An anticipated convergence of derivatives, clearinghouse and hedge accounting developments - as the regulatory drumbeat continues
Friday, January 24, 2020
By John Hintze
The move away from Libor to an alternative interest-rate benchmark for debt and derivatives pricing is proceeding, although most of the action is around infrastructure to support the transition, leaving most market participants watching on the sidelines. That will change soon: There will be accounting-related challenges that could jeopardize hedge-accounting relationships and, later in the year, an accelerated transition to an alternative rate, while regulators underscore their insistence that banks show progress.
“We think one of the big shoes to drop that will kick-start the transition will occur after the clearinghouses switch [in October] from using fed funds to the new risk-free rate to value positions and to calculate interest due on collateral that's being held in connection with those positions,” said Matt Hoffman, director at advisory firm Chatham Financial.
The expectation, he said, is that the CME and LCH clearinghouses' switching to the Secured Overnight Financing Rate (SOFR) - the preferred Libor replacement of the U.S. Alternative Reference Rates Committee - will prompt financial institutions to hedge their exposures to those transactions. That should generate SOFR swap volume that will fill out data that can be used to generate the long end of a SOFR forward curve.
“The change in the discounting methodology will force the derivative market to accelerate the transition over to SOFR,” said Yon Valtchev, fixed-income, rates and credit market specialist at Bloomberg. “This in turn will result in managing the risk using Libor/SOFR basis swaps and transition interest-rate risk management away from Eurodollar futures to SOFR futures.”
Trading in Eurodollar futures supports the short-end of the Libor forward curve, while swaps help fill out the long end, providing a tool to price term financial instruments. Valtchev said the market transition will likely start with cleared swaps. Corporates are exempt from having to clear swaps and so will not be impacted directly by the switch.
“As a result, the counterparty banks will have to either manage the basis risk on the client-facing portfolio or actively engage with the clients to switch them from Libor to SOFR,' Valtchev said.
Indications of Wider Adoption
Before October, there will be other important developments. The CME's SOFR options began trading on January 6. Both the CME Group and London-based LCH operations began offering one- and three-month futures referencing SOFR midway through 2018, and trading in those contracts will fill out the shorter end of the SOFR curve against which cash deals can be priced. Those products' trading volume is growing but still a tiny fraction of Eurodollar futures that support Libor.
“The SOFR futures market, while not offering comparable depth and liquidity to the Eurodollar futures market, is building momentum,” Valtchev said, noting that open interest on three-month futures contracts has more than doubled over the last six months.
A dynamic SOFR derivatives curve will enable market participants to gauge what the SOFR rate will be going into the future; the lack of such a curve has made it difficult for organizations to issue longer-term bonds or other cash products.
The number of bond issues climbed significantly in 2019, starting out in the single digits and reaching more than 40 per month in summer and early fall, according to Bloomberg.
Almost all the offerings have been by banks and by governmental and quasi-governmental agencies such as the World Bank and New York's Metropolitan Transportation Authority. Toyota Motor Credit remains the only U.S. corporate issuing paper referencing SOFR, although after a year it increased its $500 million, three-month commercial paper offering of October 2018 to a much more significant $1.55 billion medium-term note with a year-long maturity.
The Toyota transaction “supports our strategy by further diversifying our financing structures, and places us at the forefront of companies preparing for the discontinuation of the Libor index,” said Cindy Wang, group vice president of treasury for Toyota Financial Services. “We're pleased that the offering was met with enthusiasm from large investors seeking exposure to SOFR. This strong demand allowed TMCC to upsize the deal significantly from its initial target.”
Another development anticipated in first half of 2020 is the Federal Reserve Bank of New York publishing daily SOFR averages and possibly also a daily SOFR index. Chatham began publishing a SOFR forward curve in 2019.
