FAQ: USD LIBOR transition to SOFR
- October 1, 2021
Private Equity | Kennett Square, PA
Global Head of Hedge Accounting
Kennett Square, PA
Real Estate | Kennett Square, PA
Hedging and Capital Markets
Real Estate | Kennett Square, PA
SummaryUSD markets started transitioning from LIBOR to SOFR in 2017 after the FCA announced that LIBOR was at risk of discontinuation at the end of 2021. Chatham’s experts answer the most pressing questions asked by our clients about how the transition will affect their port.
In July 2017, the UK Financial Conduct Authority (FCA) announced that it would no longer require banks to submit cost of funds quotes to support calculating LIBOR, calling into question LIBOR’s viability and availability past 2021. LIBOR underlies hundreds of trillions of dollars in financial instruments, including loans and derivatives, and three years later, the idea of transitioning to a new rate continues to raise many questions among our clients and industry partners.
Chatham has been active in the LIBOR transition, representing end users before the key players identified below, to ensure as smooth a transition as possible from their perspective. These are some of the LIBOR transition-related questions we receive most often. You can find more information in our LIBOR transition resource stream.
- Who are the key players in LIBOR transition?
- When is LIBOR going away, and what are some of the key milestones between now and then?
- When do commercial real estate lenders, including Freddie Mac and Fannie Mae, plan to stop lending based on LIBOR?
- What is SOFR, and how is it different from LIBOR?
- How does Fed involvement in the Treasury repo markets affect SOFR?
- What are some of the key challenges facing SOFR adoption (i.e., lack of term structure, alternative rates)?
- What is term SOFR?
- What is the role of a SOFR curve?
- Can I buy a SOFR cap today?
Transition of existing loans and derivatives
- What are the main issues that must be addressed in transitioning a loan or derivative from LIBOR to SOFR?
- How are fallback triggers, rates, and spread adjustments addressed in loan and derivative documents?
- What happens to my existing LIBOR cap or swap once LIBOR goes away?
- How do I document my loan and derivative so they convert from LIBOR to SOFR at the same time? What risks do I take today when closing or hedging a LIBOR loan?
- How has accounting guidance evolved to accommodate LIBOR transition?
- How will designated hedges be impacted?
- How will debt and loans be impacted?
- How will other contracts with embedded derivatives be impacted?
- How has the SEC addressed disclosure requirements?
Basics of transition
Questions around the viability of LIBOR first arose from the LIBOR manipulation scandals that came to light beginning in 2007, though allegations of manipulation date back to the 1990s. In light of this manipulation, global regulators and policymakers engaged in a concerted effort to identify more robust alternatives. Some of the key players in the transition include:
Alternative Reference Rates Committee (ARRC): the ARRC is a private-public partnership convened in 2014 by the Federal Reserve Board of Governors (the Fed) and the Federal Reserve Bank of New York (New York Fed) to ensure a successful transition from USD LIBOR to a more robust reference rate. Chatham has responded to ARRC’s public LIBOR transition consultations and participates in ARRC working groups.
Bloomberg: ISDA selected Bloomberg in July 2019 to calculate and publish adjustments related to fallbacks that ISDA implemented for certain interest rate benchmarks in its 2006 ISDA Definitions. Bloomberg also calculates and publishes BSBY (see below), their proprietary interest rate index.
Central Clearing Parties (CCPs): LCH and the Chicago Mercantile Exchange (CME) clear a significant portion of global interest rate derivatives. As part of the ARRC’s Paced Transition Plan to increase SOFR trading, in October 2020, CME and LCH converted discounting and collateral of USD interest rate swap products from EFFR to SOFR. How the CCPs handle fallbacks will also have a significant impact on a large percentage of IBOR trades.
CME Group: The largest derivatives exchange in the world and publisher of CME Term SOFR for one-, three-, and six-month tenors.
Commodity Futures Trading Commission (CFTC): the CFTC regulates U.S. futures and over-the-counter (OTC) derivatives markets, which comprise over $300 trillion in LIBOR-linked transactions. Chatham is a member of the CFTC’s Market Risk Advisory Committee and its Interest Rate Benchmark Reform Subcommittee.
