The Financial Accounting Standards Board (FASB) on Feb. 20, 2018, issued a proposal adding an interest rate the Federal Reserve recommends as an alternative to the London Interbank Offered Rate (LIBOR) to the list of accepted benchmark rates in U.S. Generally Accepted Accounting Principles (GAAP) for hedge accounting.
Comments on Proposed Accounting Standards Update (ASU) No. 2018-220, Derivatives and Hedging (Topic 815): Inclusion of the Overnight Index Swap (OIS) Rate Based on the Secured Overnight Financing Rate (SOFR) as a Benchmark Interest Rate for Hedge Accounting Purposes, are due by March 30.
The proposal calls for adding the Secured Overnight Financing Rate (SOFR) as a benchmark rate that can be used to designate hedges of interest rate risk. The Federal Reserve plans to put the new rate into use by midyear.
The SOFR is based on the interest rates banks charge one another in the overnight market for loans they make to one another, typically called repurchase agreements. In a repurchase agreement, or repo, the borrower/seller has an obligation to buy the security back from the lender/buyer at a specified price at a set date. The Fed says that because the SOFR is based on the transactions in the open market, it is more reflective of market conditions than LIBOR, which relies more on judgment and has been tainted in recent years by scandal.
“SOFR is a volume-weighted median spot interest rate that will be calculated daily on the basis of overnight transactions from the prior day’s trading activity in specified segments of the U.S. Treasury repo market,” the FASB said. “The board believes that the addition of the OIS rate based on SOFR as an eligible benchmark rate in GAAP on a timely basis will eliminate some of the uncertainty that potentially could hamper market acceptance of the new underlying SOFR rate.”
Businesses “hedge” their exposure to spikes in interest rates by buying derivatives. Under FASB ASC 815, Derivatives and Hedging, changes in the value of the derivatives must be recorded at fair value on the income statement. Under certain conditions, companies may employ hedge accounting, which involves designating a derivative instrument for a hedged item and then recognizing the gains and losses from both items in the same period. Hedges are deemed effective if the price moves in the hedge offset the swings in value of the underlying instrument, and there is limited volatility in reported earnings.
FASB ASC 815 provides guidance about the risks associated with financial assets or liabilities that can be hedged. The risks include the changes in the fair value or cash flow of existing or forecasted issues or purchases of fixed-rate financial assets or liabilities attributable to a designated benchmark interest rate.
U.S. GAAP says an interest rate has to be widely recognized, commonly referenced and quoted in an active financial market before it can be consider a benchmark rate for accounting purposes. In theory, a benchmark interest rate should have no risk of default. In some markets, government borrowing rates may serve as a benchmark. In others, the benchmark interest rate may be referenced to the instruments banks trade among themselves, the FASB said.
FASB ASC 815 lists four rates as benchmarks: the rate on direct Treasury obligations of the U.S. government, the Fed Funds Effective Swap Rate (Overnight Index Swap Rate), the LIBOR swap rate and the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate. The FASB added the SIFMA swap rate in August 2017 in ASU No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities.
LIBOR-based derivatives are the most common hedging instruments in the market, the FASB said. LIBOR also is the rate used for many other financial transactions, including derivatives trades, mortgages and loans. But the resilience of the rate is tarnished by a rate-rigging scandal that emerged in 2012.
In 2014, the Financial Stability Oversight Council (FSOC), the interagency panel of federal financial regulatory agencies, recommended that U.S. regulators cooperate with foreign regulators, international bodies and market participants to identify alternative benchmark rates.
In response to the FSOC’s recommendations, the Federal Reserve and the Federal Reserve Bank of New York convened a special committee tasked with identifying new reference interest rates that are “more firmly based on transactions from a robust underlying market” and ultimately replace LIBOR. The Federal Reserve selected SOFR in November 2017 and considers the rate to be essentially risk free because it is tied to a deep and liquid market.
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