Research findings (Agenda Paper 14)

Back­ground

IBORs are interest reference rates, such as LIBOR, EURIBOR and TIBOR, that represent the cost of obtaining unsecured funding, in a particular combination of currency and maturity, and in a particular interbank term lending market.

Recent market developments have brought into question the long-term viability of those benchmarks. The Financial Stability Board (FSB) has undertook a fundamental review of major interest benchmarks and developed plans for reforms. In some jurisdictions significant progress towards developing alternative, nearly risk-free rates (‘RFRs’) has been made, such as the Secure Overnight Funding Rate (SOFR) in the US and the reformed Sterling Overnight Index Average (SONIA) in the UK. However, some aspects of the transition away from IBORs remain uncertain.

In this context, in June 2018 the Board decided to add to its active research agenda a research project to assess the effects on financial reporting of a potential discontinuation of IBORs.

Research findings

Market risks

When IBORs are either discontinued or no longer accepted, the terms and conditions of floating-rate financial instruments will likely need to be amended to provide for an alternative floating rate. Derivative markets could have a standardised protocol enacted by the International Swaps and Derivatives Association (ISDA), if agreed by all parties, to reduce the burden of re-negotiating outstanding contracts. However the specific conditions for the contractual amendments have not been defined yet and consensus has not yet been reached on whether or not there will be value transfers on transition.

Unlike derivatives, the process of amending legacy positions for cash (i.e. non-derivative) instruments is yet to be determined and will likely involve negotiation on a contract-by-contract basis. This could introduce temporary basis risk between derivatives and the cash products they hedge if the transition is completed under different timelines. The basis risk could also be more permanent if the derivative markets select an overnight rate and the cash markets select a term rate.

Accounting implications

There are two groups of accounting implications expected by the staff. The first group relates to issues affecting financial reporting leading up to IBOR reform. Some areas of hedge accounting require a forward-looking analysis. These include (i) the requirement to assess whether a forecast transaction designated as a hedged item is ‘highly probable’, and (ii) the prospective assessments required to demonstrate the existence of an economic relationship under IFRS 9 Financial Instruments, or, under IAS 39 Financial Instruments: Recognition and Measurement, the expectation that that the hedge will be highly effective in achieving offsetting. The staff concludes that, as a result of these requirements, the replacement of IBOR could lead to the discontinuation of hedge accounting for some existing hedge relationships as well as an inability to designate new hedging relationships. The staff therefore thinks that the Board should consider whether to make narrow amendments to IFRS Standards to provide relief from discontinuing hedge accounting.

The second group of accounting implications relates to issues affecting financial reporting on transition to RFR. Because the modalities of the transition have not yet been determined and could vary across jurisdictions, product types and agreements, the staff will need to monitor further developments in this area to be able to assess the potential implications as more information become available. The areas identified so far by the staff that might be affected include modification vs. derecognition of financial instruments and hedge accounting.

Staff recommendation

The staff recommended the Board to move the IBOR project to its standard-setting programme. The staff also recommended to prioritise the analysis of accounting issues affecting financial reporting leading up to IBOR reform by examining first issues when IFRS Standards have forward-looking requirements and, subsequently, issues which will impact financial reporting when the reform is enacted. 

Board discussion

Most Board members supported the staff’s recommendations and several members stressed the need for the Board to act quickly and proactively to address the market’s needs and concerns.

A parallel was drawn to the amendment to paragraph 91 of IAS 39 Financial Instruments: Recognition and Measurement that was introduced in response to a request to clarify whether an entity is required to discontinue hedge accounting when a hedging derivative is novated to a central counterparty due to the introduction of a new law or regulation. Some Board members and the staff noted that the issues raised by the IBOR reform are much broader and as a result, there is a risk of introducing reliefs that are not required, or that would disrupt the hedge accounting discipline. As a result the Board should take a cautious approach, and if there are real changes in the economics of individual contracts, these should be reflected in the financial statements.

One Board member noted that the project would cover both IAS 39 and IFRS 9 even though the Board had been very clear that IAS 39 would not be maintained after the implementation of IFRS 9. However given that most market participants continue to use the hedge accounting requirements of IAS 39, amendments to that Standard would also be required.

Another Board member, while not opposed to the use of standard-setting to address the issues raised by the IBOR reform, felt that she did not have sufficient information at that stage to support the staff’s recommendation to move the project to the standard-setting programme. She wanted the staff to analyse further the issues arising from the application of the Standards as a result of this reform in order to distinguish the issues that require standard-setting from the issues that do not. The staff confirmed that not all issues raised in the agenda paper would require standard-setting.

Decisions

The Board decided to move the IBOR project to its standard-setting programme (13 in favour). The Board also decided to prioritise the analysis of accounting issues affecting financial reporting leading up to IBOR reform by examining first issues when IFRS Standards have forward-looking requirements and, subsequently, issues which will impact financial reporting when the reform is enacted (13 in favour).