Financial Accounting Standards Board (FASB): the FASB is an independent, private-sector non-profit that establishes financial accounting and reporting standards for GAAP filers. Chatham has consulted with the FASB regarding the LIBOR transition and the related accounting standard, ASC 848.
Financial Conduct Authority (FCA): the UK FCA regulates the Intercontinental Exchange (ICE), the LIBOR administrator.
Intercontinental Exchange (ICE) Benchmark Administration (IBA): ICE plays a number of roles in global financial markets, including through IBA, which serves as the administrator of LIBOR.
International Organization of Securities Commissions (IOSCO): IOSCO regulates and sets standards for the global securities sector. In 2013, IOSCO released its Final Report on Principles for Financial Benchmarks, establishing guidance that the ARRC and other global standard setters have utilized in selecting replacement rates as the market transitions from LIBOR and similar rates.
International Swaps and Derivatives Association (ISDA): ISDA exists to foster safe and efficient derivatives markets and is focused on a smooth LIBOR transition in derivatives, including by drafting forms of documents informed by public feedback. Chatham is an ISDA member and has responded to ISDA’s public LIBOR transition consultations, additionally participating in LIBOR transition working groups.
The nature of these players’ involvement in the transition has evolved. For example, in March 2020, the ARRC proposed a New York state legislative proposal to amend financial contracts that lack adequate fallback language, both to address existing agreements where transition may be challenging (e.g., bonds that require 100% of bondholders to consent to transaction), as well as to minimize adverse economic outcomes in transition. In April 2021, the state of New York enacted a law that provides for existing LIBOR-based “tough legacy” contracts to transition to SOFR after a “LIBOR Discontinuance Event,” also providing a litigation safe harbor, as further detailed in our LIBOR transition update.
Similarly, in June 2020, the U.K. Parliament announced its intentions to amend and strengthen the existing regulatory framework surrounding critical benchmarks such as LIBOR. The legislation imbued the FCA with the regulatory powers to enforce the LIBOR transition. The FCA consulted on the use of its new powers to regulate use of LIBOR in transactions and to modify the methodology of how LIBOR is calculated. In March 2021, the FCA released the results of its consultation on its new powers stating that most of the respondents agreed with the proposed factors for determining whether a benchmark can be restored and is also adding additional factors that were suggested. (Back to top)
On March 5, 2021, a series of announcements and guidance by the FCA, IBA, ISDA, and Bloomberg, answered a number of open questions regarding the timing of the end of publication of all LIBORs. Although in July 2017, the FCA announced that LIBOR was at risk of discontinuation after the end of 2021, the FCA and IBA indicated that overnight, one-month, three-month, six-month, and twelve-month USD LIBOR would continue to be published through June 2023. Contemporaneous announcements were released by U.S. bank regulators suggesting that new loans must cease to reference LIBOR after December 31, 2021. Some recent notable milestones in the transition include:
- Legislative and regulatory response: On March 5, IBA announced that after considering the responses to its consultation, IBA plans to continue to publish one-week and two-month USD LIBOR through December 31, 2021 and overnight, one-month, three-month, six-month, and twelve-month USD LIBOR through June 30, 2023. The indices will no longer be representative thereafter. The announcements set the ISDA spread adjustments, which provides more concrete guidance around the calculation of the fallback rate.
- On April 6, the state of New York enacted a law that provides for existing LIBOR-based “tough legacy” contracts to transition to SOFR after a “LIBOR Discontinuance Event,” also providing a litigation safe harbor. This legislation would not override contracting parties’ discretion to amend their legacy agreements to adopt SOFR or any other replacement rate, either on a bilateral basis or via an ISDA protocol. The ARRC endorsed this decision, noting that the provisions of the New York state law are consistent with the ARRC’s March 2020 proposal for New York state legislation.
- Market participants sought a federal equivalent as a more effective solution, given questions around the applicability of the New York law in certain instances, as well as the potential for differences in legislative treatment (if any) at the state level. In July, the House Financial Services Committee adopted the Adjustable Interest Rate (LIBOR) Act of 2021 (H.R. 4616), specifying SOFR as the LIBOR replacement without “disfavor[ing]” alternative rates, though the litigation safe harbor would only apply in fallbacks to SOFR.
When do commercial real estate lenders, including Freddie Mac and Fannie Mae, plan to stop lending based on LIBOR?
