Adoption of SOFR over LIBOR – Indian Context
Leaving
LIBOR is seen as a Land Mark Transition
As
we know the underlying market that LIBOR seeks to reflect has become
increasingly less active and therefore in 2017, the Financial Conduct Authority
(FCA) announced that it would no longer induce or compel member panel banks to
provide LIBOR quote post 2021 and that the participants in the market should
expect the discontinuation.
As
we know most of our International trade deals are transacted in USD and the
discontinuation of LIBOR and utilizing SOFR for USD may seem to a new concept
to be accepted post 2021. But, what is SOFR and How does it differ from LIBOR
is a question
On
5th March, 2021, the FCA announced the cessation of 1 week USD, 2 month USD,
GBP, EUR, CHF and JPY LIBOR after 31st December, 2021. The other LIBOR sets to
be ceased publication after 30th June, 2023. As per the supervisory guidance by
The Federal Reserve Board (FRB) and Federal Deposit Insurance Corporation
(FDIC), New contracts entering before the end of 2021, should utilize a
reference rate other than LIBOR or have a robust fallback language that
includes a well-defined Alternative Reference Rate (ARR).
Risk
Free Rates (RFRs) are Alternative Reference Rates that have been developed instead
of LIBOR which include Secured Overnight Funding Rate (SOFR) for USD, Sterling
Overnight Index Average (SONIA) for GBP, Euro Short Term Rate (ESTR) for EURO,
Swiss Average Overnight Rate (SARON) for CHF, Tokyo Overnight Average Rate
(TONA) for YEN.
SOFR
inherently differs from LIBOR. While LIBOR, which is administered by ICE
Benchmarks Administration, is an unsecured reference rate submitted by panel
banks with different maturities and built-in credit risk, SOFR is an overnight,
secured reference rate administered by the New York Fed that broadly measures
the cost of borrowing cash overnight with U.S. Treasuries as collateral – also
known as the repurchase market.
Indian Context
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.
Regulator
(RBI) preliminary estimated about $50 billion of debt contracts in the form of
ECB/FCCBs and $281 billion of derivative contracts will expire beyond 2021, as
on March 2020. These figures are, however, not static as new contracts
referencing LIBOR continue to be signed.
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.
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.
In
India, MIFOR – which has LIBOR as one of its components – is a key benchmark
used in the interest rate swap (IRS) markets. An alternate benchmark based on
global ARRs will need to be developed in place of the MIFOR. At present, the
Clearing Corporation of India Limited provides guaranteed settlement for IRS
contracts that reference the MIFOR. The clearing and settlement arrangements
will also need to be modified to provide for the alternate benchmark.
A
regulators scrutiny of existing loan/derivative contracts show that contractual
fallback clauses catering to cessation of LIBOR are not available in existing
contracts, which will continue beyond 2021. Fallback clauses customized to
domestic markets but based on global practices will, therefore, need to be
developed. These contracts may have to adopt the country specific ARR as a
substitute once LIBOR ceases to exist, beyond 2021.
Alternative
reference rates have been identified in major jurisdictions, but development of
liquidity markets in these rates – a sine quo non for ensuring smooth
transition - remains at a nascent stage. The FSB has laid out a global transition
roadmap for LIBOR, emphasising that firms should be in a position to assess
their LIBOR exposures and encouraging firms to adhere to the ISDA protocol for
the transition. The FSB has also suggested that by end-2020, firms should be in
a position to offer non-LIBOR linked loans to their customers. Achieving this
roadmap will, however, require significant efforts from all stakeholders.
The
transition arrangements for a benchmark embedded in the financial system
involve multiple stakeholders across market bodies, regulators, governmental
agencies and financial entities. A coordinated approach will be necessary to
enable the smooth transition from LIBOR.
Whether Indian Banks have adopted SOFR based
pricing for Trade Finance?
Axis
Bank and ICICI Bank were among the first few lenders to execute SOFR-linked
transactions in few cases. PSU Banks still follow LIBOR Based financing
contracts with an option to transit in case of cessation of LIBOR.
Recently,
HSBC has executed its maiden trade finance deal linked to secured overnight
financing rate (SOFR) in India, joining a select group of local banks that have
explored this new interest rate benchmark identified as an alternative to
London interbank offered rate or Libor.
The
documentary credit—a way of payment that protects both the exporter and the
importer in a trade finance deal—has been discounted for a period of close to
three years using SOFR. This also marks HSBC’s first project financing in the
solar energy segment in India. The bank however did not divulge the size of the
deal citing customer secrecy.
Pace of International Adoption
J.P.
Morgan is providing leadership in this landmark transition, chairing the
Alternative Reference Rates Committee (ARRC), a group of industry participants
convened by the Federal Reserve Board.
The
Alternative Reference Rate Committee (ARRC) chose SOFR because it is completely
transaction based which reflects the cost of secured funding across variety of
participants in the market. As SOFR is an overnight rate, the market needs
to model a term structure with different maturities to reflect expectations
about where interest rates will be in the future which will allow the corporate
sectors borrowing loans to predict payment in 3 month period. For both
accounting and operational reasons, many loans and securities are indexed off
of 1-month, 3-month and 12-month points on the curve.
Forward
to 2022, LIBOR shall continue on to the middle of 2023 but the borrowings on
transact using LIBOR rates shall continue only for Risk measures and Reduction
Process and not for other transactions.
Other Banks may follow the suit or adopt a
more resilient benchmark going forward is a Key monitorable.
References
/ Useful links:
1. RBI
Article: “Libor: The Rise and the Fall” https://rbidocs.rbi.org.in/rdocs/Bulletin/PDFs/6LIBORTHERISEE3D392AFFB274D638E86916FEDFA86C3.PDF
2. Term
SOFR Rates (Reference table): https://www.cmegroup.com/market-data/cme-group-benchmark-administration/term-sofr.html
4. Industry
Developments Internationally by J. P. Morgan https://www.jpmorgan.com/solutions/cib/markets/leaving-libor