In the modern banking and financial system, benchmark interest rates and foreign exchange market practices play a very important role. LIBOR was one of the most widely used global benchmark interest rates, while Alternate Reference Rates (ARRs) have emerged as its replacement. At the same time, in India, foreign exchange market operations are guided by standards and rules laid down by FEDAI.
LIBOR (London Interbank Offered Rate)
LIBOR, or London Interbank Offered Rate, was a global benchmark interest rate that indicated the average rate at which leading international banks were willing to lend to each other in the London interbank market.
LIBOR was published for different currencies such as USD, GBP, EUR, JPY, and CHF, and for different tenors like overnight, 1 month, 3 months, 6 months, and 12 months. It was used as a reference rate for a wide range of financial products including loans, bonds, derivatives, and trade finance instruments.
Many international loans were priced as LIBOR + spread, where the spread reflected the borrower’s credit risk.
Importance of LIBOR in Banking
LIBOR played a key role in the global financial system. It acted as a benchmark for pricing loans, interest rate swaps, floating rate bonds, and other financial contracts. Banks used LIBOR to determine interest rates on corporate loans, export-import finance, and external commercial borrowings (ECBs).
Because of its wide usage, any change in LIBOR directly affected borrowing costs across the world.
Problems with LIBOR
Over time, serious issues were identified with LIBOR. The rate was based on estimated submissions by banks, not on actual transactions. This made it vulnerable to manipulation.
After the 2008 global financial crisis, interbank unsecured lending reduced sharply, making LIBOR less representative of actual market conditions. In 2012, major scandals involving manipulation of LIBOR rates came to light, severely damaging its credibility.
Due to these weaknesses, global regulators decided to phase out LIBOR.
Discontinuation of LIBOR
Regulators announced that LIBOR would be discontinued after June 2023 for most currencies and tenors. Banks and financial institutions were required to shift existing contracts and new transactions to more reliable benchmark rates.
This transition gave rise to Alternate Reference Rates (ARRs).
Alternate Reference Rates (ARRs)
Alternate Reference Rates (ARRs) are new benchmark interest rates developed to replace LIBOR. These rates are based on actual market transactions, making them more transparent and robust.
ARRs are generally risk-free rates (RFRs), meaning they do not include a bank credit risk premium. As a result, they are considered more stable and reliable.
Major Alternate Reference Rates
Different countries have adopted different ARRs:
- SOFR (Secured Overnight Financing Rate) – United States
- SONIA (Sterling Overnight Index Average) – United Kingdom
- €STR (Euro Short-Term Rate) – Eurozone
- TONAR (Tokyo Overnight Average Rate) – Japan
- SARON (Swiss Average Rate Overnight) – Switzerland
Each of these rates reflects overnight borrowing costs in their respective markets.
Difference Between LIBOR and ARRs
LIBOR was a forward-looking term rate, while most ARRs are overnight rates. LIBOR included bank credit risk, whereas ARRs are nearly risk-free. LIBOR was based on estimates, while ARRs are based on actual transactions.
Because ARRs are overnight rates, they are usually compounded over a period to calculate interest for loans and derivatives.
Impact of Transition from LIBOR to ARRs on Banks
The transition from LIBOR to ARRs has significant implications for banks. Loan documentation, derivative contracts, and IT systems needed modification. Banks had to ensure proper fallback clauses in contracts to avoid disputes.
For Indian banks involved in international banking, trade finance, and ECBs, understanding ARRs is critical for pricing and risk management.
Foreign Exchange Dealers Association of India (FEDAI)
The Foreign Exchange Dealers Association of India (FEDAI) is a self-regulatory body established in 1958. It plays a crucial role in the orderly development of the foreign exchange market in India.
FEDAI works in close coordination with the Reserve Bank of India (RBI) and provides guidelines, rules, and best practices for foreign exchange dealings among banks.
Objectives of FEDAI
The main objective of FEDAI is to ensure uniformity and discipline in foreign exchange transactions carried out by banks in India. It aims to promote professional conduct, transparency, and efficiency in the forex market.
FEDAI also acts as a forum for resolving operational issues faced by authorised dealers.
Role and Functions of FEDAI
FEDAI issues rules, guidelines, and codes of conduct for foreign exchange transactions. These cover areas such as merchant rates, interbank dealings, forward contracts, cancellation and rebooking of contracts, and handling of export and import transactions.
FEDAI also prescribes standard practices for calculation of exchange rates, interest, and charges related to forex business. This helps in maintaining consistency across banks.
Another important function of FEDAI is to coordinate with RBI on policy matters and represent the views of authorised dealer banks.
FEDAI Rules and Their Importance
FEDAI rules are widely followed by banks while conducting foreign exchange business. Though FEDAI itself is not a statutory body, its rules carry significance because RBI expects authorised dealers to adhere to them.
For banks, compliance with FEDAI rules reduces operational risk and disputes with customers. For exam purposes, FEDAI rules are often tested in relation to forward contracts, cancellation charges, and exchange rate calculations
Conclusion
LIBOR played a central role in global finance for decades, but its weaknesses led to the adoption of more transparent and reliable Alternate Reference Rates. This transition has reshaped international banking and interest rate pricing. At the domestic level, FEDAI ensures orderly conduct and uniform practices in India’s foreign exchange market.