Fannie Mae and Freddie Mac no longer accept LIBOR-based loan applications and stopped purchasing LIBOR-based loans at the end of 2020. The first SOFR-based Freddie Mac loan was originated in September 2020, and Chatham assisted the borrower in purchasing the required SOFR cap. To date, many other floating-rate lenders (e.g., global investment banks, regional and community banks, non-bank lenders, insurance companies) have begun offering SOFR-based loans, either exclusively, or alongside LIBOR at the discretion of the borrower. Some are targeting October 1 to fully transition away from LIBOR, while others are targeting December 31. (Back to top)
In June 2017, the ARRC identified SOFR as the presumptive replacement rate for USD LIBOR. The New York Fed calculates SOFR by taking the volume-weighted median of transaction-level data from three sources: 1) tri-party repo data, 2) GCF Repo (General Collateral Finance repurchase agreements) transaction data and 3) bilateral Treasury repo transactions cleared through FICC’s DVP Service (Fixed Income Clearing Corporation’s Delivery vs. Payment Service).
A primary attraction for regulators is that, unlike LIBOR, SOFR is fully transaction based and therefore less susceptible to market manipulation. There are approximately $1 trillion of daily market transactions underlying the calculation of SOFR. Conversely, USD LIBOR relies primarily on expert judgment of the LIBOR panel bank's submissions to calculate this rate. The most actively traded USD LIBOR tenor is three months, and less than $1 billion of transactions typically underlie the calculation of this rate each business day.
The Fed plays a significant role in setting SOFR and LIBOR rates. Both SOFR and LIBOR react to Fed monetary policy and target rates although in different ways. LIBOR is forward looking and anticipates upcoming Fed rate changes. As we approach the date of the anticipated rate change, LIBOR will drift closer and closer to the new expected rate. By comparison, SOFR is an overnight rate that typically adjusts the day following a change to the Fed Funds target rate.
While the New York Fed publishes spot SOFR daily since 2018, they have also started publishing 30-day and 90-day compound SOFR, that lenders can reference to ease administration of loans. While these rates are backward-looking, lenders have the ability to incorporate a setting in advance of a given interest period, or a few days before the end of such interest period, typically from two to five business days.
SOFR is a measure of the overnight cost of financing U.S. Treasury securities in the repurchase agreement (repo) market. The SOFR rate is an average of the market transactions from bilateral trading (trimmed to exclude certain transactions using high-demand “on special” collateral) and the tri-party repo market. The dynamics driving pricing, volatility and risk in the U.S. Treasury repo market therefore also impact daily SOFR settings.
The Fed’s Federal Open Market Committee is responsible for periodically setting targets for several key interest rates, enforced through open market operations. The New York Fed conducts both repo transactions and reverse repo transactions in the tri-party repo market to manage the level of reserves in the banking system to further support the transmission of monetary policy to the economy. In a repo transaction the NY Fed is a lender, providing reserves to Primary Dealers in what equates to a collateralized loan. In a reverse repo the NY Fed reduces reserves by effectively borrowing funds from the market. The Fed’s involvement in the repo markets, meant to ensure an orderly and liquid market, influences the SOFR rate by effectively setting both a floor and a ceiling on repo rates. When the Fed lends funds via repo, they implicitly provide an avenue for primary dealers to convert their Treasury and MBS holdings to reserves. This lending can act as a backstop, encouraging those dealers to lend out reserves to other market participants and helping to ensure that repo rates don’t rise above the Fed’s targets. When the Fed borrows funds via reverse repo transactions, they provide an alternative means for market participants to earn interest on their excess cash, which by design, keeps the Fed Funds rate from falling below the lower bound of the Federal Reserve’s target.
SOFR has set at five basis points (0.05%) since the Fed raised the rate it pays on reverse repo operations from 0% to 0.05% in June, 2021. While the Fed has brought much stability to the treasury repo market in the last year, future Fed intervention, or lack thereof, may result in additional volatility to Treasury repo rates and SOFR.
What are some of the key challenges facing SOFR adoption (i.e., lack of term structure, alternative rates)?
The fact that SOFR is an overnight, secured, risk-free rate, as compared with LIBOR, an unsecured, forward-looking term rate, gives rise to challenges for the market to overcome.
