LIBOR transition—impact on hedge accounting

Robert Pickel, Chair of P.R.I.M.E. Finance, explains the concerns around hedge accounting in the context of the transition away from LIBOR and discusses how these concerns are being addressed.

Background

After 30 years, the London Interbank Offered Rate (LIBOR) and other IBORs are being phased out. An estimated $370 tln global financial contracts are referenced to LIBOR, see here. Therefore, the transition to alternative risk-free rate (RFRs) is likely to have far reaching effects, impacting areas beyond merely the terms of a contract. Contracts referencing LIBOR, such as cross currency swaps, inflation swaps and swap options, will all be affected by this transition, as will bonds, loans and mortgages. 

This News Analysis addresses the impact of this transition on financial reporting by thousands of derivatives users. In particular, the change in benchmark rates is likely to trigger issues relating to accounting standards under US Generally Accepted Accounting Principles (US GAAP) promulgated by the Financial Accounting Standards Board (FASB) and the International Financial Reporting Standards (IFRS) promulgated by the International Accounting Standards Board (IASB). The widely-used practice of hedge accounting and the continued effectiveness of existing hedges could be undermined if not addressed by the FASB and the IASB in a timely fashion. The effect will be to introduce volatility into financial statements of public reporting companies if hedges are no longer effective.

This News Analysis generally refers to LIBOR instead of IBORs more generally. The issues addressed in this News Analysis are applicable to any situation where underlying instruments and a related hedge reference an IBOR, but the sheer size of financial contracts referencing LIBOR make it the LIBOR of greatest concern.

What is hedge accounting?

Hedge accounting is an accounting standard that allows the offsetting of cash flows between an underlying instrument and a hedge related to that instrument. The illustration below provides an example of where Company A issues bonds to the public with interest payable by reference to LIBOR. To offset this risk, Company A enters into a fixed-for-floating interest rate swap with the Bank. The Bank agrees to make payments by reference to LIBOR and the Company agrees to make payments at a fixed rate. Looking at the totality of the two transactions (the bond and the swap), the Company has protected itself from fluctuations in LIBOR. In other words it has ‘hedged its risk’. 

LIBOR diagram1

However, for such a hedge to be considered ‘effective’, the cash flows need to offset each other to a significant degree. As the very basis of creation of the hedge is to avoid fluctuations and limit exposure, it is essential that the cash flows substantially offset each other. To regulate this, GAAP and IFRS  have adopted an 80-125% rule. As per this rule a hedge is considered effective if between 80 and 125% of the risk is offset by the fixed interest rate. For the transaction to qualify for hedge accounting the documentation should prove that this rule is met both retrospectively, looking back over past accounting periods, and prospectively, looking forward over the remaining term of the hedge.

Why is the market concerned about hedge accounting in the context of the transition away from LIBOR to RFRs?

The market’s primary concern about LIBOR transition is that a hedge may no longer be ‘effective’ and that parties to swaps used to hedge underlying exposures will no longer be able to report financial results on a hedged basis, introducing volatility to financial statements. In the example above, the Company had effectively hedged its risk through the fixed-for-floating swap with reference to LIBOR. Assuming that the term of both the bond and the swap extended beyond the expected disappearance of LIBOR at the end of 2021, the hedge would no longer be effective at that point. To avoid this result, the underlying instrument (the bond in the example) and the related hedge would need to be amended to reference a new benchmark. 

Derivatives users must also consider the effect of LIBOR disappearance in the near term, even though LIBOR still exists. As noted above, the effectiveness of the hedge must be considered on a prospective, as well as a retrospective, basis. According to the IASB, such an impending change could be considered problematic currently as it cannot be determined that the hedge is effective for the full term. 

 

What are the FASB and IASB doing to address these concerns?

IASB 

  • The IASB recently issued an exposure draft in which it considered the reporting implications of benchmark reform. It identified replacement and pre-replacement issues, but only provided proposed guidance on pre-replacement issues, the prospective effects described above.  
  • The IASB is not proposing that anything be done now to address the period after LIBOR’s expected disappearance at the end of 2021, but it will continue to consider these issues. 

FASB

  • In October 2018, FASB recognized Secured Overnight Financing Rate (SOFR) as a benchmark U.S. Dollar interest rate for hedge accounting purposes. This was an important step in order to encourage greater use of SOFR.  
  • FASB has a current project on reference rate reform the purpose of which is to facilitate the effects of LIBOR transition on financial reporting – see here

What has been the response to the IASB and FASB actions in the market? 

