John C Williams, President at the Federal Reserve Bank of New York, joked at the 2019 US Treasury Market Conference: “Some say only two things in life are guaranteed: death and taxes. But I say there are actually three: death, taxes, and the end of LIBOR.” The LIBOR transition is a landmark event, and most discussions in India have focussed on the impact. But the lessons LIBOR transition hold for Indian benchmark reforms are more interesting.

London Interbank Offered Rate (LIBOR) is the benchmark rate for an estimated $400-trillion worth of derivatives, loans and other financial instruments. Till 2013, LIBOR was an average of polled rates from a panel of banks and represented the unsecured rate at which banks said they could borrow from other banks.

After the global financial crisis, trades dried up in the interbank market as banks were uncomfortable lending to peers due to an increased perception of credit risk. LIBOR submissions became more reliant on the expert judgment of a small set of banks, and widespread rigging was unearthed; fines imposed on banks worldwide from the resulting LIBOR scandal totalled over $9 billion.

Moving away from LIBOR

Resulting regulatory reviews focussed on two aspects — reforming LIBOR during the transition period; and developing alternative reference rates (ARRs) for transition from 2021.

From January 2014 onwards, LIBOR’s methodology was changed to reflect a wholesale funding rate anchored in transactions to the greatest extent possible, using a standardised transparent methodology, and to reduce expert judgment.

The ARRs identified for key global currencies are overnight nearly risk-free rates which reflect wholesale transactions from financial institutions. The rates could be unsecured, eg Sterling Overnight Index Average (SONIA), or secured eg US Secured Overnight Funding Rate (SOFR), and the choice is made on the basis of the liquidity and structural features of underlying money markets.

ARRs are an accurate representation of money market interest rates. But they fall short of being a true discount rate for pricing derivatives of longer maturities or a benchmark for bank lending due to the lack of a robust term structure. The development of forward-looking term structure continues to be an area of focus.

India’s estimated $435 billion of external borrowings at the end of 2019, and derivatives linked to MIFOR — which, in turn, is derived from USD LIBOR — will be affected. The transition playbook itself is relatively straightforward, and follows LIBOR transition to ARRs.

Issues associated with domestic lending rates are more nuanced. Unlike banks in the developed world, which offer loans based on external reference rates, Indian banks have long used internal benchmarks like the marginal cost of lending rate, base rate and the benchmark prime lending rate which lacked transparency and constrained monetary transmission.

Last September, the RBI mandated that banks transition to an external benchmark, which is either a policy repo rate, T-bill rates, or other money market benchmarks. In response, most banks transitioned to the policy repo rate as the benchmark of choice.

While this improved monetary transmission, a policy rate does not reflect evolving market conditions and would constrain future changes to monetary policy framework. In the US, concerns were raised when Fed actions had a huge influence on the SOFR, despite it being a market-determined rate, and it was felt there should be some distance between policymakers and market rates.

Suitable alternative

An ideal lending benchmark has several desirable properties — reliability, liquid term structure, relationship with banks’ marginal cost of funds, and a high correlation with policy rates. None of the current external benchmark options meets all the criteria. However, to get to an ideal benchmark, we should coalesce around one option and improve it over time; the Bank of England’s recent reform of SONIA to improve liquidity by expanding the scope of transactions is a case in point.

It is also desirable to make it a market-participant driven process with active regulatory guidance; the Active Reference Rates Committee, comprising private market participants and convened by the New York Fed to ensure a smooth transition from USD LIBOR to SOFR, is another example.

In addition to lending benchmarks, another potential area for reform is the MIFOR, an interest rate derived from foreign currency interest rate and forward currency premia. MIFOR is an admittedly inelegant solution for currency hedging compared to a cross-currency basis curve, and yet is an artefact of history.

LIBOR transition will happen in the near future, despite extraordinary market conditions delaying most other financial reforms. In the process, several countries have grappled with and settled on their reference rate choices and come out with their transition plans. Their experiences hold valuable lessons for future Indian benchmark reforms.

Subrahmanyam is Partner, FS Risk Advisory at E&Y. Ramachandran is Director of Capital Markets Policy (India) at CFA Institute