prpri RBI: Foreign exchange rate – The rise & ignominy of LIBOR RBI: Foreign exchange rate – The rise & ignominy of LIBOR

Reserve Bank of India vide its communication dated July 8, 2021 made an advisory to banks and other RBI-regulated entities emphasizing the need for preparedness for the transition away from London Interbank Offered Rate (LIBOR). Let us look at this most important message which has already shaken the foreign exchange world which virtually runs on LIBOR as the rate on which the transactions are built. Considered as sacrosanct, time has shaken its foundations and it was found to be manipulated to help some. Let the communication be reproduced from RBI website.

https://taxguru.in/rbi/roadmap-libor-transition.html

Let us look at its advisory in details. (From main communication)

“The key steps to be taken in this regard include:

i. Banks and financial institutions are encouraged to cease entering into new financial contracts that reference LIBOR as a benchmark and instead use any widely accepted alternative reference rate (ARR), as soon as practicable and in any case by December 31, 2021.

ii. Banks and financial institutions are urged to incorporate robust fallback clauses in all financial contracts that reference LIBOR and the maturity of which is after the announced cessation date of the LIBOR settings.

iii. Banks and financial institutions are encouraged to ensure that new contracts entered into before December 31, 2021 that reference LIBOR and the maturity of which is after the date on which LIBOR ceases or becomes non-representative include fallback clauses.

iv. Banks have also been advised to cease using the Mumbai Interbank Forward Outright Rate (MIFOR), a benchmark which references the LIBOR, as soon as practicable and in any event by December 31, 2021. In this context, Financial Benchmarks India Pvt Ltd (FBIL) has started publishing daily adjusted MIFOR rates from June 15, 2021 and modified MIFOR rates from June 30, 2021 which can be used for legacy contracts and fresh contracts respectively.

v. Contracts referencing LIBOR / MIFOR may generally be undertaken after December 31, 2021 only for the purpose of managing risks arising out of LIBOR / MIFOR referenced contracts undertaken on or before December 31, 2021.”

What does it convey in simple terms?

  • No LIBOR but ARR as bench mark as soon as practicable but in no case beyond December 31, 2021.
  • All to include robust rollback clauses in all financial contracts to safeguard them. Fallback clauses would help even in cases LIBOR is inapplicable.
  • Yes, similarly stop using Mumbai interbank Forward Outright Rate which is based on LIBOR too.
  • Clause IV does take care of various issues connected to LIBOR.
  • Obviously, contracts dealing with risks related to LIBOR before 31.12.2021 but handled after the said date can refer LIBOR.

Yes, one easily understands the non- utility of LIBOR and the circumstances where it can be used.

Interestingly, those who dealt with LIBOR for decades or foreign exchange puritan as I would like to call, may be shocked beyond belief, to look at the ignominy of LIBOR.

Why did RBI issue this advisory and is there some background?

Let me go to page 2 of RBI annexure para 1.

Background

The Financial Conduct Authority (FCA), UK, in a press statement dated March 05, 2021 announced that all LIBOR settings will either cease to be provided by any administrator or no longer be representative:

  • Immediately after December 31, 2021, in the case of all Pound sterling, Euro, Swiss franc and Japanese yen settings, and the 1-week and 2-month US dollar settings; and
  • Immediately after June 30, 2023, in the case of the remaining US dollar settings.

Replacing LIBOR by ARR would help banks and other financial institutions order to manage potential customer protection, reputational and litigation risks as well as avoid disruptions to the safety and resilience of financial institutions and overall financial stability of the economy.

Did RBI raise this issue earlier?

RBI had in August 2020, advised the banks/others to assess their exposures on LIBOR based ones and put up a Board approved plan for action.

It is important to recapitulate the message given by RBI on November 11, 2020 about the rise and fall of LIBOR.

https://rbi.org.in/scripts/BS_ViewBulletin.aspx?Id=19898

From the empowering RBI communication, the following write up is remembered.

Let us have the introduction given by RBI as the starting point.

“2012 was a landmark year in the world of financial benchmarks. The most widely used financial benchmark, the LIBOR, was found to have been manipulated by individuals at various financial institutions. The event created shock waves in the financial system – the credibility of a financial reference used to price and determine payoffs for trillions of dollars of loans/bonds/derivatives came under a cloud. The crux of the problem lay in the fact that LIBOR prices a market – the market for unsecured wholesale term lending for banks – in which dwindling volumes rendered efficient pricing difficult (Bailey, 2017). Structural changes in the financial markets, especially since the global financial crisis, meant that transaction-based submissions leading to LIBOR formation tapered off and what is left are estimates.”