With an eye on the end-2021 deadline, U.S. federal regulators have asked banks for their transition plans to ensure management of operational and other risks. Those agencies have been joined by the New York State Department of Financial Services (DFS), which has oversight of many sizable financial institutions and has requested submission of Libor transition risk management plans from its “regulated depository and non-depository institutions, insurers and pension funds” by February 7. [DFS subsequently extended that deadline to March 23.]
“Our financial institutions with Libor exposure need to prepare to manage the significant risks associated with its likely cessation, and be ready to transition to alternative reference rates,” said DFS Superintendent Linda Lacewell.
Maintaining Hedge Accounting
Early this year, swap users will have to address a few potentially important accounting issues stemming from Financial Accounting Standards Board (FASB) Topic 848, aiming to facilitate the transition to SOFR, and a new International Swaps and Derivatives Association (ISDA) protocol for simplifying the shifting of existing swaps to an alternative benchmark. Both are expected to arrive toward the end of the first quarter, requiring derivative end-users to make important decisions to ease the accounting burden and maintain hedge-accounting relationships.
Hedge accounting, which enables companies hedging risk to avoid recognizing the mark-to-market value changes of the derivatives in P&L, requires forward-looking analyses and expectations, including the interest expense a company anticipates in the future. Today, naming Libor as the rate to determine that expense after 2021 is a risky proposition, since regulators have stated they will no longer require banks to support the index past that point.
A staff member of the Securities and Exchange Commission said in 2018 that it would grant temporary relief by allowing organizations to also state a LIBOR-replacement rate in that probability assertion, said Rob Anderson, director in Chatham Financial's accounting advisory practice. But such temporary relief is superseded when a FASB standard is released.
“Companies should be evaluating the impact of Topic 848 and the need to adopt and apply certain aspects of it in Q1 of 2020,” Anderson said. “Even if companies don't adhere to the ISDA protocol right away, they should carefully consider the elections in Topic 848 and discuss them with their auditor so that they can continue to qualify for hedge accounting.”
The timing on that will be tight, he said, since companies will be working on their 10Ks in February and March.
“Companies should understand the impact of the relief FASB is providing before they issue their Q1 financial statements,” he added.
Nonfinancial corporations and regional and smaller financial institutions increasingly outsource aspects of their operations, whether relying on bank technology providers such as Fiserv and Jack Henry & Associates, or on systems from SAP, Kyriba and FIS. That technology was designed with Libor in mind, and will have to accommodate SOFR and potentially other Libor alternatives.
Bloomberg's Valtchev said he believes this risk has not be adequately addressed, and whether those providers are prepared for the transition should be on organizations' radar.
“What is their plan for the transition? This is a question that corporates need to find the answer to,” he said.
Acceleration in Britain
According to a January 13 Reuters report, Finastra in November updated its LoanIQ software for Sonia (Sterling Overnight Index Average), the U.K. Libor alternative. But only 15 of 60 major financial clients had made the switch, which is said to require six to 18 months for upgrading and testing.
In London on January 16, the Bank of England and Financial Conduct Authority asked for “clear evidence” of Libor transition efforts and designated March 2 as an “appropriate” date for the switch to Sonia in interest rate swaps. Their statement noted that “average cleared over-the-counter Sonia swaps exceeded £4.5 trillion per month over the past six months, and the traded monthly notional value is now broadly equivalent to sterling Libor.”
Referring to the transition roadmap of the Working Group on Sterling Risk-Free Reference Rates, the U.K. authorities added, “In addition to shifting the swap market convention, the roadmap details other priorities set by the working group, including ceasing GBP issuance of Libor-based loans by third-quarter 2020 and managing down legacy Libor-linked swap portfolios and exposures.”
Edwin Schooling Latter, FCA director of markets and wholesale policy, said, “We have seen great progress in the development of the Sonia derivatives market. I encourage all market participants to join the initiative to put Sonia first over Libor from 2 March. This should help make Sonia the market standard in sterling swaps as is already the case in the bond market.”