March 1, 2019

What You Need to Know About the New Benchmark in Accounting for Hedging Activities

In fall 2018, the Financial Accounting Standards Board (FASB) issued ASU 2018-16, which adds a new U.S. benchmark interest rate for purposes of applying hedge accounting under Topic 815 (Derivatives and Hedging).  The Secured Overnight Financing Rate (SOFR) Overnight Index Swap (OIS) Rate was introduced as an alternative to the current benchmark interest rates eligible in the United States, which include interest rates on direct U.S. Treasury obligations (UST), the London Interbank Offered Rate (LIBOR) Swap Rate, the OIS Rate based on the Federal Funds Effective Rate, and the recently added Securities Industry and Financial Markets Association Municipal Swap Rate.

What exactly is the SOFR and how is it determined?

The SOFR was identified by the Alternative Reference Rate Committee (ARRC), at the request of the Federal Reserve (Fed), as an alternative reference interest rate, which is based on actual transactions in a robust market and is in compliance with the financial benchmarks outlined in International Organizations of Securities Commissions principles.  The ARRC and the Fed established this rate based on three distinct sources with an aggregate average daily volume of $808 billion.

The three sources from which the Fed gathers data daily to determine the SOFR include Tri-Party Treasury Repo Transactions, Treasury Repo Transactions, and Bilateral Treasury Repo Transactions.  From this data, the Fed filters transaction rates by category from lowest to highest, and removes the bottom 25% of trading volume in an effort to target and eliminate outlier data where treasury collateral is most likely to be trading special, which occurs when specific-issue collateral repo transactions take place at rates below those of general collateral because providers are willing to accept a lesser return in order to obtain a particular security.  From this processed data, the Fed delivers a Transaction-Weighted Median Repo Rate, which becomes the day’s Daily SOFR Benchmark Value.  This rate is posted on the next market business day, normally by 8 a.m. ET.

How has SOFR performed?

SOFR, when compared to the Effective Fed Funds Rate (EFFR), correlates closely, trailing by 3.9 basis points on average.  However, SOFR  displays higher volatility near quarters’ end which is likely attributable to banks making quarter-end adjustments.

Why adoption?

With FASB’s efforts to improve accounting for hedging activities, FASB looked to ARRC and the Fed, who requested that the OIS rate based on SOFR be considered eligible as a U.S. benchmark interest rate for purposes of applying hedge accounting under Topic 815.  Due to the Fed expressing concerns over the sustainability of LIBOR, ARRC identified the SOFR as a preferred rate to the LIBOR due to the newly developed rate being more firmly based on actual transactions in a robust market.

For public entities that have already adopted ASU 2017-12, ASU 2018-16 is effective for the fiscal year beginning after December 15, 2018, and interim periods for that year.  For non-public entities that have adopted ASU 2017-12, the effective date for ASU 2018-16 is the fiscal year beginning December 15, 2019, and interim periods therein.  For entities that have not already adopted ASU 2017-12, this update is to be adopted concurrently with ASU 2017-12.  Early adoption is permitted during any interim period upon issuance, given the entity has already adopted ASU 2017-12.

For more information on how SOFR will affect your organization’s future hedging arrangements, contact one of our PYA representatives below at (800) 270-9629.

 

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