RBI suggests lowering MIBOR concentration in interest rate derivatives

The regulators of different countries noted the suggestions and began reforming their money market benchmarks.

The Reserve Bank of India recently released a Report of the Committee on MIBOR (Mumbai Interbank Outright Rate) Benchmark. MIBOR is an inter-bank interest rate used to price interest rate products particularly interest rate derivatives (IRD). The report argues that the IRD markets trade extensively on MIBOR which leads to concentration risk.

Interestingly, the report was released in the backdrop of ending of another global interest rate benchmark - LIBOR (London Inter Bank Offered Rate). Banks have used interbank interest rates for lending and borrowing to banks for a long time. These interest rates were established in London. In 1986, British Bankers Association started administering LIBOR. Every weekday BBA asked 17 major banks to report the interest rate they will borrow from each other across 7 maturities. The four highest and four lowest rates are excluded. The rest of the rates are averaged and that is LIBOR for the 7 maturities of the day. Overtime LIBOR became the benchmark interest rate for not just US Dollar lending but for other currencies too. Different countries started their own benchmarks came to be known as EUR LIBOR (Europe), TONA (Japan), KOFR (Korea) etc.

End of LIBOR and its Impact

During the 2008 crisis, it was accused that LIBOR was being rigged by bankers to underprice interest rate risks. There was wide criticism that banks first determined LIBOR and then traded in them. It is like the regulator makes regulation for itself. It was decided that LIBOR would cease to exist as a benchmark. The new benchmark interest rates would be determined by observing actual interbank rates. The new benchmarks will be published by either the regulator or an independent administrator. The regulators of different countries noted the suggestions and began reforming their money market benchmarks. The authorities stopped publishing LIBOR rate in 2023 and synthetic contracts stopped being published on October 1 2024.

Let us review benchmark interest rate in India. MIFOR was started in 1998 by the National Stock Exchange (NSE) in 1998. Two rates were published – the MIBOR and the Mumbai Interbank Bid Rate (MIBID). The rates were computed through a polling process conducted by NSE, similar to that of LIBOR. In 2002, FIMMDA (Fixed Income Money Market and Derivatives Association of India) joined NSE and the benchmark was rechristened as FIMMDA-NSE MIBID/MIBOR.

Following the LIBOR crisis, the RBI constituted a Committee on Financial Benchmarks in 2014. The Committee recommended that the benchmark rate should be administered by another body and benchmark rate be should be based on actual transactions. Accordingly, Financial Benchmarks India Limited was established in 2014 and it started publishing the overnight interbank rate in 2015 replacing the “FIMMDA-NSE Overnight MIBID/MIBOR” with “FBIL- Overnight MIBOR”, the current MIBOR.

Evolution of India's Benchmark Rates

Coming now to be MIBOR Committee report of 2024. The Committee notes that after MIFOR was published in 1998, Interest Rate derivatives (IRD) were started in 1999. In the last 25 years, IRD markets have grown significantly from Rs 4000 cr in 2000 to Rs 100 lakh crore in January 2024. The market instruments have also evolved from a plain vanilla fixed to floating swap to swaptions. Foreign banks constitute majority of the market followed by private sector banks and primary dealers. Public sector banks play a limited role in IRD markets.

Enhancing Market Diversity and Participation

One aspect of Indian IRD markets is that it is highly concentrated market. Nearly 85 percent of IRD market constitutes of one instrument: Overnight Swaps based on MIBOR. There are both pros and cons of this concentration.

The pro is that a single instrument is simple, easier to value and thus enables better risk management. It also concentrates liquidity, potentially leading to tighter bid-ask spreads, improved price discovery, and greater market depth. Globally, most IRD markets are concentrated on a single instrument.

The con is that multiple instruments based on different benchmarks provide diversity. The lesson from LIBOR crisis was that one instrument dominating markets leads to multiple problems once it become less representative. More choices allow market participants to select products that best match their needs, hedging strategies, and risk tolerance.  The markets have also evolved overtime and participants prefer more secured collateralised benchmark rates, whereas MIBOR is uncollateralised.

Recommendations for Reform

Based on these pros and cons, the Committee has made several recommendations to reform MIBOR markets.

First, the FBIL should publish MIBOR based on first three hours of transactions than just one hour to cover more trades. Second, it could publish a new benchmark based on secured money markets - Secured Overnight Repo Rate (SORR) computed from trades in first three hours of repo transactions. Third, one needs to gradually transition from MIBOR to SORR once there is enough liquidity and depth in the SORR market. The Committee also made suggestions to widen the IRD market by allowing non-residents to the onshore IRD markets, beyond MIBOR OIS, for purposes other than hedging in a gradual manner. The IRD regulations for different participants may be reviewed to encourage more participation and flexibility.

To sum up, the 2024 RBI Committee on MIBOR adds to the ongoing discussion and changes in the money market interest rate benchmarks. So far the discussion was around publishing benchmark interest rates based on actual transactions by an independent administrator which was FBIL. The Committee has taken another step towards identifying concentration of MIBOR as a risk and has also suggested to shift from LIBOR to SORR. This is a step in the right direction as given heightened uncertainty, it is always better to have more choices and a benchmark that is based on collateralised transactions.