- The key challenges facing SOFR adoption include 1) lack of derivative availability on Term SOFR and 2) lack of a credit component. I think we need to develop these ideas better here. Term structure: One of the key challenges facing SOFR adoption has been the lack of a term structure for SOFR. Unlike the LIBOR market, which includes several tenors (e.g., one-month, three-month, etc.), though the term SOFR market has begun to develop, as we discuss below. There are three general approaches to handle the term structure issue.
- For standard cleared swaps, SOFR is compounded in arrears (i.e., backward-looking, compounding each setting over the course of the period) which presents challenges from an operational perspective because the parties don’t know the SOFR compounded rate until a day or two before the period ends (taking into account the typical 2-business day lookback). This operational challenge particularly affects the cash market (loans), as there is less time to provide notices and process payments, which could lead to late or missed interest payments.
- Compounded in advance rates compound daily SOFR settings from the previous period. Because these compounded rates are known at the beginning of the interest period, payments are known further in advance of the payment date easing the operational challenges compared to compounded in arrears. In early 2020, the Fed began publishing 30-, 60-, and 90-day SOFR compound in advance averages to help with bank system constraints around independently calculating compounded in arrears rates. Freddie Mac and Fannie Mae currently are in the process of switching to the Fed’s SOFR averages in their loans. One issue with a compounded in advance rate is that the compounded rates do not align with the interest period over which interest is calculated. This misalignment tends to be small, on average, but can be material when the Fed is changes rates, or interest rates are volatile.
- In April 2021, CME Group announced the launch of one-, three-, and six-month CME term SOFR, representing a potentially significant step towards development of a liquid term SOFR market. The launch of these rates is particularly notable after the concept experienced a number of apparent (at the time) setbacks. In September 2020, the ARRC released an RFP seeking a potential administrator to publish forward-looking SOFR term rates; on July 29, 2021, the ARRC formally recommended the CME Group’s forward-looking SOFR term rates (Term SOFR) to further support the transition from LIBOR. More details are included in the term SOFR section below.
- Lack of credit sensitivity: Another key challenge is that some market participants — notably U.S. regional and community banks and some global financial institutions — have argued that SOFR does not reflect a typical bank’s borrowing or funding costs nearly as accurately as LIBOR because SOFR is a risk-free rate (RFR) that lacks credit sensitivity. Their concern is that SOFR potentially could reduce the availability of credit under market stress, and in response, others in the market have designed alternative rates to better reflect banks’ and financial institutions’ borrowing costs, including the American Interbank Offered Rate (AMERIBOR) and the Bloomberg short-term bank index (BSBY). ISDA modified its definitions in early May 2021 to accommodate these rates — specifically, AMERIBOR and BSBY. We describe these and other credit-sensitive rates here. (Back to top)
Why did the CFTC’s Market Risk Advisory Committee (MRAC) develop the SOFR First initiative?
SOFR First has four phases with phase one, involving USD linear swaps. The MRAC has supported the SOFR First initiative, which calls for interdealer brokers to transition from trading LIBOR linear interest rate swaps to SOFR linear swaps beginning July 26, 2021. The first phase of this initiative has been notably increasing SOFR liquidity and the other three phases are expected to further drive up SOFR trading ahead of the end of 2021 when banks may no longer offer new LIBOR-based contracts. The SOFR First market best practice recommends keeping interdealer brokers’ screens for LIBOR linear swaps available for informational purposes, but not trading activity, until October 22, 2021. After this date, these screens should be turned off altogether. The remaining SOFR First phases involve cross currency swaps, non-linear derivatives, and exchange traded derivatives. (Back to top)
What is term SOFR?
Creation of SOFR term rates is the final step in the ARRC’s paced transition plan. Term SOFR refers to a forward-looking SOFR rate that covers a period longer than a business day, for example one-, three-, six, and twelve-month periods. In April 2021, CME Group announced the launch of one-, three-, and six-month CME term SOFR, representing a potentially significant step towards development of a liquid term SOFR market.
While LIBOR rates are based on term lending, SOFR instruments such as SOFR OIS swaps and futures are needed to build the SOFR forward term structure. The Fed considered proposals to publish SOFR term rates once liquidity is sufficient. On April 20, however, the ARRC announced a set of key principles to be used as guidance while considering the necessary conditions for a SOFR term rate. The key principles to be followed include meeting the ARRC’s criteria for alternative reference rates, being rooted in a robust set of derivatives transactions, and having a limited scope of use.
