[Mukund Arora is a second-year BBA LL.B. (Hons.) student at the Symbiosis Law School, Pune]
London Interbank Offered Rate (LIBOR) was a benchmark rate used to price lending transactions among major global banks in the international market. It demonstrated the borrowing costs between banks on unsecured terms. According to the Federal Reserve System, it was utilized to price financial products worth at least USD 200 Trillion short-term funding transactions on any given day globally. Major banks would submit their interest rates on short-term loans to the Intercontinental Exchange (ICE) daily, following which an average of these rates would be calculated to derive the LIBOR rates. Following an investigation on the integrity of the benchmark, financial institutions worldwide are transitioning out of LIBOR.
This post seeks to reassess the potential legal risks faced by Indian banks while making this transition and examine why LIBOR’s substitutes- the Alternative Reference Rates, are likely to be more robust benchmarks than the LIBOR.
Why was LIBOR discontinued?
LIBOR was at the core of the scandal that unfolded in London in 2012. Leading banks like Barclays, Citigroup, and UBS were held guilty for manipulating the LIBOR to benefit their positions in the capital markets. These banks colluded to manipulate the LIBOR rates by coordinating their positions in the market with their submission of LIBOR rates. Therefore, the LIBOR submissions made by these banks allegedly did not arise from actual transactions or interest rates but were suited to keep the benchmark at their preferred levels. This would mean that the LIBOR would either be artificially low or high as opposed to its original value. The banks entered into deferred prosecution agreements with the regulators and accepted all the charges. These banks were penalised billions of dollars by the regulators from various jurisdictions. This was followed by the resignation of the top executives of these banks. Criminal action was initiated against the employees of these banks. In R v. Tom Hayes, a Citibank employee was sentenced to fourteen years in prison for manipulating the LIBOR.
Regulatory prohibition on using LIBOR as a benchmark
The benchmark was used to determine the interest rate on financial products, including home loans, student loans, insurances, credit cards, derivatives, and other interbank products. Therefore, changes in LIBOR’s basis points would often impact interest payments made by consumers worldwide monumentally. Institutions like transportation systems, pensions funds, and mutual funds with investments based in LIBOR linked securities were also susceptible.
It was considering the scandals surrounding LIBOR and its growing unpopularity in the London interbank market, the U.K. Financial Conduct Authority (“FCA”) decided to discontinue the reference rate by the end of 2021. Following this, regulatory bodies and governments around the world began to look for solutions for pre-existing LIBOR-based contracts and securities and began seeking alternatives to the reference rate.
In India, the RBI, through a circular, first required all the banks and financial institutions to halt the utilization of LIBOR as the reference rate with effect from 31 December 2021. It encouraged the parties to cease entering contracts referencing LIBOR as a benchmark. This is similarly applied to the Mumbai Interbank Forward Offer Rate (MIFOR), directly linked to the USD LIBOR. It further directed the incorporation of Alternative Reference Rates while entering new financial contracts. Widely accepted ARRs include The Secured Overnight Financing Rate (SOFR), Sterling Overnight Interbank Average (SONIA), and Euro Short-Term Rate (ESTR).
Certain legal and financial risks have been at the core of the LIBOR transition worldwide. Regulatory bodies globally adopted different systems to facilitate the transition while minimizing risks. RBI had proposed a cut-off date of 31 December 2021 for the transition. It tasked the Indian Banks Association (IBA) to oversee the transition arrangements. The IBA, among other initiatives, had shared a guidance note among its members to allow them to evaluate their readiness for LIBOR transition on various factors, including exposure assessment and assessment of the accounting, tax, information technology-related implications.
