The London Interbank Offered Rate (LIBOR) has long been a key reference rate for global financial transactions, with more than US$370 trillion in contracts presently pegged to it. However, the global financial crisis of 2008 highlighted the declining sample size for calculating LIBOR. After 2008, LIBOR increasingly relied on what the Intercontinental Exchange Benchmark Administration called “market and transaction data-based expert judgment”. In 2012, some major financial institutions were found to have manipulated the benchmark. This impugned the integrity of LIBOR and led to moves to replace it with a less risky alternative reference rate (ARR). International banks persuaded the authorities not to terminate LIBOR immediately, to avoid wreaking havoc in global financial markets.
Markets will face a great challenge as LIBOR is deeply embedded in the current global financial framework. Some pertinent issues that could emerge are:
(i) A number of ARRs have been put forward to succeed LIBOR in financially stable nations, and due to this the market will have conflicting ARRs;
(ii) different rates will result in profit and loss (P&L) volatility, which will in turn cause ambiguity in risk assessment;
(iii) borrowers will forum shop for the cheapest reference rates and this will lead to chaos in the markets;
(iv) the shift will affect accounting practices, where changes in hedge accounting may create uncertainty across accounting entries and may result in P&L fluctuations;
(v) the transition may cause adverse changes in the interest rates charged to borrowers, which may trigger early redemption provisions of the financial contracts;
(vi) equity funding will be favoured in the uncertain circumstances that surrounds the debt market;
(vii) variations in ARRs leading to changes in interest for debt instruments may have unforeseen tax implications;
(viii) domestic loans may be preferred by Indian corporates, rather than resort to external commercial borrowings due to uncertainty;
(ix) there may be delay in implementing an ARR as regulators seek the views of market players (who themselves are uncertain about their positions) before finalizing their policies.
Various ARRs are now being considered to succeed LIBOR. Reference rates such as Secured Overnight Finance Rate (SOFR), Tokyo Overnight Average Rate, Sterling Overnight Index Average and Swiss Average Rate Overnight seem to be promising and have gained some traction. The International Swaps and Derivatives Association launched the IBOR Fallbacks Supplement, which has currently been adhered by approximately 12,000 entities across 80 jurisdictions and remains open for further adherence. Indian giants, State Bank of India and ICICI Bank Limited have recently executed interbank money market deals pegged with SOFR. While the market players have made collective strides for a smooth transition, it is unlikely that any ARR will achieve the popularity of LIBOR.
While institutions and regulators are assessing the situation and determining the perils of the transition, the following considerations may be taken into account to formulate a road map for the LIBOR transition:
(i) Borrowers need to be sensitized about the transition and the modalities thereof;
(ii) sophisticated infrastructure for the management of risk to be set up and the possibility of upgrading the existing infrastructure to minimize the cost of transition needs to be considered;
(iii) lending institutions need to formulate dispute mitigation strategies, as various consumer groups have/will institute legal action alleging inter alia their participation in price fixing cartels for determination of the lending rates;
(iv) creditors not only require to formulate a discovery process where all impacted contracts are aligned for modifications, exposure and risk remediation but also a fallback process and renegotiation of the contractual framework needs to be initiated with their clients;
(v) financing transactions entered into during the transition period should provide for enabling provisions such as, procedure for the fixation of new reference rates, allocation of costs of transition, dispute resolution, early redemption provisions, modification of statutory filings and limitation of liabilities of the parties.
(vi) financial institutions should frame and institute internal procedures to fill any gaps left by regulators; and
(vii) lending institutions must maintain strong client relationships, and provide comfort to affected consumers by engaging with them at all intervals.
Abir Lal Dey is a partner and Aroop Das is an associate at L&L Partners Law Offices. Mythili Rajan, an associate, also assisted with the article
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