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Bangladesh’s transition from LIBOR to RFR

Published : Thursday, 30 December, 2021 at 12:00 AM  Count : 1810

Bangladesh’s transition from LIBOR to RFR

Bangladesh’s transition from LIBOR to RFR

Interest rate benchmarks play a key role in global financial markets. The London Interbank Offered Rate (LIBOR) is the benchmarks for the investment throughout the world.  LIBOR is the most popular and worldwide accepted benchmark rate in determining loan pricing in multiple currencies.
A group of large banks, known as "panel banks", report their funding rates to theIntercontinental Exchange Benchmark Administration since 2014. The LIBOR rates are derived from an average of submissions by panel banks. Those numbers are averaged, adjusted, and released at about 11:55 a.m. London time each business day.
LIBOR is currently available for five currencies (US dollar, pound sterling, euro, Swiss franc, and yen). LIBOR is a forward-looking or "term" rate quoted for five currencies (USD, GBP, CHF, JPY and EUR) and seven tenors (overnight/spot next, one week, one month, two months, three months, six months and 12 months).
LIBOR has been widely used as a reference rate for financial contracts and as a benchmark to gauge funding costs and investment returns for a broad range of financial products, including adjustable-rate mortgages, credit cards, floating-rate bank loans, and interest rate or cross-currency swaps. It is estimated that globally, more than $300 trillion financial contracts are currently benchmarked on LIBOR.
In the cash markets, the main financial instruments referencing LIBOR include floating rate notes, syndicated loans and bilateral corporate loans, term wholesale deposits, overdraft and trade finance facilities, covered bonds, capital securities, perpetuals and securitisations, as well as retail and commercial mortgages.In Bangladesh, the overseas banks use to calculate the interest rate for local corporate clients on the basis of tenure such as LIBOR+2% -3 months or 6 months etc. The additional interest on LIBOR added as service charge for the local banks.
There are two main concerns with LIBOR. First, there has been a significant decline in the sample size for calculating LIBOR since the 2008 financial crisis. In its aftermath, fewer panel banks have been reporting, and those that do, report fewer quotes based on market transactions. There have been questions around integrity and reliability of LIBOR post global financial crisis of 2007/08, leading to loss of confidence among market participants.

Moreover, LIBOR has increasingly relied on what the Intercontinental Exchange Benchmark Administration calls "market and transaction data-based expert judgment." There have been a range of irregularities uncovered by regulators, which have led to large fines for those involved. As a result, global regulatory initiatives have sought to develop alternative reference rates (ARRs).

In July 2018, FCA recommended that market participants transition toalternative risk-free rates (RFR). The development of term benchmarks based on risk-free rates (RFRs) is an important aspect of the work to facilitate a successful transition from LIBOR. A coordinated approach involving multiple stakeholders across market bodies, regulators, governmental agencies and financial entities is being undertaken to enable the smooth transition from LIBOR.
In July 2017, the United Kingdom's Financial Conduct Authority announced it will no longer compel banks to submit rates for the London interbank offered rate (LIBOR) beyond 2021, a Risk Free Rates (RFRs) are alternative reference rates that have been developed for use instead of LIBOR.

As a result of this announcement, financial regulators worldwide have been strongly encouraging financial institutions exposed to the LIBOR reference rate to prepare for its replacement before the end of 2021. Across jurisdictions, regulators are promoting national currency-specific alternative reference rates.
The key differences between RFRs and LIBOR are: unlike LIBOR which is a forward-looking rate for seven different tenors or durations for each currency, the applicable RFR is a backward-looking overnight rate and is based on actual transaction data. The risk-free rate is the rate of return of an investment with no risk of loss. It is a predictive rate for the relevant interest period; the "in advance" RFR reference rate is a historic rate for a prior observation period.

Most often, either the current Treasury bill, or T-bill, rate or long-term government bond yield are used as the risk-free rate. T-bills are considered nearly free of default risk because they are fully backed by the government. Although in practice, the risk-free rate of return does not truly exist, as every investment carries at least a small amount of risk.

Based on this decision, Central Banks around the world, including Bangladesh Bank have given the consent for banks to transition away from LIBOR to other Risk Free Rates from 01 January 2022. From 2022 onward, all new loans and LCs / SBLCs will be priced differently in addition to carrying out entire outstanding loans and LCs / SBLCs with switching Libor to new interest rate.

The Bangladesh Bank issued a FE circular no 22 dated June 21, 2021 to fix a fresh reference rate for short term trade financing ahead of the phase out from the London Interbank Offered Rate globally after December 31, 2021. The circular allowed the banks to charge 3.5 per cent per annum on top of the reference rate in the currency of financing for discounting or early payment of export bills. Besides the 3.5-per cent plus reference rate, the banks were allowed to charge up to 2.5 per cent on risk free reference rate. Currently, the banks are allowed to charge six-month LIBOR plus 3.50 per annum against short term trade financing.
RFRs do not have a tenure element, have the robustness to change according to market conditions, are based on reliable and sufficient market data, are subject to controls and governance, and reflect actual funding rates of the market. RFR is a benchmark rate based on overnight deposit rates. As they are derived from a large volume of real observable transactions, they are considered as 'risk-free'. The RFRs are not based on professional judgment rather on legitimate transactions.
RFR marks one of the biggest structural changes in the financial world which will have major consequences for the functioning of banks, financial institutions and corporations with respect to financial risk management, regulatory and legal compliance, operations and accounting etc.
The writer is a legal economist

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