Project Pages

Secured Overnight Financing Rate—London Interbank Offered Rate Replacement

Project Description: A primary objective of this project is to consider replacing citations of the London Interbank Offered Rate (LIBOR) in GASB standards with one or more acceptable benchmark reference rates or, alternatively, developing criteria for an acceptable reference rate in lieu of identifying specific rates. The project also will address whether the requirement to cease hedge accounting due to a termination event should be amended to exclude terminations that result from amending an existing derivative instrument or entering into a new derivative instrument for the purpose of replacing LIBOR as the reference rate.

Status:
Initial Deliberations: April 2019


Secured Overnight Financing Rate—London Interbank Offered Rate Replacement—Project Plan


Background: LIBOR (and other IBORs, such as the Tokyo Interbank Offered Rate, TIBOR, and the Euro Interbank Offered Rate, EURIBOR) is a reference rate that is incorporated into the terms of approximately $350 trillion of financial instruments worldwide, about $150 trillion of which is benchmarked to U.S. LIBOR, including those entered into by U.S. state and local governments—predominantly interest rate swaps and other derivatives but also including floating rate bonds, loans, and other instruments.

LIBOR represents an average of the rates at which major British banks expect they can borrow from each other without putting up collateral. It is calculated each business day in London for 10 different currencies and 15 maturities from overnight to one year and is based on surveys of panels of large banks.

For a variety of reasons—including the diminishing objectivity of the rate due to a decreasing number of transactions in the markets underlying LIBOR (and other IBORs)—a multinational process is underway to establish new reference rates that are more reliable and robust.

In the U.S., the replacement reference rate will be the Secured Overnight Financing Rate (SOFR), which is calculated daily based on overnight transactions from the prior day’s trading activity in specified segments of the U.S. Treasury repurchase agreement market. As such, the rates are based on actual transactions rather than estimates, as is the case with LIBOR.

The most challenging aspect of the sunset of LIBOR likely will be its potential impact on the hedge accounting provisions of Statement No. 53, Accounting and Financial Reporting for Derivative Instruments. For derivatives that are effective hedges, changes in their fair value are recognized as deferred outflows of resources or deferred inflows of resources. Should a hedging derivative cease to be effective or terminate, the accumulated deferrals are recognized in investment income and subsequent changes in the derivative’s fair value also would be recognized in investment income.

The question arises whether the revision of the terms of a derivative to replace LIBOR with SOFR or another reference rate (or the replacement of the derivative with a virtually identical derivative but for the change in reference rate) would constitute a termination event that would end hedge accounting for that transaction. Although derivatives are less prevalent among state and local governments than they were at the time Statement 53 was issued, they remain widely used by states and other larger governments, certain business-type entities, and pension plans. For those governments, the dollar amounts involved are significant, making the termination of the derivative and the subsequent end of hedge accounting a notable financial event.

Accounting and Financial Reporting Issues: The major issues that will be considered during the project are as follows:
  • How should the replacement of LIBOR be addressed: (1) by replacing existing citations of LIBOR with SOFR or other new reference rates or (2) by describing the characteristics of an acceptable reference rate?
  • If the Board decides to pursue the latter, what are the characteristics of an acceptable reference rate?
  • Do the circumstances related to the revision or replacement of derivative instruments in response to the end of LIBOR merit an exception to the hedge accounting termination provision of Statement 53, similar to exception in Statement 64?
Project History:
  • Added to current technical agenda: December 2018
  • Task force established? No
  • Deliberations began: April 2019
Work Plan:
 

Board Meetings

Topics to Be Considered

August 2019: Review first draft of the standards section of an Exposure Draft.
October 2019: Review preballot draft of an Exposure Draft.
October 2019 (T/C): Review ballot draft of an Exposure Draft and consider for approval.
November 2019–January 2020: Comment period.
March (T/C)–April 2020 (T/C): Redeliberate issues.
May 2020: Review preballot draft of a final Statement.
June 2020: Review ballot draft of a final Statement and consider for approval.
 