On July 29, the ARRC formally recommended the CME Group’s forward-looking SOFR term rates (Term SOFR) and released best practices related to its use to further support the transition from LIBOR. The ARRC also released guidance regarding the scope of use for Term SOFR derivatives, which at that time stated that end users may hedge cash products that reference Term SOFR with Term SOFR derivatives.
The ARRC updated their initial best practices on August 27 to clarify the scope of the use of Term SOFR. The revised scope of use reiterates that end users may wish to hedge cash products that reference Term SOFR with Term SOFR derivatives and that the ARRC supports such use. Relative to this recommendation, an end user is described as any party to the underlying cash product, such as a borrower, lender, or guarantor. These parties may then enter into Term SOFR swaps, caps, swaptions, or other derivatives to hedge cash product exposure or a portfolio of exposures and may also adjust or unwind these exposures, including by way of novation. Importantly, a financial institution that is not a CFTC-registered Swap Dealer or interdealer market maker in interest rate derivatives may also offset such exposure with an upstream dealer.
The ARRC re-emphasized that it does not endorse the use of Term SOFR derivatives for most of the market, including CFTC-registered Swap Dealers, and encourages the use of derivatives based on SOFR overnight and SOFR averages where possible, even for end users. The impact of this scope of use on market liquidity for borrowers who wish to utilize Term SOFR derivatives is not yet clear. (Back to top)
The SOFR curve is a key component of pricing and discounting of SOFR financial contracts. As discussed above, SOFR payments are averages of SOFR daily rates. To value future SOFR payments, and also to discount payments of other rates, a SOFR forward curve is needed. A SOFR curve can be used for both compound in arrears and compound in advance payments. For example, a SOFR curve was needed to properly handle the mid-October 2020 discounting switch from EFFR to SOFR at the clearing houses. The same SOFR curve can also be used to help value OIS SOFR swaps and compound in advance SOFR caps. (Back to top)
Can I buy a SOFR cap today?
Cap provider banks have been offering SOFR caps since September 2020, and more continue to indicate that they currently can or soon will be able to offer caps and other interest rate derivatives, though spreads have been wide because of the lack of a liquid market. In fact, ISDA continues to highlight there is more work to do regarding non-linear products like caps and has formed an IBOR transition working group specifically tasked with thinking through implementation challenges related to non-linear products. (Back to top)
Transition of existing loans and derivatives
What are the main issues that must be addressed in transitioning a loan or derivative from LIBOR to SOFR?
The main issues in transitioning a given loan or derivative are:
- Fallback triggers: what will give rise to a transition from LIBOR?
- Fallback rates: what rate will replace LIBOR?
- Spread adjustment: how will the loan spread and derivative economics be adjusted to reflect any difference between LIBOR and its replacement rate? (Back to top)
How are fallback triggers, rates, and spread adjustments addressed in loan and derivative documents?
The ARRC has prepared a series of recommendations and draft documents to address these questions for loans, as has ISDA in derivatives. They generally are aligned — with some notable differences — and address these issues as follows:
- Fallback triggers
- Cessation: public statements indicative of permanent discontinuation
- Pre-cessation: declaration that LIBOR is no longer representative, insufficient number of dealers providing quotes, et al.
- Fallback rates - this is one area in which the ARRC and ISDA are not entirely aligned
- ARRC: waterfall of Term SOFR, followed by Daily Simple SOFR, followed by an endorsed benchmark rate
- ISDA: SOFR compounded in arrears
- Spread adjustment: five-year median historical spread shifted by adding two banking days relative to the LIBOR period. In light of regulators' announcements, ISDA’s spread adjustments for one- and three-month LIBOR to SOFR were set at 0.11448% and 0.26161%, respectively.
With that, we’ve seen a variety of approaches across various types of lenders (e.g., global investment banks, regional and community banks, non-bank lenders, Freddie Mac and Fannie Mae), and many of these approaches have evolved and continue to evolve over time, meaning that a given lender’s transition language may look different in new or amended loans now, even as compared with how the same lender’s language looked one or two years ago.
There are two broad approaches to addressing these issues in loan documents.
