LIBOR transition: 3 key focus areas may require immediate actions from corporates
Corporates | Kennett Square, PA
SummaryTwo key events in the transition from LIBOR occurred during October and could affect your organization’s existing derivatives and debt portfolios. This article outlines the accounting and operational impacts of these milestones as well as immediate actions that you should consider taking.
October 2020 was a critical month for the LIBOR transition with two events that marked major milestones in the phase-out of LIBOR:
- On October 16, 2020, CME and LCH, the largest central clearing houses in the derivative market, switched from using the Federal Funds Overnight Indexed Rate (“OIS”) to the Secured Overnight Financing Rate (“SOFR”) to discount valuations as well as to calculate interest due on collateral.
- On October 23, 2020, the International Swaps and Derivatives Association (ISDA) published the 2020 IBOR Fallbacks Protocol and amended definitions. The Protocol and amended definitions will become effective on January 25, 2021.
Since both events could affect your organization’s existing derivative and debt portfolios, Chatham has summarized the accounting and operational impact of these events.
The discounting transition will impact parties to cleared swaps by introducing SOFR discounting risk which affects the value of existing positions. Chatham’s valuation models and infrastructure support this market change on all impacted cleared USD LIBOR swaps. Chatham has switched to using SOFR discounting on valuations for cleared swaps beginning October 16, 2020. If your portfolio includes cleared swaps, you may need to take immediate action to switch the valuation methodology from OIS to SOFR discounting.
Chatham expects that all uncleared USD transactions will move to be discounted on SOFR soon. For parties to uncleared OTC derivatives, we will follow guidance on appropriate valuation methodology and industry practice to determine the appropriate discounting methods. When the switch occurs, Chatham will provide advance notice to clients in connection with making this discounting change for uncleared derivatives.
(Related insight: "SOFR forward curve update and the CCP 'Big Bang'")
Operations: ISDA IBOR Fallbacks Protocol
ISDA’s 2020 IBOR Fallbacks Protocol allows parties to automatically amend their ISDA documentation — including trade confirmations — to incorporate the updated IBOR definitions that will go into effect on January 25, 2021. The amended ISDA definitions for the IBOR benchmarks incorporate more robust fallback provisions that will apply in the event of a permanent cessation of the underlying reference rate such as USD-LIBOR-BBA, or in some cases, when LIBOR is no longer representative of the underlying market. The Protocol enables parties to efficiently amend their Protocol-covered documentation in a consistent manner and with multiple counterparties all at once. For the terms of the Protocol to apply, all parties to the document being amended must also be adhering parties to the Protocol. The hedging entity and its counterparty(ies) complete their Protocol adherence by delivering ISDA’s Adherence Letter to ISDA for acceptance, which Chatham can help facilitate.
While the Protocol provides significant benefits by allowing parties to amend numerous documents at once, Protocol adherence may not necessarily be the optimal choice for all companies wishing to prepare for the permanent cessation of LIBOR. Some companies may benefit from customizing their IBOR fallback language on a case-by-case basis, particularly if a company’s non-ISDA-based documentation (such as loan documents) contains bespoke fallback provisions or spread adjustments. The Chatham team is happy to assist you as you consider adhering to the ISDA protocol or making other changes to your derivative instruments.
Further, on October 9, 2020, the Internal Revenue Service issued Revenue Procedures (“Rev Proc”) 2020-44, which provides guidance on the application of modifications to financial instruments as part of ISDA or ARRC fallbacks. The Rev Proc describes the tax treatment of contract modifications related to applying ARRC contract fallback language or adhering to the ISDA Protocol. We encourage you to discuss the impact of the Rev Proc with your tax team.
(Related insight: "ISDA's IBOR Fallbacks Protocol FAQ")
The discounting transition from OIS to SOFR is considered a change in valuation methodology, which is primarily the result of recent developments in market conditions and not the result of a change in accounting principle. Therefore, this change will only affect the valuations as of the transition date and going forward but will not be applied retrospectively to prior periods. In addition, the change in valuation methodology may require additional disclosures in the financial statements. Your organization and its auditors will need to assess the materiality of the impact and, as warranted, include appropriate disclosure around this event.
For companies that apply hedge accounting to existing USD swaps, the change in discounting and the adherence to ISDA protocol may be considered changes to the critical terms of the hedging relationship that require de-designation of the hedging relationship. Topic 848 (“Reference Rate Reform”) provides specific optional expedients addressing both events. Appropriate election of these expedients allows companies to continue existing hedging relationship without being impacted by the changes. If you decide to adhere to the ISDA protocol in Q4 2020, timely documentation of the elections must be in place prior to the issuance of year-end financial statements. Chatham can assist you with the necessary ASC 848 election documentation and any associated financial disclosures. In addition, the change in discounting will have an impact on data points used in regression effectiveness assessments. Additional analysis may be required due to the discounting change. Chatham is prepared to help our clients through the transition, please contact your Chatham representative for assistance in this area.
In summary, immediate actions may be required from the accounting and operational perspectives. Please reach out to your Chatham representative if you are considering adhering to the protocol, need assistance with switching to SOFR discounting, or preparation of accounting documentation.
Questions about the LIBOR transition?
Talk to a Chatham hedging or hedge accounting expert.
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.20-0435
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