Along with the statement on monetary policy, the Reserve Bank of India (RBI) also releases a statement on developmental and regulatory policies (SDRP), which lists changes in the banking and market regulations. In its October 2018 policy, one of the changes in SDRP was related to regulatory oversight of benchmark administrators.
The central bank recently put out draft guidelines on the regulatory framework for financial benchmarks. Most people are likely to have ignored these guidelines because they are not sure what it means. However, these developments are part of global changes in financial markets which are important.
So, what do we mean by financial benchmarks? Financial Benchmark India Private Ltd (FBIL) explains it as: “Financial benchmarks are indices, values or reference rates used for the purpose of pricing, settlement and valuation of financial contracts. Globally huge volumes of financial transactions are referenced to or valued using various such benchmarks.”
Thus, in equity markets, BSE Sensex or Nifty serve as benchmarks; in debt/bond markets there are inter-bank interest rates; in forex markets, there are reference exchange rates. Therefore, one can say reference rates market is the soft infrastructure required for the functioning of financial markets.
The most important such benchmark for interest rates is the London Inter-bank Offered Rate (Libor), which was developed by the British Bankers Association (BBA) in 1986. First, the BBA polls 18 select banks on their view on the cost of funds in the inter-bank market. Second, using the trimmed mean approach, BBA rejects the highest and lowest four rates. Third, it calculates the average of the middle 10 banks to arrive at the Libor.
After the 2008 global financial crisis, inquiries revealed that these select banks were colluding and underreporting Libor. This, in turn, led to overall lower interest rates in inter-bank markets, allowing the same banks to profit. This disrupted the soft infrastructure. The colluding banks were fined heavily for their misconduct, but this could not prevent erosion of trust in financial markets.
In order to restore trust and design new benchmarks, regulators decided to stop using polled rates and instead use market-based interest rates on actual transactions. The mighty Libor is now going to be phased out by 2021. UK’s Financial Conduct Authority is working out a mechanism to help facilitate this transition in London’s financial markets.
As a result, most countries are instituting changes to market-driven benchmarks. In 2014, the Federal Reserve convened the alternative reference rates committee (ARRC), which opted for Secured Overnight Financing Rate, or SOFR, as the alternative to Libor. New York Fed administers and publishes SOFR.
Similarly, UK is moving to Sterling Overnight Index Average (SONIA); Canada is moving to the Canadian Dollar Offered Rate; Australia to Bank Bill Swap Rate (or BBSW) and the Eurosystem to Euro Short Term Rate (ESTER). Both the International Organisation of Securities Commissions (IOSCO) and Financial Stability Board (FSB) are coordinating these efforts at the global level.
India is also addressing these challenges. In June 2013, RBI instituted a committee to review the existing financial benchmarks, which noted that the calculation of benchmarks in India was satisfactory, but the governance framework needs redressal. They suggested that Fixed Income Money Markets and Derivatives Association (FIMMDA) and Foreign Exchange Dealers Association of India (FEDAI) may be designated as administrators for all rupee interest rate and foreign exchange benchmarks, respectively, with RBI playing the role of an overseer. In order to avoid conflicts, the committee recommended establishing “a separate independent structure, either jointly or separately, for administration of the benchmarks on the lines of Singapore”.
FBIL is an outcome of this recommendation. It started with administering the Mumbai Inter Bank Offer Rate (MIBOR) rate, which was earlier managed by the National Stock Exchange, and is now computed on previous transactions and not polls, as was the case earlier.
FIBIL is gradually taking up responsibilities for managing other benchmarks, such as reference rates for the foreign exchange rate, as announced in July 2018. The recent RBI guidelines noted above are to regulate these benchmark organisations, which will gradually assume an important status in financial markets.
To sum up, the global financial crisis shook the very foundations of financial markets with financial benchmarks being one of them. Global authorities’, particularly central banks, are now working on alternate benchmarks, given their importance in running financial markets.
Indian policymakers have done well to show alacrity to these ongoing global developments and instituting changes looking at both, domestic context and global practices. This is welcome and should be followed in other domains of economic policy as well.(Amol Agrawal is faculty at Ahmedabad University. The views expressed here are his own.)