- Hardwired approach: Some in the market use loan fallback language that includes a specific rate, index, or the determination (or future determination) of a substitute rate by a specific committee or organization (such as the Fed, the ARRC, or ISDA). The ARRC recommended SOFR as its preferred substitute rate and released its “hardwired approach” to fallback language for syndicated loans (updated June 2020). This fallback language uses a decision waterfall based on SOFR to determine the substitute rate.
- Amendment approach: Others prefer to retain flexibility in their loans and include language incorporating whatever fallback rates are ultimately adopted by the marketplace. In April 2019, the ARRC released its “amendment approach” to fallback language for syndicated loans, allowing flexibility for loan parties to agree on the selection of a substitute rate and amend their existing documentation accordingly.
The ARRC’s recommendations are not mandatory, and most lenders have their own preferred form of LIBOR transition language. This language also has evolved over time, such that a given lender’s preferred form of transition language probably looks different now than it did a year ago. However, over the past six months, Chatham has begun seeing more lenders begin to incorporate either the ARRC hardwired approach verbatim or a modified version thereof.
On the derivatives side, ISDA’s revised definitions, IBOR Fallbacks Protocol (the Protocol), and related Fallbacks Supplement to the 2006 ISDA Definitions, have been in effect since January 25, 2021, to better accommodate permanent cessation of LIBOR. The Protocol is designed to facilitate an efficient transition of existing derivatives. Any derivative executed since the effective date that incorporates the 2006 ISDA Definitions has automatically incorporated these changes without need for the Protocol. (Back to top)
In the event of LIBOR’s discontinuation, ISDA’s existing benchmark fallback language, which contemplates temporary unavailability, rather than wholesale discontinuation/replacement, calls for the parties to request and average quotes from a group of banks; but in that scenario, it is likely that most banks would be unwilling to provide a quote on a permanently discontinued rate. This is one of the reasons that ISDA is undergoing a process to revise its definitions to include more robust fallback language. To the extent that the updated fallback methodology is incorporated into the terms of the existing trade, once fallback is triggered, the derivative will be updated to begin referencing the new fallback rate (e.g., SOFR). If an entity does not incorporate the revised ISDA definitions into the terms of its derivative, it remains to be seen how this will play out in practice. It is unclear what will happen if an entity does not, or refuses, to incorporate the updated fallback methodology into the terms of its transaction.
Chatham expects the majority of the market to use SOFR compounded in arrears, with a lookback to the SOFR from two days earlier, for the derivatives fallback rate. Unfortunately, it’s too early to tell how the volatility markets will develop; data necessary to calculate volatility and convexity isn’t readily available given how new SOFR is. Nearly all the regulators’ focus at this stage has been on determining rates and calculating payments, as compared with related issues like volatility markets. This presents challenges not only for caps but also for calculating XVA (Credit Valuation Adjustments, Debit Value Adjustments, Funding Value Adjustments, etc.) on other products like swaps. CME began offering SOFR options on 3-month SOFR futures earlier this year. The availability of option products will allow for volatility markets to develop. (Back to top)
One significant open question is whether loans and hedges can convert in such a way as to minimize unnecessary cost to a borrower. The answer lies in whether the transition language in the loan and cap or swap are consistent in terms of the fallback trigger, fallback rate, and spread adjustment. If any of these do not match, there could be a negative impact to a borrower, particularly those sensitive to hedge accounting treatment.
There remain differences between the lending and derivatives markets at this stage, which could drive market participants to negotiate bilateral adjustments to their derivative transactions (to match their hedged items) rather than adhering to the new ISDA protocol as a standardized practice. This concern about the need for consistency has been echoed by other stakeholders responding to ISDA’s public consultations regarding fallback methodology and pre-cessation triggers. End users need to be aware of the potential for mismatch and what that could mean from a risk perspective, advocating and pushing for change where necessary to minimize the gap.
ISDA’s Benchmark Reform Working Group is in the process of updating the 2006 ISDA Definitions to include a modular approach towards term rate calculations. The supplemental language and updated Confirmation templates are intended to allow parties to make elections to better align their derivatives with calculation conventions existing in the cash market.