As one who has extensively used LIBOR in all foreign exchange transactions including currency transactions or trade related ones, I am bewildered that it had the patronage of a few individuals in financial institutions who illegally gained by manipulating the said rate while the whole world religiously followed as the base.

Let us learn some details about its origin, how it is computed and how after its discontinuance, India will be affected, all relevant to LIBOR, the unassailable value in monetary theory to fall into ignominious oblivion etc.

The origin

LIBOR has been associated with Euro dollar market from 1960 onwards.  The origin of the term ‘LIBOR’ has been credited to a Greek banker called Minos Zombanakis, who was running the London branch of Manufacturer’s Hanover, now part of JPMorgan. In 1969, he organized an $80 million syndicated loan for the Shah of Iran, referenced to what he called a London interbank offered rate. These rates were initially computed for three currencies – the US dollar, the British pound and the Japanese yen. Over time,  more currencies / maturities got added and, at its peak, LIBOR rates were announced for ten currencies in 15 maturity terms ranging from overnight to one year.

 At present, 35 LIBOR rates are posted each day for seven maturities each for five major currencies, viz., the Swiss franc, the Euro, the Pound sterling, the Japanese yen, and the US dollar.

Let us know how it is calculated every day?

RBI communication familiarizes us as under, its computation.

Exactly as explained below, LIBOR got its glory and its inevitable fall due to misuse of the process by the leading banks.

LIBOR rates are computed as a ‘trimmed mean’ of polled rates elicited from major banks based on responses to the question: ‘At what rate could you borrow funds were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 a.m.?’ The subjective nature of the question, especially related to timing and size – ‘reasonable market size’ and ‘just before 11 a.m.’ – leave LIBOR vulnerable to manipulation. Concerns about LIBOR and its governance process are, however, not new. As the use of LIBOR grew during the 1970s and 1980s, polling banks started accepting Eurodollar deposits at interest rates linked to LIBOR, leading to adverse incentives to report lower rates. At the same time, the same banks quoted LIBOR related price for their foreign exchange related contracts, derivative business etc., all running into billions of US $.

This led to LIBOR and its governance being taken over, and handled by the British Bankers’ Association in 1986. Naturally its value was decided by the expert judgement of banks which in turn led to no details emerging of the method of calculation of LIBOR.

Conflict of interest arose among those banks who helped to decide its value but it was associated with their large loan contracts and derivative business.

Then, why did the inter- bank rate lose its value among the countries?

Let us note the inglorious period of its loss of value in history. (To be quoted from RBI article)

  • “Discrepancies were first observed during 2007-08 when the polled rates were found to be not reflecting the actual rates at which banks lent to each other. The possibility that banks were reporting LIBOR quotes significantly lower than those implied by prevailing credit default swap (CDS) spreads was highlighted in a Wall Street Journal article.
  • This brought attention to the fact that there were incentives for banks to manipulate LIBOR rates as instruments through which banks signal their perceived credit-worthiness, especially in periods of stress or through which trading positions could be influenced. Post this publication, there was an immediate spike in the 3-month USD LIBOR rate from 2.7 to 2.9.”
  • It is sad to notice that investigations revealed manipulation in LIBOR rates andby 2012, manipulations in LIBOR fixations were established and banks were levied with fines totaling about $ 9 billion for misconduct. What was the market loss by following the said rate in all transactions is any body’s guess?

In spite of improvements in calculation of LIBOR, Financial Conduct Authority (FCA) announced that it would not compel panel banks to submit LIBOR beyond 2021.

It has been decided to replace LIBOR by Alternative Reference Rate that would reflect the short-term money market rates which would not be susceptible to manipulations and it should offer reference rates for financial contracts that extend beyond the money market, and also serve as a benchmark for term lending and funding.

Now let us confine our discussion to Indian foreign exchange market.

In view of above developments, in the context of manipulation of LIBOR, RBI constituted a Committee on Financial Benchmarks (Chair: Shri P Vijaya Bhaskar) (CFB) in June 2013, to review the systems governing financial benchmarks in India.

Let us learn the CFB recommendations and its after effects. As recommended by CFB, an independent entity, i.e., Financial Benchmark India Pvt. Ltd (FBIL), was set up to act as an administrator for benchmarks in debt, interest rates and foreign exchange markets.

