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LIBOR

 

Source: The Hindu

 

Context: The Reserve Bank of India (RBI) has issued an advisory to banks and other RBI-regulated entities asking them to take steps to ensure a complete transition away from the London Interbank

Offered Rate (LIBOR) from July 1. 

Explanation
What is LIBOR?It is a benchmark interest rate at which major global banks lend to one another in the international interbank market for short-term loans.

 

It serves short-term loans with maturities from Overnight to 1 year.

It also acts as a basis for Corporate and Government Bonds, mortgages, student loans, credit cards, derivatives, and other Financial Products.

How does LIBOR work?Administered by ICE Benchmark Administration (IBA), regulated by the UK’s Financial Conduct Authority (FCA).

 

It is based on five currencies, including the U.S. dollar, the euro, the British pound, the Japanese yen, and the Swiss franc, and serves 7 different maturity periods.

Why is LIBOR being brought to an end?LIBOR’s credibility was damaged by rate-fixing scandals in 2012.

The panel banks’ submissions were alleged to be inaccurate or manipulated to project market strength.

 

After the 2012 Wheatley Review, a number of reforms were introduced to reduce subjective input and make LIBOR a transaction-based benchmark.

 

However, despite the reforms introduced, the number of transactions in the short-term wholesale Funding Market reduced over time. Thus, LIBOR became more vulnerable to short-term market illiquidity and amplification of price moves that could cause systemic risks.

What are the alternative reference rates?Secured overnight financing rate (SOFR) is being widely used as a substitute for LIBOR across the world.

 

Other Benchmarks rates – (1) CHF – SARON; (2) EUR – ESTER; (3) GBP – SONIA (Already in use since March 31, 2021); (4) JPY – TONA.

What are the limitations of SOFR?Based upon the repurchase (repo) markets, it is at the repo markets’ mercy.
What are the other challenges of shifting from LIBOR?There could be a lot of volatility in the financial markets as the deadline arrives. The RBI has issued two circulars giving the roadmap to the transition and arrangements to be made for the same.