A number of currency-specific Risk-Free Rates (RFRs) have been identified as suitable alternatives to LIBORs under the ISDA Fallbacks Supplement (here). RFRs are overnight rates, do not have tenors and are calculated using a backward-looking, or historical, method. Once finalized, ISDA’s modifications to their Definitions would allow market participants to better align their derivatives with the conventions employed in their cash products. Updates to the 2021 Definitions remain under consultation with an anticipated launch date of May 17, 2021 and an effective date of October 4, 2021. (Back to top)
GAAP requires extensive analysis of contract modifications, the results of which can lead to current P&L impacts and loss of hedge accounting. Revenue, leasing, debt, loans, and derivatives are all impacted by these analyses. FASB recently issued Topic 848 which disregards these analyses as long as the modifications relate solely to reference rate reform. Additionally, hedged accounting may continue while there is still uncertainty about how the contracts will ultimately transition to an alternative reference rate. Without this guidance hedge accounting for interest rate exposures would be lost by all market participants.
FASB issued Topic 848, Reference Rate Reform in March 2020. Topic 848 is a set of exceptions and practical expedients to current GAAP for contracts that are affected by reference rate reform. These exceptions and practical expedients treat the amendment of these contracts as a modification or continuation of the contract, as opposed to a termination. Additionally, Topic 848 extends practical expedients to allow hedging relationships to continue and to temporarily ease certain of the effectiveness assessment requirements. These expedients may only be applied if all of the contractual changes relate to reference rate reform, which will require documentation of the contractual changes and the election of the expedients.
The IASB has provided IBOR reform guidance in two phases: Phase 1 provides guidance relating to pre-replacement issues that impact hedge accounting, such as the probability assessment for cash flow hedges; prospective and retrospective assessments of effectiveness; and separately identifiable risk components. Phase 2 focuses on replacement issues including contractual amendments and falling back to a new rate. Overall the reliefs provided are broadly similar to those available under US GAAP. For more information related to IFRS, see our accounting guidance for the GBP LIBOR to SONIA transition. (Back to top)
For derivatives designated in hedge accounting relationships, a modification to the critical terms of a derivative requires that the hedge accounting relationship be discontinued. A new hedge accounting relationship can be established for the modified derivative if new accounting documentation is put in place. However, this revised hedge accounting relationship is more complex to account for and typically requires a more sophisticated approach. Optional expedients are available in Topic 848to overcome the requirement to re-designate the hedging relationship.
Fundamental to cash flow hedging relationships is the expectation that the future hedged transactions are probable to occur. Given the current definitions of hedged transactions, amended contracts that reference a new index would not qualify and hedge accounting would need to cease. Topic 848 allows an entity to assume that the derivative and exposure will transition to the replacement rate at the same time.
For fair value hedges, the value assigned to the hedged debt will need to be updated for the change in the reference rate, though no specific approach is mandated in Topic 848.
Effectiveness assessments are also impacted. There are several simplified approaches that would become invalid upon amendment of the derivative or hedged exposure. Topic 848 provides a range of optional expedients that will allow an entity to change assessment methods or ignore certain elements in the assessment. Quantitative effectiveness assessments may require market data that is not available and reasonable proxy data may be appropriate. (Back to top)
When a debt contract is modified it must be analyzed to determine whether the change in cash flows indicates that the modification is in substance an extinguishment of the old contract. If deemed extinguished, any unamortized debt issuance costs must be recognized in current period earnings. Topic 848 provides relief in this area and waives the requirement to assess modified debt if the only modification is to reference rate reform related changes. (Back to top)
Upon issuance and modification, all contracts must be analyzed for embedded derivatives. Both qualitative and quantitative factors are considered to determine whether the embedded derivative should be accounted for separate from the host contract.
Topic 848 grants relief so that amendments related to reference rate reform will not trigger analysis of embedded derivatives.
New contracts will pass through the existing requirement to analyze embedded derivatives, though the market data for a new reference rate may not be robust enough initially to complete the analysis. In this case, a reasonable proxy may be appropriate.
Lessees carry most leases on the balance sheet as a liability with an associated right-of-use asset, while certain leases are off balance sheet. A modification in the contract requires a reassessment of this classification. Topic 848 grants relief for this reassessment.
