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India to launch new overnight benchmark rate from July 22

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India will adopt from July 22 a new method to set the overnight interest rate benchmark.

What is overnight benchmark rate?

The overnight benchmark rate refers to the interest rate on short-term financing (usually a day) between central bank, banks and other financial institutions. As the amount of money a bank has fluctuates daily because of lending and withdrawals, banks experience a shortage or surplus of cash at the end of the business day. Those banks that experience a surplus often lend money overnight to banks that experience a shortage so the banking system remains stable and liquid.

What is new about in this rate?

Previously, the rate used to be fixed by taking the ‘opinion’ of all big financial institutions every day, about the level of interest rate at which they are either willing to borrow or lend. In other words, it used to be compiled by polling market participants.

Now, the new rate will be based on traded levels instead of contributions from market participants. It will be based on trade-weighted call money transactions conducted on Clearing Corporation of India’s trading platform between 0900-1000 IST. So now instead of basing the rate on subjective opinions of market participants, which can be vulnerable to manipulation, the new rate will be determined by an algorithm which takes in to account the level of transactions to determine the rate.

The new method will replace the current Mumbai Inter-Bank Offer Rate (MIBOR), and will be called the FBIL Overnight MIBOR.

Previously National Stock Exchange and Thomson Reuters used to administer the overnight rate benchmark. Now it will be administered by the board of Financial Benchmarks India Private Ltd (FBIL).

Why was it required?

Last year, the world saw a massive scam involving overnight benchmark rates, shaking people’s confidence in financial institutions. It involved the London interbank offered rate (LIBOR) based on which overnight rates are determined around the world. It was revealed that the banks participating in determining the LIBOR rate rigged the system to favour them.

The new FBIL Overnight MIBOR reflects RBI’s response to that controversy. It is a proactive response by RBI and Indian domestic industry to avoid such controversy in India.