The market response to the IASB’s recent guidance on hedge accounting requirements has been mixed. On the one hand, it would be chaos to require restatements now so the short term guidance is welcome. On the other hand, not addressing the accounting effects of LIBOR’s disappearance in a timely fashion will leave reporting companies uncertain as to steps that they should take to address that disappearance.

The IASB should continue to respond to developments in the transition away from LIBOR and provide guidance for that transition prior to the disappearance of LIBOR. What the most recent amendments have provided is a salve for market participants who may have been worried about losing the accounting benefit of their hedges.  The expectations of the market for further amendments to the hedge accounting rules are that they should help, not hinder, the transition.

It is expected that the derivatives market will transition to new benchmark through use of an ISDA protocol, a means of amending bilateral documentation in an efficient, multilateral way. Cash markets, such as those for bonds and loans, will not be able to use a protocol mechanism as there are often many holders of a company’s debt. The mortgage market, being a retail market, presents different challenges of explaining to many retail borrowers the reason why their mortgage can no longer be pegged to LIBOR. 

Some bonds issuers have amended outstanding bonds for a new benchmark while still hedging derivatives based on LIBOR, such as the case in the UK of Associated British Ports switching from LIBOR to SONIA (a Sterling benchmark) for its £65 million worth of floating-rate notes, becoming the first bond issuer to obtain consent from its bondholders for such a transition – see here.  To the extent it has hedged its interest rate exposure on any of those notes, it can sign the ISDA protocol and align the notes and the hedge.

The ideal situation is that the transition happens instantly across all financial instruments. Then one would have, say, SOFR obligations with SOFR hedges (and, almost certainly, continued effective hedging). That, of course, is not realistic so cash and derivatives market participant will need to make decisions on hedge accounting treatment based on the guidance provided by the accounting standards setters.

How urgent is it to resolve this issue and why?

There are several reasons for the urgency in resolving these issues. A survey conducted by ISDA and other trade groups identified that the change in benchmark interest rates concerned market participants – see https://www.isda.org/a/OqrEE/IBOR-Transition-Report.pdf, pg.34. A change to a critical term of a derivative, such as the reference interest rate, could require that the transaction be terminated. The goal of the ISDA protocol is to avoid this possible argument, which is essentially a frustration of contract claim. Assuming the protocol is successful in amending outstanding derivatives, but the hedged instruments are not changed, the hedges will likely  no longer be effective, introducing volatility to a company’s financial statements.

The liquidity of the RFR markets is another cause for concern. For instance, SOFR, an alternative to U.S. Dollar LIBOR, was first published in April 2018. SOFR- based derivatives do not yet have the trade volume that LIBOR derivatives do. This lack of liquidity might impact the assessment of the effectiveness of a hedge. Further, the RFRs are overnight rates, whereas LIBOR offered overnight to one-year term rates. Adjusting term LIBOR to overnight SOFR is likely to lead to gains and losses between the parties to a swap – see https://advisory.kpmg.us/content/dam/advisory/en/pdfs/2018/preparing-for-the-libor-transition.pdf, pg. 2.  Timely guidance from the IASB and the FASB would allow entities to calculate the likely gains and losses and to understand how and when contractual changes should occur. 

Are there any other key points to be aware of on this issue?

Hedge accounting has been a hallmark of IASB and FASB standards for 20 years, and changes that potentially undermine hedge accounting, such as the disappearance of LIBOR, will significantly impact public reporting companies that are active users of derivatives. As discussed above, the transition is likely to create volatility in the financial statements of these institutions. If the accounting issues of benchmark reform are not addressed properly, these companies may be less likely to enter into swaps. In turn, the depth of trading could be affected with serious implications for risk management and the liquidity of the derivatives and underlying markets.

Considering the broader perspective, the key question for the markets is whether the IASB and FASB are going to be responsive in the near term to deal with potential mismatches between an underlying instrument and its related hedge. A considered and timely response from the standard setters would go a long way to limiting the adverse impacts of LIBOR transition on hedge accounting.

This news analysis was written by Robert Pickel, Chair, Panel of Recognised International Market Experts in Finance (P.R.I.M.E. Finance). Invaluable assistance was provided by Abhaya Ganashree and Conrad Pritzker, summer interns with P.R.I.M.E. Finance. Antonio Corbi of ISDA was generous with his time in providing the industry perspective on the issues discussed.

 

 

 

 

 

Filed Under: LIBOR

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