Is LIBOR Redundant and How SONIA Is A Better Prospect?

Is LIBOR Redundant and How SONIA Is A Better Prospect?

10 Dec 2019 05:19 PM
 

Why LIBOR?

Most of us understand the importance of the global interest rate benchmark LIBOR – London Inter-Bank Offered Rate, especially when millions of dollars are benchmarked against it for decades since 1984. The necessity of a uniform measure of interest rate across financial institutions evolved which is used as a reference for interest rate set by the central banks. It is used for a wide range of financial products like interest rate swaps, forward rate agreements, consumer loans, hybrid products, etc. It is the base for most derivatives and structured products in the foreign exchange market.

Manipulated Libor

Prior to the global financial crisis, real estate mortgage, which has Libor interest rate as its benchmark, was at its peak. But post 2008 a decline in interbank borrowing transactions was seen. Since Libor is not based on actual transactions but on estimates of the panel of contributing banks, the Libor is suddenly losing its charm. Then in 2012 it came in the spotlight when it was manipulated by many panel banks, thus catching the eye of the critics and calling it a ‘LieBor’ instead.

The main assumption while operating the Libor interest rate was of an unsecured and permanent interbank market but post the financial crisis in 2008, the level of liquidity in the interbank lending market almost disappeared. Very few participants were lending on an unsecured basis for a short term of about three months. Along with this came more stringent regulations increasing the capital reserves for wholesale debt. Some banks stopped giving indicative prices thus the whole price discovery process was not transparent anymore which further impacted the credibility of Libor as a benchmark. With the almost negligible borrowing activity, the sustainability of the benchmark was questioned.

SONIA – an alternative of Libor rate

Since Libor had started losing its popularity amongst the borrowers, the search for a more reliable and robust benchmark started. The task was to identify and use risk free rates as they could be more reliable as they are derived from market transaction data and are not based on judgments. In April 2017, the Bank of England chose SONIA or Sterling Overnight Interbank Average Rate as an alternative to LIBOR interest rate. It is based on actual transactions which are vetted by the Bank of England.

Shifting a benchmark which is used for many contracts across maturity specially those ending in 2021, is not as easy task. Most financial markets are unaware of the imminent end of LIBOR, though since last year some British banks have started switching to Sonia. Good co-ordination amongst regulators, banks would be sought for a seamless switch. It is used for overnight funding of trades during the off-market hours, thus Sonia got stability to overnight rates. Last year, Bank of England expanded Sonia to include overnight unsecured transaction which can be negotiated bilaterally. It will use a volume weighted trimmed mean for determining the rate.

Other alternatives

The forward looking SONIA term rates are still unknown and thus may not be an immediate substitute for the Libor. There are many others in competition like the ESTR from European Union or TONAR from Japan, SOFR from United States of America. Whichever benchmark comes in place, needs to be trustworthy and widely accepted.

Most Indian borrowing happens through the external commercial borrowing or ECBs for dollar. The interest cost of these borrowings is linked to Libor rate. Rather even the central bank Reserve Bank of India (RBI) regulations on these ECBs are marked to Libor for calculating the loan costs. With the change in the benchmark, all these borrowers will have to shift to the other benchmarks. The current Mumbai Interbank Forward Offer Rate or MIFOR is also linked to Libor and that will also see a relevant change.

So who would it be?

Borrowing is a necessity for growth and mostly the companies have borrowing or derivative dealing overseas. Even when planning to borrow abroad, the interest rate against which the loan is pegged to has to be understood. Thus as the 2021 comes closer and as loans mature, a universal alternative benchmark would have to be fixed sooner than later to avoid chaos in the financial markets around the world, especially the foreign exchange market.

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