Risk-free rates may fail liquidity test for hedge accounting

Experts fear trades referencing SOFR and €STR will not be eligible for hedging relief

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Benchmarks that are in line to replace Libor are in danger of not achieving the required liquidity to meet new hedge accounting standards, bankers warn.

Under IFRS 9, which came into effect at the start of 2019, hedging activity must have a risk component that is “separately identifiable and reliably measurable” to qualify for hedge accounting status.

For benchmarks, this means the rate must be liquid enough to have an easily observable market within 24 months from the date it is designated as a risk component. Failure to meet the requirement could result in the breakdown of hedge accounting relationships.

“Some of these new benchmarks – such as SOFR and €STR – are still in their infancy and so although there are developing markets, some may argue they are not currently deep or liquid enough to potentially qualify for this ‘separately identifiable and reliably measurable’ definition for use in hedge accounting,” says Bradley Anderson, head of accounting solutions at BNP Paribas.

Industry groups are preparing to switch trillions of dollars worth of Libor-linked instruments to alternative reference rates in advance of Libor’s likely discontinuation at the end of 2021.

In some countries, the replacement rates are new and untested: SOFR in the US and €STR in the eurozone. The UK’s replacement rate Sonia has been used in financial markets since 1997, which makes it less likely to fall foul of the new accounting rules.

Bankers say the 24-month deadline is even more of a concern given the wider financial disruption wreaked by the coronavirus pandemic since the start of the year.

“While these benchmarks still have 24 months to meet the requirement, in light of lockdown and the impact that it’s had on financial markets, 24 months is just too short,” says Anderson.

“Although six months ago risk-free rates were developing quickly and that timeline looked achievable, now the world has changed significantly and 24 months is an aggressive timetable for markets to meet,” he adds.

However Andrew Spooner, lead partner on IFRS 9 financial instruments at Deloitte, believes that 24 months isn’t an unreasonable deadline for benchmarks to meet the requirement. He argues that if a benchmark fails to become liquid in that time, then it calls into question the very rationale for using that benchmark for a financial instrument in the first place.

“I don’t think it’s unreasonable to put a marker down for when these markets have to develop. It’s up to auditors to look at the depth of the market over this period and see whether they think it’s sufficiently deep in order to regard a benchmark as separately identifiable. We’ll just have to wait and see,” he says.

A similar problem exists in the Fundamental Review of the Trading Book, as products linked to risk-free rates that lack sufficient liquidity could be considered non-modellable and attract a capital add-on.

In light of lockdown and the impact that it’s had on financial markets, 24 months is just too short

Bradley Anderson, BNP Paribas

The global body responsible for IFRS 9, the International Accounting Standards Board, released a draft paper in April to address industry concerns over the effect of Libor transition on hedge accounting. The exposure draft was discussed at a meeting of the IASB on June 23–25.

EY’s Clifford believes that ambiguities in the language of the exposure draft may have dangerous ramifications for SOFR in particular, potentially undermining what the IASB intends.

He says one reading of the draft implies that there needs to be a zero coupon bond market based on SOFR for the benchmark to qualify as separately identifiable – something which he believes is unlikely to happen.

“There’s a concern that SOFR may never form the basis for the bond market in the US and that it only remains as a benchmark for derivatives, while the cash and the bond market are priced on something different,” he says.

“I’m hoping this issue is due to the fact that a lot of the exposure draft is written very concisely and succinctly and so is therefore capable of being misread. The draft could therefore benefit from a bit more written guidance and clearer language, as in fact you could read it to mean that SOFR would never be eligible for hedge accounting purposes – regardless of the 24 months issue – which I don’t think is what the IASB intends,” he continues.

An IASB staff paper on the issue released ahead of the meeting noted this feedback but stuck to the 24 month timeline, saying that “the board is of the view that a clearly defined end point is necessary given the temporary nature of the proposed amendment”.

It did though note feedback that a requirement for the 24-month period to apply on a hedge-by-hedge basis would be operationally difficult, given it would mean new time periods to monitor for each new trade. The paper clarified that the 24-month period would instead apply once, from the first time that the new benchmark is designated as a hedged risk.

The paper’s proposals were approved by the IASB board at the June 23–25 meeting.

P&L volatility

The meeting also addressed industry worries about a Libor transition mismatch creating unwelcome earnings volatility on balance sheets.

Under plans to switch financial products to new risk-free rates, users will include a fixed spread to take into account the credit risk element of Libor. The spread is designed to minimise valuation changes arising from the switch.

Under the IASB’s April proposals, banks were concerned that a hedged item that was revalued to reflect the benchmark change would only consider the new risk-free rate directly, ignoring the fixed spread. The hedge on the other hand would include the spread.

The valuation difference between the two would then have to be fed through to the profit-and-loss statement, causing unnecessary earnings volatility, which the proposals were seemingly designed to minimise.

Speaking before the IASB meeting, Anderson said: “Essentially, you may be in a situation where you’d have less profit-and-loss volatility and a better accounting outcome if you ignore the relief provided by the IASB altogether,” he said.

However, the IASB clarified in the June meeting that the valuation change will take into account risk-free rates as well as the fixed spread, allaying bank fears.

But a further concern remains unaddressed. The rule changes may set broader unwanted precedents for what counts as a modification to contracts, accountants say.

The IASB is based in London’s Canary Wharf

The new rules state that a financial asset or liability can be considered to have been modified if the basis for determining its cashflow has changed – even if the contract itself hasn’t been amended. If this is the case, firms must change the hedged item’s carrying value to reference the new rate, but the cashflows are to be discounted at the old rate.

So for example, if a bank was transitioning from Eonia to €STR – a difference of 8.5 basis points – it would have to change its balance sheet’s carrying value to €STR, yet discount those new cashflows using Eonia. This would result in a change in carrying value, which would have to be recognised in P&L.

The new rules provide an exemption for such modifications if they’re done for Libor transition purposes, allowing firms to simply change the effective interest rate without changing the carrying value on the balance sheet, avoiding P&L impact. But accountants are concerned that the rule has wider ramifications for the definition of ‘modification’ outside of benchmark reform circumstances.

“The IASB may be setting a precedent that any time an asset’s cashflow changes, it counts as a modification and therefore may create an immediate P&L impact in the future – which I don’t think was their intention,” says BNP Paribas’s Anderson.

Similarly, EY’s Clifford says that now is not the time for the IASB to be opening up a debate about what counts as a modification to contracts or not, as it simply creates an additional confusing step when it comes to banks trying to account for Libor transition.

“Why try to give guidance over what counts as a modification within the context of Libor transition when the practical expedient solves the problem anyway? Does the IASB really need to go there at this stage?” he says.

The IASB staff paper acknowledges these concerns, but the rule changes were approved in their current form at the June meeting.

The amendments now need to be endorsed by the European Union for eurozone banks to be able to use them.

As long as the rules are endorsed by the EU in time for banks’ annual accounting reports, then they will be able to benefit from the accounting relief.

“The IASB has got a really quick turnaround here but I’m sure they’ll achieve that timeline as the overall support for the exposure draft has been strong,” says Deloitte’s Spooner. “I think it’s reasonable to expect that the industry will be able to apply these rules by the end of this year.”

Editing by Alex Krohn