Tuesday 27 April 2021
The Interbank Offered Rates (IBORs) play an important role in the global financial markets. For example, we often come across financial products based on LIBOR, the London Interbank Offered Rate. LIBOR is determined based on the rates at which global banks say they would lend to each other in the interbank market for short-term debt instruments. It is published for GBP, USD, EUR, JPY, CHF currencies.
LIBOR and other IBOR benchmarks index a wide variety of financial instruments worth trillions of dollars and other currencies, ranging from mortgages to derivatives. The last few years has undermined the reliability of some existing benchmarks, for example, the LIBOR scandal which was a result of some banks colluding with each other to manipulate the rates. As a result, it has been decided that the major benchmarks such as LIBOR will be replaced with alternative, nearly risk-free rates (RFRs).
LIBOR is expected to cease after the end of 2021 and its replacement by the relevant RFR will have an impact on the financial statements.
What are RFRs?
The RFRs are based on actual transactions that reflect the average of the interest rates that banks pay to borrow overnight from other banks. They are based on active and liquid markets. The key RFRs are listed below.
GBP: SONIA (Sterling overnight index average)
USD: SOFR (Secured overnight financing rate)
EUR: €STR (Euro short-term rate)
JPY: TONA (Tokyo overnight average rate)
CHF: SARON (Swiss average rate overnight)
What is the difference between IBORs and RFRs?
LIBOR and other IBORs are intended to measure unsecured interbank lending rates and mostly include a spread for credit and liquidity risk premium. The RFRs are based on overnight rates and hence are nearly risk-free so do not imply a spread. RFRs are therefore expected to fix lower than their IBOR equivalents.
IBORs are term rates published for different periods, for example, 3-month LIBOR or 6-month LIBOR. They are forward-looking i.e., published at the beginning of the borrowing period. RFRs are mostly backward-looking overnight rates based on actual transactions and are published at the end of the overnight borrowing period.
Due to the difference in how IBORs and RFRs are determined, adjustments are required to the RFRs for credit and term differences in the contracts that reference IBORs to the RFRs. It is however likely that in the future we may see forward-looking term versions of the RFR which would include spread adjustment being used.
What is the impact of transition on IFRS financial statements?
If you are a preparer of IFRS financial statements, the International Accounting Standards Board (IASB) has published pre-replacement and post-replacement guidance on interest rate benchmark reforms. The Phase 1 guidance covers pre-replacement issues wherein the board acknowledges that discontinuation of hedge accounting solely due to uncertainties around the replacement would not provide useful information to users of the financial statements. It therefore amended specific hedge accounting requirements in IFRS 9 (and IAS 39) to provide exceptions during this period of uncertainty. These amendments apply for annual periods beginning on or after 1 January 2020 and are mandatory for all hedges.
The Phase 2 guidance deals with replacement issues. It covers modification of financial assets, financial liabilities and lease liabilities. It also provides reliefs in relation to specific hedging relationships affected due to the transition. These amendments apply for annual periods beginning on or after 1 January 2021.
Both Phase 1 and Phase 2 require additional disclosures in the financial statements to enable users to understand the effect of IBOR reform on the financial instruments and risk management strategy.
About the Author
Saket Modi is an IASeminars instructor on IFRS and IPSAS based in London. He has designed and facilitated courses on IFRS, in particular IFRS 9 financial instruments, for delegates from over 50 countries in UK, Europe, Africa, Middle East and Asia. He is a qualified accountant and CFA® charterholder.