All you need to know about Libor’s end and the new risk-free rate that will replace it
The London Interbank Offered Rate, or Libor, is going into oblivion.
Come new year’s eve and what was once one of the most important financial numbers will cease to exist, bringing to an end its two-decade history.
So, what really was Libor and why is its existence coming to an end?
Libor is a global benchmark interest rate at which big banks across the world lend to one another. Libor essentially helped determine how derivatives as well as loans, from those availed by businesses and credit cards to student loans and mortgages, have been priced, over the last couple of decades.
Simply put, Libor indicates the borrowing costs between banks. The rate has been calculated and published by the Intercontinental Exchange, a US-based Fortune 500 company formed in 2000. It operates global exchanges, clearing houses and provides mortgage technology, data and listing services. The company owns exchanges for financial and commodity markets, and operates 12 regulated exchanges and marketplaces.
Libor is being scrapped nearly 10 years after several banks were caught attempting to rig it.
What is the aggregate size of the loans whose rates are currently determined by Libor?
Libor currently helps price loans of the order of $265 trillion, as of the beginning of 2021.
Which currencies is Libor based on?
Libor is based on five currencies—Japanese Yen (JPY), Euro (EUR), Swiss Franc (CHF), UK Pound Sterling (GBP) and US Dollar (USD).
What is Libor being replaced with?
Libor is being replaced by so-called risk-free rate (RFR) benchmarks, which are based on a deep and liquid pool of underlying transactions, unlike Libor, which is determined by panel-based submissions, which were misused.
These RFRs were established by working groups that were set up for them.
So, what RFRs did the working groups suggest?
Srinivas Varadarajan, managing director at Deutsche Bank India, wrote in The Economic Times that based on the characteristics of the national markets, the respective working groups selected the Secured Overnight Financing Rate (SOFR) for USD Libor and the Tokyo Overnight Average Rate (TONA) for JPY Libor.
The groups also selected the Euro Short-term Rate (ESTR) for EUR Libor, the Swiss Average Rate Overnight (SARON) for CHF Libor and the Sterling Overnight Index Average (SONIA) for GBP Libor.
“The RFRs are completely new benchmarks, except for SONIA. They started with little liquidity but we have seen the increase in liquidity this year with the cessation of new contracts for GBP Libor and CHF Libor and the push for the interdealer market to trade RFR benchmarks over Libor (what the market commonly refers to as SOFR First and TONA First),” Varadarajan said.
“A liquid RFR is essential to avoid any market dislocation or wide bid and offer spreads that may impact funding and collateral postings,” he added.
Which version of RFR does India use?
India uses the Mumbai Interbank Forward Rate, or MIFOR, which is based on the USD Libor and the forward premium derived from the Indian forex markets.
The Indian Banks Association has selected the Modified Mifor. The Financial Benchmarks India Pvt Ltd started publishing Adjusted Mifor from 15 June 2021 and the Modified Mifor from 30 June 2021.
“Adjusted Mifor is for use in legacy contracts while Modified Mifor is for use in new contracts. In addition, the Reserve Bank of India issued an advisory to banks to cease using Mifor and Libor (except under certain situations) for new contracts by the end of 2021,” Varadarajan said.
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