Transitioning from LIBOR - An IPP’s Perspective

14 January 2022

Transitioning from LIBOR - An IPP’s Perspective

Authored by Shyam Sharma, CFO - O2 Power

Currently, the most discussed topic within the financing fraternity globally is the transition from London Interbank Offer Rate (LIBOR) to a risk-free rate (RFR) before June 30, 2023. This is also a hotly debated subject in India between our borrowers and banks.

The Renewable Energy (RE) sector is one of the leading sectors availing foreign loans to reduce overall borrowing costs, and is gearing to meet the deadline. The finance world is desperately searching for a substitute to sustain pricing harmony across the globe.

LIBOR Background

LIBOR is the most widely used benchmark globally for short-term interest rates in majority of the financial products ranging from loans to derivatives. At present, Libor is being calculated for five currencies -- USD, GBP, EUR, CHF and JPY -- and for seven tenors in respect of each currency --Overnight / Spot Next, One Week, One Month, Two Months, Three Months, Six Months and 12 Months). This results in the publication of 35 individual rates (one for each currency and tenor combination) every applicable London business day based on input data provided by LIBOR panel banks, called Contributor Banks.

Phasing Out LIBOR – The Need & Process

Due to widespread manipulations by contributor banks in deciding LIBOR and lack of underlying transactions available to determine the benchmark, regulators across countries had been pushing for LIBOR to be replaced Risk-Free Rates (RFR), and have assigned 30th June 2023 as the deadline for complete transition. RFRs will be based on a deep and liquid pool of underlying transactions and will provide a transparent benchmark rate thereby avoiding collusion among participating banks as happened in the case of LIBOR.

Working groups were set up in the U.S.A., Japan, Europe, the U.K. and Switzerland to recommend and select the RFR. The respective working group selected the Secured Overnight Financing Rate (SOFR) for USD Libor, the Tokyo Overnight Average Rate (TONA) for JPY Libor, Swiss Average Rate Overnight (SARON) for CHF Libor, Euro Short-term Rate (ESTR) for EUR Libor and Sterling Overnight Index average (SONIA) for GBP Libor.

In India, the Mumbai Interbank Forward Rate (MIFOR) is based on USD Libor and the forward premium derived from Indian forex markets. The Indian Banks Association (IBA) has selected Modified MIFOR. The Financial Benchmarks India Pvt Ltd has started publishing Adjusted MIFOR from 15th June 2021 and Modified MIFOR from 30th June, 2021. Adjusted MIFOR is to be used in legacy contracts while Modified MIFOR is for use in new contracts. RBI issued an advisory to banks to cease using MIFOR and LIBOR with some exceptions for new contracts by 31st December, 2021. Taking into account the number of forex contracts written by the State Bank of India, Axis Bank and ICICI Bank, SOFR is widely expected to be used as the new benchmark rate in India replacing LIBOR.

Challenges Ahead

A liquid RFR is a prerequisite to avoid any market dislocation or wide bid and offer spreads that may have bearing on funding and collateral postings. Unlike LIBOR, RFRs are over-night rates and not term rates, not forward-looking and do not contain an embedded credit spread. In order to recreate the term structure and credit spread, the RFR is daily compounded and a credit spread adjustment is added.

This fundamentally changes when cash flows are known a few days before the payment date instead of well in advance. However, for transactions like loans, borrowers may want cash flows to be known upfront by using a forward-looking term rate. This may lead to basic risks, hedging mismatches and valuation differences between different financial products. Being a new benchmark and fundamental change of determining rates, the acceptance among borrowers is slow. Banks need to provide lot of guidance to their clients to make them comfortable.

Globally, outstanding transactions linked to LIBOR are at $223 trillion, of which $74 trillion could be maturing by June 2023. The bulk is in derivative contracts for $213 trillion. Any new benchmarking will mean that there will be losers and gainers, and the amounts involved may be large. Taking this forward, the threat of risk posed to the financial system needs to be evaluated. Banks must make disclosures as part of market risk carried and the mitigating measures.

IPP Transition Issues

Legacy financing contracts referencing LIBOR will need immediate amendment to include fallback language and define the steps to move to new reference benchmarks. It is critical for firms to incorporate fallback language into all their contracts to ensure these contracts can continue using alternative benchmarks once LIBOR ceases.

In case of new financing transactions, developers need to negotiate contract in SOFR (in case of USD products) and other RFRs in case of other currencies.

As there RFRs are new, there is an understanding gap on the customer side over how the new RFR will be benchmarked to LIBOR . The new pricing for the financial products and getting a finer pricing from banks is a challenge presently.

Way Forward

As the era of LIBOR comes to an end, banks and customers need to ensure that they are prepared for the transition and ready to adopt new RFRs or risk being left out of the market. It will involve investment in new resources, workflow and IT. Libor and MIFOR will cease soon, embracing the RFRS is the way forward.

With the close of December 31, 2021 , forex training systems must mentor staff well, because based on the recommendations of the Alternative Reference Rates Committee of RBI, banks are already using SOFR (Secured Overnight Finance Rate) as an alternative, with little preparation and no experience.

LIBOR successfully played the role of a unifier in finance world throughout its life. It will be certainly missed.

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