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If you use Hedge Trackers’ Outsourcing and/or Software suite (Capella) services, you might be wondering what’s going to happen when interest rate reform occurs and SOFR replaces LIBOR in early 2021. Although that seems a bit far away, we think most clients will be preparing and converting from LIBOR to SOFR based derivative pricing beginning next year. As a service company, Hedge Trackers is already committed and ready to convert to and make available SOFR based derivative pricing for our clients when the marketplace shifts.
What About Transition Timing?
We anticipate our client base will transition to SOFR at differing times. There will be early, mid and then some late adopters. While there is some flexibility in deciding when to transition, availability of market inputs, regulatory changes and market maker preference may dictate adoption timing. It is therefore important to proactively prepare for the transition. Hedge Trackers stands ready to discuss and consult with our clients on what the implications might mean for their derivatives and credit facilities.
How are My Derivatives Affected?
For foreign currency derivatives, forward point curves, discount rates and CDS spreads will adjust to the underlying marketplace. They will no longer be LIBOR based and will transition to SOFR based. Effectiveness testing that uses interest rate inputs will also be affected. These changes in inputs will impact the valuation of your foreign currency derivatives and, over time, effectiveness tests.
Interest rate derivatives will be more directly impacted as will the underlying debt. What complicates the matter even more is the derivative (swap) and the exposure (debt) might have reference rate changes at different times. While ASC-848 allows for concessions for the impact on hedge accounting resulting from any mismatches, lack of historical benchmark data will result in developing new effectiveness testing protocols for future relationships. This could impact your ability to maintain hedge accounting and could even result in triggering fallback provisions, which tend to have significantly higher rates.
Companies that move to SOFR based pricing will need to disclose the change. The disclosure should reference the instruments and the transition from the old rates (LIBOR) to the new rates (SOFR). Changes in valuations based on changes in rate curves should be disclosed if material in nature.
Quick Reference Checklist
In order to prepare your company and team for the coming interest rate reform, Hedge Trackers has put together a list of questions to ask your organization and counterparties. We also stand ready to guide our clients through this process, should they need or want to discuss the impact of rate reform in greater detail.
What to Do?
- Have you established a Transition Management Protocol?
- Educate yourself, monitor market discussions through news outlets, market participants, counterparties, services providers, etc. and communicate with management
- Have you identified and validated your company wide LIBOR exposure across asset classes?
- Check Fallback Provisions on: Credit Facilities, Leases, Derivatives, Accounts Receivables/Payables, Transfer Pricing Contracts and more
- Have you assessed contractual remediation and fall back provisions?
- What rates do your contracts use if LIBOR goes away?
- Some say rates could be as high as 15%. What’s yours?
- Evaluate impact on hedge accounting and reporting
- Hedges and debt may end up with different reference index rates post LIBOR, which could lead to a loss of special hedge accounting (after 2022 per ASC 848) , and the economics would not work
- Disclosure Considerations
- Have you contacted your counterparties?
- Expect to negotiate changes in IR swap critical terms
- Negotiate away bad provisions in borrowing agreements now. If you’re too late re-working your contracts, your counterparties may stall, and this could cost you additional cash outlays during the transition.
- Look for less obvious impacts to LIBOR changes
- Derivative contracts that are fair valued
- Discount rate inputs
- How will curves be adjusted for credit now that SOFR is the base curve?
- How will SOFR impact effectiveness testing calculations?
Hedge Trackers will be supporting our clients through the interest rate reform period and the discontinuation of LIBOR based derivative pricing. Clients that use Hedge Trackers for Outsourcing and/or the Capella suite have the ability to price their derivatives based on LIBOR or SOFR interest rates today. If you have any questions or concerns about the services we perform for you related to this change, please contact us.