Interest Rate Reform and Implications on Foreign Currency Derivatives

What's the Issue?

Britain is ending support of the London Interbank Offered Rate (LIBOR) on or about 2021. US regulators currently plan to replace LIBOR with the Secured Overnight Financing Rate (SOFR) curve. The pending “Illiquid LIBOR Market” and related lack of transparency will render valuations of LIBOR priced instruments troublesome.

How Are My Foreign Currency Derivatives Affected?

For foreign currency derivatives, forward point curves, discount rates and CDS rates (credit defalut rates used to discount for credit) will change. The calculations or math using these inputs will not change, but the inputs will. Forward curves will no longer be LIBOR based and will transition to SOFR based inputs. This transition will not be transparent to market takers, but will evolve as arbitrage opportunities are created in the market place.

Effectiveness tests including time value will be affected as the inputs change and even effectiveness tests that exclude time value will move to risk free discounting. Fortunately these changes will affect both the hedged item and the hedging instrument equally. As a result the we don’t expect most US GAAP FX hedge relationships to be impacted. For IFRS companies the credit spreads included in effectiveness testing will increase as all credit is moved from IBOR based discounting to the new credit free curves, likely effecting the slope of hedge relationships.

Cross currency swaps will likely need more attention. Both the derivative and hedged debt (if any) will need to be renegotiated to adjust resets, daycounts, fixed rates, etc.— and for the swap, both legs of the swaps may change.

Since the proposed SOFR curve is “risk free”, there will need to be a new approach to credit risk discounting in order to provide meaningful and accurate valuations under ASC 820.

Disclosure Considerations

For companies with only currency forward and/or option contracts there would generally not be any disclosures about the SOFR conversion. However, companies should be aware that market disruptions created as different economies move to SOFR-like pricing at different times might impact currency markets and liquidity in the currency trading markets.

Many companies trade 100 percent of their balance sheet portfolio monthly and might face illiquid markets and related high spreads (costs) on trading dates. Foreign debt and related cross currency swaps may require disclosures about the instruments and the expected transition from the old rates (LIBOR and similar) to the new rates (SOFR and similar) plus related curve adjustments made for credit.

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 counter parties, across all asset classes.

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 and other IBOR exposures across asset classes?
    • Check Fallback Provisions on: Credit Facilities, Leases, Derivatives, Accounts Receivables/Payables, Transfer Pricing Contracts and More
    • Review ISDAs for all “IBOR” clauses
  • 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 and Cross Currency swap critical terms
    • Negotiate away bad provisions in borrowing agreements now. If you’re too late re-working your contracts, your counter parties 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?

Conclusion

While it is clear that interest rate reform will impact interest rate derivatives and debt instruments, be careful to assess other LIBOR priced derivatives such as foreign currency forward and option contracts. The pricing of these derivatives are also dependent on the LIBOR and other IBOR curves and will be impacted by the change to SOFR.

Are you prepared for the change? Hedge Trackers’ expert consulting team is ready to assist companies navigating through this transition period. We are providing client support for foreign currency and interest rate derivatives as well as any possible special hedge accounting complications related to the interest rate transition process. For more information on the transition to SOFR and how it might affect your company please contact us.