ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues in derivatiViews, reflecting ISDA's long-held commitment to making the market safer and more efficient.

As awareness of benchmark reform has increased, so too has understanding of the various issues. And few of those issues stand to have as big an impact on corporate balance sheets as the accounting implications of a shift from interbank offered rates (IBORs) to alternative risk-free rates (RFRs).

At risk is the continuation of hedge accounting relationships, critical for the balance sheet stability of corporates across the globe. Simply put, a change in the reference rate could cause a breakdown of some of those relationships, resulting in an immediate impact on profit and loss (P&L) statements.

The subsequent balance sheet volatility would not reflect the economic or risk position of the company – despite having a hedge in place to offset risk, the mark-to-market gains and losses on the derivatives hedge could have to start being recognized in the P&L, while the gains and losses on the instrument being hedged would not.

Fortunately, help is at hand. The two main accounting bodies – the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) – are both aware of this issue and are looking to put in place solutions.

Last month, the IASB published an exposure draft looking at so-called phase-one issues – those that arise during the period of uncertainty before existing benchmarks are replaced with alternative RFRs. This is an important step forward, and ISDA welcomes the proposed relief from specific, forward-looking requirements that could have resulted in the discontinuation of hedge accounting solely due to the uncertainty arising from interest rate benchmark reform.

However, the IASB has yet to explore its ‘phase-two’ issues – those likely to arise upon the actual migration from IBORs to RFRs. These include, for example, whether firms can modify hedge accounting documentation to reflect the switch to an RFR without having to terminate their existing hedge accounting relationships.

This is a critical part of the puzzle, and is integral to how market participants prepare for benchmark reform. A lack of clarity could discourage firms from shifting to RFRs, hindering transition efforts.

This is a complex project, and it’s understandable that the IASB wants to wait for more information. But market participants need as much certainty as early as possible, so we would urge the IASB to prioritize these issues and start working on them now.

It’s also important that the IASB and FASB coordinate their work on this important topic. Benchmark reform is challenging enough without having to navigate differences in accounting treatment. Needless to say, ISDA will support both the IASB and FASB as they strive to deal with the accounting implications of a switch to RFRs.

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