Secured Overnight Financing Rate—London Interbank Offered Rate Replacement—Recent Minutes


Minutes of Meeting, July 16–18, 2019
 
The Board continued deliberations on the LIBOR replacement project, first discussing whether guidance should be provided specific to lease modifications. The Board tentatively decided to propose an exception to the lease modification guidance for contracts amended only to change the index rate upon which variable payments depend. The Board then discussed three alternatives regarding the scope of the lease modification guidance exception and tentatively decided to propose that the scope of the exception be limited to circumstances in which the original contract references an interbank offered rate (IBOR) or a rate based on an IBOR—the moderate approach.
 
Additionally, the Board tentatively agreed to propose guidance that a government assume that the reference rate on which the hedged cash flows are based is not altered as a result of reference rate reform, for purposes of determining whether an expected transaction is probable of occurring.
 
The Board then discussed the application of hedge accounting termination provisions and tentatively decided to propose an exception to the hedge accounting termination provisions for certain hedging derivative instruments. Furthermore, the Board tentatively decided to propose that the exception be limited to hedging derivative instruments that continue to be effective and the scope of the proposed exception be limited to circumstances in which the original hedging derivative instrument references an IBOR or a rate based on an IBOR. In addition, the Board tentatively decided not to propose specific guidance on which reference rates may be selected as a replacement. The Board also tentatively decided to propose that if the replacement is effectuated by ending the original hedging derivative instrument and entering into a new hedging derivative instrument, those transactions be required to be ended and entered into on the same date. Lastly, the Board tentatively agreed to propose that critical term changes that are either essential to or related to the replacement of a reference rate be permitted.

Minutes of Teleconference, May 13, 2019
 
The Board continued deliberations on the Secured Overnight Financing Rate—London Interbank Offered Rate Replacement project by first discussing characteristics of a benchmark interest rate. The Board tentatively decided to retain the existing approach of specifying which rates are appropriate benchmark interest rates for the application of the consistent critical terms method.
 
The Board then discussed alternative reference rates and tentatively decided that the Effective Federal Funds Rate and the Secured Overnight Financing Rate (SOFR) should be proposed as appropriate benchmark interest rates for taxable debt. Additionally, the Board tentatively agreed that the derivative instruments guidance permits a more generic swap rate based on SOFR. The Board also tentatively decided that a nearly risk-free rate that is adjusted with a spread should not be considered an appropriate benchmark interest rate. Lastly, the Board tentatively decided that LIBOR should be removed from the derivative instruments guidance as an appropriate benchmark interest rate for taxable debt.

Minutes of Teleconference, April 1, 2019


The Board began deliberations on the Secured Overnight Financing Rate—London Interbank Offered Rate Replacement project by discussing background information on benchmark interest rate reform. The Board then discussed potential amendments to Statement No. 53, Accounting and Financial Reporting for Derivative Instruments, as amended, and tentatively decided to propose that paragraph 9 of that Statement be amended to remove the specific examples: “Common reference rates are the London Interbank Offered Rate (LIBOR), the Securities Industry and Financial Markets Association (SIFMA) swap index, the AAA general obligations index published by Municipal Market Data, or a commodity pricing point. For example, a commodity swap’s variable payment may be linked to the price of No. 2 heating oil at the New York City harbor price point.” Additionally, the Board tentatively decided to propose that the first sentence of the definition of reference rate in the Glossary of Statement 53 be replaced with the following to be more consistent with the FASB’s definition of underlying: “A specified interest rate, security price, commodity price, foreign exchange rate, index or prices or rates, or other variable (including the occurrence or nonoccurrence of a specified event, such as a scheduled payment under a contract). A reference rate may be a price or rate of an asset or liability but is not the asset or liability itself. A reference rate is a variable that, along with either a notional amount or a payment provision, determines the settlement of a derivative instrument.” Furthermore, the Board tentatively decided to propose that the definition of reference rate in the Glossary of Statement 53 be amended to remove the following two sentences: “Common reference rates are LIBOR, the SIFMA swap index, the AAA general obligations index, and the pricing point of a commodity. For example, a commodity swap’s variable payment may be linked to the price of No. 2 heating oil at the New York harbor pricing point.” Lastly, the Board tentatively decided to propose that the last sentence of the definition of a reference rate in the Glossary of Statement 53 be amended as follows: “Other literature may refer to a reference rate as a reference index or underlying” and that the Glossary of Statement 53 should be amended to remove the definition of underlyings.

