accounting issues will also be crucial. Transition arrangements for MIFOR-linked IRS contracts will be unique to the country but could be relatively less tricky to handle, as such contracts are traded only in the interbank market.
Beyond these issues is the need for preparation of the banking and the broader financial system for the transition. A large number of business processes that will be impacted by the transition will need to be re-engineered. All IT systems that use LIBOR will need to be changed. With financial institutions in India often using a mix of inhouse and third-party vendors, IT changes will be far from easy. Most importantly, personnel at different levels will need to be made aware and even trained.
The transition away from LIBOR to a new benchmark will be full of challenges. Every stakeholder – the financial sector; regulators; tax, legal and accounting systems; and real sector participants needs to play a role. Alternative reference rates have been identified in major jurisdictions, but development of liquidity markets in these rates – a sine quo non for ensuring smooth transition – remains at a nascent stage. The FSB has laid out a global transition roadmap for LIBOR, emphasising that firms should be in a position to assess their LIBOR exposures and encouraging firms to adhere to the ISDA protocol for the transition. The FSB has also suggested that by end-2020, firms should be in a position to offer non-LIBOR linked loans to their customers. Achieving this roadmap will, however, require significant efforts from all stakeholders.
The transition arrangements for a benchmark embedded in the financial system involve multiple stakeholders across market bodies, regulators, governmental agencies and financial entities. A coordinated approach will be necessary to enable the smooth transition from LIBOR