In RBI’s review of guidelines for restructuring of derivatives contracts in LIBOR transition issued on 6 August 2021, the change has been referred to as a “force majeure” event. This could, in consequence, attract the doctrine of frustration, allowing parties non-performance as a result of an event outside their control. Section 56 of the Indian Contract Act, 1872 deals with contracts that become impossible to perform. However, whether this could constitute a force majeure event and whether the discontinuation makes performance impossible is subject to the court’s interpretation. It may be argued that the benchmark is an essential part of the contract, and the application of an ARR would result in a significantly changed outcome for the parties. Further, RBI, in all its releases,had permitted the use of “other widely accepted Alternative Reference Rates” in the currency concerned. Thus, if more than one benchmark is further applicable to these contracts, it may also become subject to negotiation by the parties. Large syndicated loans would require even more time to transition.
As a point of comparison, a New York law passed in March 2021 mandated SOFR as a benchmark replacement for contracts with no fallback language that provide any possibility of alternatives or renegotiation or tough legacy contracts. Owing to this legislation, parties were prohibited from claiming a breach of contract as a result of LIBOR’s discontinuation.
However, the banks in India have not faced these litigation risks. The banks added ARRs or fallback clauses to existing international loan agreements to a successful extent. This can primarily be attributed to the fact that this change is global and applicable to entities worldwide. Additionally, the transition has been facilitated under a specific framework laid down by the RBI. Parties agreeing to determine a new benchmark for their contracts that is relatively safer than LIBOR would also work to their benefit. The international banking division of UBI recently declared its adoption of SOFR and SONIA to conclude international deals for USD and GBP loans, respectively. IDBI also followed suit to announce the replacement in compliance with the regulatory directions. Therefore, it has become more important to assess the viability of the ARRs.
What is different?
The calculation methodology of SOFR makes it more reliable and harder to manipulate. It is a broad measure of transactions in the U.S. Treasury repo market. It is based on the cost of borrowing cash overnight collateralized by U.S. Treasury securities in the repurchase agreement market. On the other hand, LIBOR was based on a panel bank output incorporating a limited number of transactions. SOFR is considered a risk-free rate since it is based on overnight treasury transactions, whereas LIBOR encompassed a risk of bank borrowings. Similarly, SONIA is managed by the Bank of England. It is derived from the weighted average interest rate on all unsecured Sterling loans reported by financial institutions. These transactions, however, have a minimum deal size of 25 million Pounds and are brokered by the Wholesale Markets Brokers’ Association as a calculation and publication agent. Like SOFR, SONIA is hard to manipulate since it is based on actual transactions.
The transition can largely be attributed to a change brought about in the regulatory ecosystem over time. Historically, LIBOR was left ineffectively regulated under the control of the British Bankers Association (BBA). It was only after the revelations of the LIBOR scandal that the legislature transferred the publication of the benchmark from the BBA to the intercontinental exchange, following which its calculation method was altered. The production of the benchmark then came under the regulation of FCA. The transfer of control from a private banking association to a statutory regulatory authority is believed to ensure more transparency and credibility. Similarly, in the U.S., SOFR is administered by the Federal Reserve Bank of New York in cooperation with the Treasury Department’s Office of Financial Research (OFR), making it more reliable and robust, far from a system of self-regulation by the banks. In the U.K., SONIA is now regulated by the FCA and administered by the Bank of England. The International Organization of Securities Commissions published a report in 2013 outlining the best practices for financial benchmarks, with which the Bank of England and the RBI now comply. It took into consideration factors like the submission procedures, content and transparency of methodologies, and governance processes. The RBI in India,through its Financial Benchmark Administrators (Reserve Bank) Directions, 2019, regulates the usage of these benchmarks with closer scrutiny. Through this, it sets up an oversight committee, review, formulation, internal control measures, and various extensive procedures to ensure effective regulation. It had previously decided to chalk out an alternative for the MIFOR but has currently relied on the ARRs.
The magnitude of damage that the LIBOR scandal caused is unsettled. For a number that is referred for transactions running up trillions, even minor manipulation can lead to significant differences. With the transition almost winded up, the need to ensure the viability of ARRs becomes all-important. With effective regulation, the interests of consumers around the world and the integrity of the markets can be protected.
– Mukund Arora