Next, the Board discussed the specification of benchmark interest rates in accounting literature and tentatively decided that a benchmark interest rate should be viewed as a market-driven rate. Lastly, the Board decided that the potential characteristics of a benchmark interest rate should be further developed for Board consideration.

 

Secured Overnight Financing Rate—London Interbank Offered Rate Replacement—Tentative Board Decisions to Date


The Board tentatively decided to propose the following:
  • Statement No. 53, Accounting and Financial Reporting for Derivative Instruments, as amended, should be amended as follows:
    • Paragraph 9 should be amended to remove the specific examples: “Common reference rates are the London Interbank Offered Rate (LIBOR), the Securities Industry and Financial Markets Association (SIFMA) swap index, the AAA general obligations index published by Municipal Market Data, or a commodity pricing point. For example, a commodity swap’s variable payment may be linked to the price of No. 2 heating oil at the New York City harbor price point.”
    • The first sentence of the definition of reference rate in the Glossary should be replaced with the following to be more consistent with the FASB’s definition of underlying: “A specified interest rate, security price, commodity price, foreign exchange rate, index or prices or rates, or other variable (including the occurrence or nonoccurrence of a specified event, such as a scheduled payment under a contract). A reference rate may be a price or rate of an asset or liability but is not the asset or liability itself. A reference rate is a variable that, along with either a notional amount or a payment provision, determines the settlement of a derivative instrument.”
    • The Glossary should be amended to remove the following two sentences: “Common reference rates are LIBOR, the SIFMA swap index, the AAA general obligations index, and the pricing point of a commodity. For example, a commodity swap’s variable payment may be linked to the price of No. 2 heating oil at the New York harbor pricing point.”
    • The last sentence of the definition of a reference rate in the Glossary should be amended as follows: “Other literature may refer to a reference rate as a reference index or underlying.”
    • The Glossary should be amended to remove the definition of underlyings.
       
  • The following would be considered in relation to the specification of benchmark interest rates in accounting literature:
    • A benchmark interest rate should be viewed as a market-driven rate.
  • The existing approach of specifying which rates are appropriate benchmark interest rates for the application of the consistent critical terms method will be retained.
  • The Effective Federal Funds Rate should be an appropriate benchmark interest rate for taxable debt.
  • The Secured Overnight Financing Rate (SOFR) should be an appropriate benchmark interest rate for taxable debt.
  • The derivative instruments guidance should permit a more generic swap rate based on SOFR.
  • A nearly risk-free rate that is adjusted with a spread should not be considered an appropriate benchmark interest rate.
  • LIBOR should be removed as an appropriate benchmark interest rate for taxable debt.
  • An exception to the lease modification guidance for contracts amended only to change the rate upon which variable payments depend. 
    • The scope of the exception should be limited to circumstances in which the original contract references an IBOR or a rate based on an IBOR.  
  • For purposes of determining whether an expected transaction is probable of occurring, a government should assume that the reference rate on which the hedged cash flows are based is not altered as a result of reference rate reform. 
  • An exception to the hedge accounting termination provisions for certain hedging derivative instruments. 
    • The exception to the hedge accounting termination provisions should be limited to hedging derivative instruments that continue to be effective. 
    • The scope of the exception should be limited to circumstances in which the original hedging derivative instrument references an IBOR or a rate based on an IBOR. 
    • Specific guidance on which reference rates may be selected as a replacement should not be developed. 
    • If the replacement is effectuated by ending the original hedging derivative instrument and entering into a new hedging derivative instrument, those transactions should be required to be ended and entered into on the same date. 
    • Critical term changes that are either essential to or related to the replacement of a reference rate should be permitted.