Certain long-duration construction contracts are recognized in earnings based on a percentage of completion. Amendment of the contract requires a reassessment of the amount recognized in earnings and possibly a new pattern of recognition in the future. Topic 848 provides relief for this analysis if the modification is solely due to replacement of a reference rate. (Back to top)
Over the last two years, the Securities Exchange Commission (SEC) has encouraged entities to include additional disclosure in their filings to discuss the impact of reference rate reform. This disclosure should likely reside in the Management Discussion and Analysis section of financial statements. The SEC suggested the following disclosure:
- Population of contracts that extend past 2021 that reference LIBOR and the plan to convert those contracts.
- The actions that are needed to mitigate the exposure to LIBOR cessation.
- The expected impact on profitability.
- The expected impact on the effectiveness of the company’s hedging strategy.
- Disclosure that allows investors to see the issue through the eyes of management.
- The impact on business, systems, processes, risk management, and clients.
The SEC welcomes pre-filing consultation so companies can get the level of disclosure right. (Back to top)
What does Chatham recommend?
With the extension of LIBOR’s publication through June 2023, many borrowers have decided to deprioritize preparing for the LIBOR transition; but timing of the transition is more nuanced than many headlines would suggest, and loan documents may be drafted in a way that gives rise to risk of an early and potentially unfavorable transition. With that, Chatham generally recommends that borrowers be proactive with respect to the LIBOR transition, beginning with understanding their exposure.
Chatham recommends that all LIBOR-based borrowers do the following:
- Review and inventory their loans and associated derivatives as to trigger, fallback, and spread adjustment language (or lack thereof) as soon as possible
- Incorporate more robust fallback language into their loans (see Chatham’s recommendations)
- Monitor the LIBOR transition, specifically including:
- issuance of non-LIBOR indexed debt for signs of preparedness on the part of lenders and increased appetite from lenders and investors for exposures to benchmarks other than LIBOR
- the major U.S. clearinghouses’ (LCH and CME) incorporating SOFR into their valuation and collateral calculations for cleared USD interest rate swaps in October 2020, and the subsequent impact on SOFR derivatives activity
- Understand transition guidance and any relief afforded
- Assess potential regulatory scrutiny as to various entities within an organization
Chatham further recommends that LIBOR-based borrowers who hedge their interest rate exposure with OTC caps, swaps, etc., spend time reviewing the revised ISDA definitions and the ISDA protocol, along with any bilateral agreements issued by ISDA or specific lenders/hedge providers, to determine the optimal hedge fallback mechanism for their specific situation. Moreover, to the extent that the borrower has OTC derivatives documented via non-ISDA agreements (e.g., the German framework agreement, DRV, or the French framework agreement, FBF), the borrower should analyze those agreements as well. Those who hedge with cleared derivatives should have seen a more immediate impact arising from the "clearinghouse big bang." (Back to top)
LIBOR-based borrowing/hedging is by far the most prevalent among our real estate, private equity, and corporate client bases. These clients use LIBOR swaps, caps, and swaptions to hedge floating-rate loans and anticipated fixed-rate debt (although with the SOFR-First Initiative improving SOFR liquidity, SOFR swaps are a viable alternative to hedge anticipated fixed rate debt. Many clients are reviewing fallback language in their existing cash market instruments (loans) and comparing those terms to ISDA’s Fallback Protocol to understand the potential mismatches in timing and pricing of fallbacks. Another focus, is ensuring flexibility for LIBOR fallbacks and cessation events in loans currently being negotiated. Some clients have included trigger language in derivative trade confirmations for longer-dated trades, likewise, focusing on flexibility and commercial reasonableness. As for financial institutions, we’ve seen many of our clients move away from LIBOR-based balance sheet hedging programs to Fed Funds based programs. (Back to top)
What LIBOR transition-related resources are available?
- Chatham Financial frequently publishes LIBOR content, here are some essential entries:
- The New York Fed publishes the following SOFR rates each business day at 8 a.m. EST:
- Some key players in LIBOR transition have published the following:
- ARRC: Recommended Best Practices for Completing the Transition from LIBOR (May 2020)
- Fannie Mae and Freddie Mac: LIBOR Transition Playbook (April 2021)
- ISDA: Benchmark Reform and Transition from LIBOR
- FASB: Reference Rate Reform
Still have questions?
Please send a message to the Chatham team if you have questions around the USD LIBOR transition or how use of SOFR in your loans and derivatives could affect your interest rate exposure.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.19-0239
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