Developing Alternative Reference Rates – LIBOR Cessation

Central banks and regulatory authorities the world over are preparing for the cessation of LIBOR (the London Inter-Bank Offered Rate) for most currencies by end-2021, the reference benchmark for a wide range of financial products and services for several decades before it became discredited in a long-running manipulation scandal that was uncovered in 2012 in the aftermath of the global financial crisis in 2008.

LIBOR is generally still the most referenced short-term interest rate in the world. Islamic financial institutions also used LIBOR as a guidance benchmark to pricing their products and services, partly because of the absence of a Sharia’a-compliant alternative.

The result has been a scramble to develop alternatives such as the transaction-based alternative reference rate (ARR) forcing financial institutions to update their contracts and other communications materials in time for the proposed ending of LIBOR support on 31 December 2021.

According to Clyde & Co, the international law firm based in London, the transition from LIBOR to alternative rates over the next year represents one of the biggest changes to the financial services industry ever. “With an estimated US$370 trillion of LIBOR related activity globally, covering loans, bonds, derivatives, working capital and trade products, the LIBOR transition will significantly affect how contracts are priced and how risk is managed by market participants, lenders, borrowers and guarantors which use LIBOR as their operating model,” explained the law firm in a recent briefing.

The Islamic finance industry, as an integral niche part of the mainstream global financial system, is no exception. How many central banks in the 57 OIC member countries will be ready for the LIBOR cessation and transition to ARR is unclear. The short-to-medium-term impact on the Islamic financial services industry too remains uncertain.

Bank Negara Malaysia (BNM) for instance launched the Malaysia Overnight Rate (MYOR) at end September 2021 as the new ARR for the conventional financial sector in the country after a robust market consultation which started in January 2021. Globally, ARRs are being introduced to improve the integrity of financial benchmark rates as part of a transition to transaction-based rates, in line with the LIBOR reforms after the Financial Crisis.

“The introduction of ARRs aims to facilitate usage of benchmark rates that are more robust and based upon transactions in active, liquid markets. In Malaysia, the MYOR will run in parallel to the existing Kuala Lumpur Interbank Offered Rate (KLIBOR) with periodic reviews to ensure that the financial benchmark rates remain robust and reflective of an active underlying market,” explained BNM.

The current reference rate for the Malaysian Islamic finance industry is the Kuala Lumpur Islamic Reference Rate (KLIRR). According to BNM, as part of its ongoing efforts to further develop the Islamic financial market, it is collaborating with the Financial Markets Committee (FMC) and the Islamic Market Technical and Development Committee (IMTDC) of the Association of Islamic Banking and Financial Institutions Malaysia (AIBIM) and the Financial Markets Association Malaysia (FMAM), to develop a new Islamic benchmark rate to replace KLIRR during the first half of 2022.

The FMC was established by BNM in May 2016 and comprises representatives from the Bank, financial institutions, corporations, financial service providers and other institutions which have prominent roles or participation in the financial markets.

KLIRR on the other hand was introduced in 2006 as a reference rate for the Islamic interbank money market. However, its use as a pricing reference has remained limited. BNM in consultation with the FMC, in tandem also conducted a comprehensive review on the suitability of the continuity of KLIRR. The decision was made in October 2021 to develop and launch an alternative Islamic reference rate that adheres to global standards for financial benchmarks.

In October 2021, the Bahrain-based International Islamic Financial Market (IIFM), the Islamic finance industry’s leading standard-setting body, announced “the approval of its Sharia’a Board’s RFR implementation related Compliant Standard Structuring Solutions for Murabahah and Ijarah transactions.

“The global benchmark rate reform is a significant regulatory driven development that also has consequences for Islamic financial transactions. Globally, work on phasing out of LIBOR and transition to Risk-Free Rates (RFR’s) or Alternative Benchmark Rates is now approaching discontinuation date of 31 December 2021 for currencies such as USD, EUR, GBP, CHF, JPY and certain other hard currencies used in the domestic as well as cross border trades, except in a few cases the final deadline will be June 2023.”

IIFM took the lead by creating awareness in the Islamic finance industry on this significant development and highlighted the challenges posed, in particular to Islamic financial product structures, transactions, documentation, credit and legal matters through consultation with key industry stakeholders. This culminated in the publication of “the industry’s first and only white paper on “Global Benchmark Rate Reforms and Implications of IBOR Transition for Islamic Finance” in March 2021.”

Since the publication of the white paper, IIFM has moved forward and started working on implementation of RFRs in Islamic Financing and Hedging transactions so that the transition to RFRs does not affect industry development and competitiveness. Contributions from leading financial institutions, accounting firms, law firms and a few other market participants came together to create awareness and highlight potential challenges that the Islamic financial industry may face in its activities due to this new transformation development.

According to IIFM Chairman, Khalid Hamad Al Hamad of the Central Bank of Bahrain, “IIFM has always strived to take active role in the industry’s development and its unification and the publication of these Sharia’a-compliant solutions required for smooth transition by the Islamic Finance industry. Developing a Sharia-a solution on these new alternative benchmark rates is testament to IIFM’s valuable contribution to the industry and no doubt these standard guidelines will greatly benefit all the market participants globally.”

In order to form a consensus around the development of viable and standardized Sharia’a-compliant solutions and amendments particularly in documentation, IIFM worked with three specific work streams namely Financing, Hedging and Sukuk to deal with this important development and to reach practical and workable solutions relating to IIFM mandated areas of focus.

The publication of the IIFM Sharia’a-compliant standard structuring solutions for RFR’s implementation for Murabahah and Ijarah transactions, emphasised Ijlal Ahmed Alvi, Chief Executive Officer of IIFM “is culmination of the hard work carried out by the financing workstream and final guidance and approval by the IIFM Sharia’a Board.

“Publication of these Sharia’a-compliant Standard Solutions amplifies the importance of collaboration needed to overcome challenges and develop Sharia’a-compliant standardized guidelines, solutions and documentation as the Islamic finance industry cannot develop on a sound footing without cooperation and support of all stakeholders, who can drive maximum benefit by ensuring wider implementation levels of these RFR implementation related standard solutions which will be beneficial to the users as well as to the industry globally.”

Another alternative is the compounded in arrears structure, using the Secured Overnight Financing Rate (SOFR) for US dollar credit facilities and remains the rate recommended by the Alternative Reference Rate Committee (ARRC), which was established in the US to deal with the transition away from US dollar LIBOR.

In fact, in April 2021, the Islamic Development Bank (IsDB) issued its debut SOFR-linked Sukuk, which is also the first such offering in the global capital markets. The IsDB raised US$400 million through the 3-year Sukuk offering – a Floating Rate Note (FRN) subscribed by a single investor on a Private Placement basis.

The SOFR will be one of the new global benchmark rates replacing LIBOR. SOFR, according to the IsDB, is a broad measure of the cost of borrowing cash overnight collateralized by US Treasury securities. Dr Zamir Iqbal, Vice President (Finance) and CFO of IsDB maintained that “with almost US$22 billion in Sukuk outstanding, it is imperative for IsDB to plan for ensuring a smooth transition away from LIBOR and offer new instruments to investors who are important stakeholders in the transition.”

Zakky Bantan, the Manager of Capital Markets at IsDB, also confirmed that the Bank anticipates “further SOFR-linked Sukuk issuances in order to build IsDB’s SOFR-linked curve. We will also continue our efforts for other risk-free rate issuances soon.”