The globally accepted, decades-old financial benchmark, the London interbank offered rate (Libor), retires at the end of 2021 for most rates, or by mid-2023 for others. The Reserve Bank of India (RBI) on 8 July 2021 issued an advisory notice to banks and other RBI-regulated entities to prepare to transition from Libor into any widely accepted alternate reference rate (ARR) before 31 December 2021.
Because of fundamental deficiencies in the Libor process, the Financial Conduct Authority, UK (FCA), which oversees the reporting of Libor, announced in March 2021 that all Libor settings will either cease to be provided by any administrator or will no longer be representative. This will be immediately after 31 December 2021 in the case of all pound sterling, euro, Swiss franc and Japanese yen settings, and one-week and two-month US dollar settings, and immediately after 30 June 2023, in the case of remaining US dollar settings.
For banks, financial institutions and large companies that are looking at international borrowings or bond issues, transitioning from Libor to ARRs is a complex exercise involving a major shift in their financial risk management, regulatory and legal compliance, operations and accounting processes, as Libor has been the prevailing rate for so long.
The challenges facing the banks in switching from Libor to ARRs stem from the inherent differences in the calculation of the two. Libor is a forward-looking term rate that has credit risk embedded in it, while ARRs are overnight, backward-looking rates based on actual transaction data that do not include premiums for longer-term funding. The effect of these differences is that ARRs are not equivalent to Libor and are typically quoted at a lower rate. To put any ARR on a par with an unsecured reference rate like Libor, an adjustment factor comprising credit and liquidity risk premiums must be added. Some of the ARRs adopted in the global market are the secured overnight financing rate, the sterling overnight interbank average rate, the euro short term rate, the Swiss average rate overnight and the Tokyo overnight average rate. Each of these ARRs has its own advantages and issues. Banks and borrowers will have to make informed decisions in selecting ARRs based on their features, and by weighing the risks and corresponding returns.
In India, the Mumbai interbank forward outright rate (Mifor) is used as a reference rate for setting prices on forward-rate agreements and derivatives. The USD Libor is one of its components. The RBI has advised banks to cease using Mifor as soon as practicable, and in any event by 31 December 2021. Financial Benchmarks India also started publishing daily adjusted Mifor rates from 15 June 2021 and modified Mifor rates from 30 June 2021, which can be used for legacy and fresh contracts respectively.
The RBI has urged banks and financial institutions to incorporate robust fallback clauses in all financial contracts that reference Libor and the maturity of which is after the announced end of Libor settings. From the standpoint of documentation, it is essential to scrutinise existing facility agreements and options available to the parties. For new facility agreements, there has to be an emphasis on whether to adopt an ARR from the outset or to put in place contractual mechanisms that facilitate the transition from Libor to the ARR.
As the countdown to Libor replacement has begun, all market participants need to gear up for the transition and ensure that systems are in place to implement the change. For lenders, it will be important to ensure that the transition neither impacts their overall cost of lending nor increases legal risks due to amendments in financing agreements. Similarly, borrowers will want to ensure that they are not prejudiced by the change and that the transition, whether from existing facilities or in future loans, brings certainty in relation to loan pricing. Apart from balancing the interests of borrowers and lenders, the enormity of the task lies in re-engineering the systems and business processes impacted by the transition, and coordinating the actions of stakeholders in market bodies, regulators, governmental agencies and financial entities to ensure a smooth transition from Libor.
Soumyajit Mitra is a principal associate and Nishtha Arora is an associate at SNG & Partners
SNG & Partners
One Bazaar Lane, Bengali Market
New Delhi – 110001
Tel: +91 11 4358 2000