The FBIL now administers various benchmarks – Overnight Mumbai Interbank Outright Rate (MIBOR); Mumbai Interbank Forward Outright Rate (MIFOR); Market Repo Overnight Rate (MROR); Forward Premia Curve; Foreign Currency Rupee Options Volatility Matrix; and Rupee reference rates.

In 2019, a regulatory framework for financial benchmark administrators, aimed at ensuring acceptable standards of governance and accountability as well as the quality of benchmarks and of the computation methodology in the benchmark administration process was introduced.

Six financial benchmarks, viz, MIBOR, MIFOR, USD/INR Reference Rate, Treasury Bill rates, valuation of Government Securities and valuation of State Development Loans (SDL) were notified as significant benchmarks in January 2020.

However, the following complications would arise.

  • 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). Preliminary estimates suggest that about $50 billion of debt contracts in the form of ECB/FCCBs and $281 billion of derivative contracts will expire beyond 2021.
  • LIBOR linked exposures are External Commercial Borrowing 74 US $ billion, FCNRB deposit 24 US$ Billion, Cross currency swap 83 USB, FCY Interest rate swap 260 USB, MIFR interest rate swap 91 USB.
  • 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.

What has been the work of RBI to weather this monumental financial storm?

The Reserve Bank has been participating in and monitoring global developments related to LIBOR transition and has tasked the Indian Banks’ Association (IBA) to consult on relevant issues.

 The IBA has since formed three workstreams on (i) LIBOR transition arrangements, (ii) rates and methodology and (iii) outreach to market participants. IBA has also circulated a guidance note among its member banks to enable them assess their preparedness for LIBOR transition on various parameters, viz., exposure assessment and assessment of the accounting, tax, information technology (IT) related implications.

 The rates and methodology workstream are developing an acceptable alternative for MIFOR while the outreach workstream is reaching out to stakeholders through webinars and conferences to create awareness about the upcoming challenge.

Before I conclude, what the world has initiated towards replacement of LIBOR, the unworthy product of the West, mostly manipulated by big institutions and pittance given as fine?

5 countries with their present ARRs adorn my next para.

U.S.A.———– Secured Overnight Financing Rate (SOFR)

U.K. ————— Sterling Overnight Interbank Average Rate (SONIA)

E.U. ————–Euro Short Term Rate (ESTR)

Switzerland——-Swiss Average Rate Overnight (SARON)

Japan————— Tokyo Overnight Average Rate (TONAR1)

Note; All of them of overnight tenor, some of them secured and some, not, accepted by banks/non-banks mostly except in Switzerland, where non-banks have not agreed, and the source is B.I.S.

Conclusion

Yes, having been a follower than a leader so far in foreign exchange market and a sincere follower of LIBOR related business, India like any other jurisdiction in the world is struggling to shift to a system LIBOR less but the end of 2021 is not far away. RBI has advised all stake holders to prepare for facing the accounting, tax, information technology and other issues though it is expected that it will continue to shoulder the required responsibility to tide over the immediate transition period, develop internationally acceptable ARR and continue to govern and monitor the new system regularly to evade the after effects of further manipulations by unscrupulous international business.

Yes, I agree who would have predicted the demise of LIBOR and that too most disgracefully?

With the world still dominated by Western banks and meek following by others, can we not expect more like LIBOR and again misleading by leading banks?

Eternal vigilance is the price for liberty and exercise of its power. RBI should move away from reactive to proactive stance in foreign exchange and like its research wing which stands among the best in the world, and a large number of its papers are being quoted, new research to introduce new products to usher new monetary revolution in India is need of the hour.

Being an eternal optimist, the thriving brilliant youngsters from RBI and other banks would lead the way for our nation.

*****

Disclaimer: The contents of this article are for information purposes only and do not constitute an advice or a legal opinion and are personal views of the author. It is based upon relevant law and/or facts available at that point of time and prepared with due accuracy & reliability. Readers are requested to check and refer relevant provisions of statute, latest judicial pronouncements, circulars, clarifications etc. before acting on the basis of the above write up.  The possibility of other views on the subject matter cannot be ruled out. By the use of the said information, you agree that Author/TaxGuru is not responsible or liable in any manner for the authenticity, accuracy, completeness, errors or any kind of omissions in this piece of information for any action taken thereof. This is not any kind of advertisement or solicitation of work by a professional.

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