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Libor to SOFR Switch Will Be Challenging

Response to CME’s SOFR futures contracts may provide early signal.

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Accounting & Disclosure

FASB Gives SOFR Early Support (Too Early?)

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March 01, 2019

FASB to proceed cautiously on steps to facilitate Libor replacement

Accounting-MoneyStraying from convention and perhaps looking to lend a hand to a budding product, the Financial Accounting Standards Board (FASB) in October of last year approved the benchmark rate to replace Libor. Now the accounting standard setter is monitoring the rate’s progress to determine how to aid the transition, and significant decisions lie ahead.

The New York Federal Reserve began publishing last April the Secured Overnight Funding Rate (SOFR), the US’s risk-free rate (RFR) anticipated to replace Libor. Markets in SOFR futures contracts and cleared swaps soon followed as the early building blocks for a market in more sophisticated SOFR-based financial products, followed by several offerings SOFR-based debt by major institutions, in early attempts to bolster the initiative.

FASB typically requires new benchmark rates it approves for hedge accounting to be broadly indicative of interest rates in the economy. Rob Anderson, director in Kennett Square, PA-headquartered Chatham Financial’s hedge-accounting practice, said that FASB has approved SOFR as a benchmark rate before it has met that threshold, in an effort to support the development of a liquid SOFR market.

FASB noted Nov. 25 that it added SOFR as a “US benchmark interest rate to facilitate the Libor to SOFR transition and provide sufficient lead time for entities to prepare for changes to interest-rate risk hedging strategies for both risk management and hedge accounting purposes.”

In addition, transitioning to a very different floating-rate benchmark—SOFR based on overnight, secured repurchase-agreement (repo) transactions compared to unsecured, term Libor—is occurring at the same time markets for SOFR-based financial products are being created. FASB has not yet decided on the treatment for existing contracts that change from Libor to SOFR.

“FASB wants to think very carefully about how to craft the transition guidance,” Mr. Anderson said. “On one hand, FASB wants to be very accommodating to support the broad market transition to SOFR, and on the other they don’t want the relief to extend to unintended facts and circumstances.”

More time will elucidate market participants’ transition pain points, Mr. Anderson said, and there’s a growing chorus of parties who question whether SOFR is the correct replacement rate.

FASB anticipates first addressing SOFR issues in a public meeting later this year, although a date has yet to be set. The standard setter states that one issue will be whether changing to SOFR benchmark will, for accounting purposes, require modifying instruments or actually “extinguishing” the existing one and recognizing a new one to replace it.

Another issue is whether existing fair-value or cash-flow hedging relationships can be preserved if the reference rate changes. In other words, Will derivatives priced over SOFR adequately hedge term-floating rate debt, so that hedge accounting treatment is retained and the risk of financial-statement volatility avoided?

Unlike Libor, which has one-month and three-month terms, SOFR is a daily compounding rate. This means that SOFR users won’t know the final rate until the end of that period. Constituents have instead pushed the Alternative Reference Rates Committee (ARRC) to develop term SOFR rates, similar to Libor, so borrowers know exactly what their interest payments will be at the end of the term.

Mr. Anderson said some derivatives may transition to SOFR at a different time than the debt that they hedge, raising a question about whether they would qualify for hedge accounting.

“It does introduce risk, because it’s not guaranteed it will pass [hedge accounting requirements] every time,” he said. “You’ll have to continue to do the math,” he added, particularly if volatile markets cause a prolonged dislocation.

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