BC10. The proposed Update discussed in paragraph BC9 added the OIS rate based on SOFR to the list of eligible benchmark interest rates in the United States. In reaching this decision, the Board acknowledges that OIS contracts based on SOFR are not yet widely traded in the U.S. financial markets. Nonetheless, the Board decided to propose that the OIS rate based on SOFR should be added as a benchmark interest rate for several reasons.
BC11. The Board considered the circumstances surrounding the Fed’s request to add the OIS rate based on SOFR as a benchmark rate for hedge accounting purposes before the rate is present in swap contracts. The Board recognizes the underlying reasons for the effort undertaken to identify an alternative reference rate as discussed in paragraph BC5 and understands that there is widespread support for the ARRC’s transition plan to integrate the underlying SOFR rate into the U.S. financial markets. The Board also is aware of the effect of the substantial changes occurring in the marketplace on hedging activities and the importance of adding the OIS rate based on SOFR for hedge accounting purposes in facilitating transition from LIBOR to SOFR.
BC12. In considering whether a new benchmark interest rate should be added for hedge accounting purposes, the Board assessed whether the future OIS rate based on SOFR would be expected to meet the characteristics of a benchmark rate in GAAP. The Master Glossary of the Codification defines the term benchmark interest rate as follows:
A widely recognized and quoted rate in an active financial market that is broadly indicative of the overall level of interest rates attributable to high-credit-quality obligors in that market. It is a rate that is widely used in a given financial market as an underlying basis for determining the interest rates of individual financial instruments and commonly referenced in interest-raterelated transactions.
In theory, the benchmark interest rate should be a risk-free rate (that is, has no risk of default). In some markets, government borrowing rates may serve as a benchmark. In other markets, the benchmark interest rate may be an interbank offered rate.
BC13. Although the OIS rate based on SOFR is an emerging rate, the Board believes that it would satisfy the characteristics of a benchmark rate according to the Master Glossary definition based on an assessment of the attributes of the repo transaction rates supporting the SOFR rate (and the OIS rate based on SOFR), which reflect the financing rates on overnight repo transactions secured by U.S. Treasury securities. From a credit risk perspective, overnight repo transactions collateralized by U.S. Treasury securities, which are regarded as among the highest quality securities in the financial system, are nearly risk free. The Board also observes that the repo transaction rates supporting the SOFR rate (and the OIS rate based on SOFR) are widely recognized and quoted in the Treasury repo market, which is larger than the Fed Funds market that underlies the OIS rate based on the Fed Funds Effective Rate. Therefore, in the Board’s view, when considered from the perspective of the underlying rates, the characteristics of a benchmark rate are satisfied.
BC14. This is different from the Board’s approach when it added LIBOR as a benchmark rate. At that time, the Board considered the characteristics referenced in the Master Glossary definition of benchmark interest rate mainly on the basis of the volume of derivative instruments referencing LIBOR, rather than the volume of underlying market-based transactions that support that rate. Given market evolution, the Board believes that it is compelling to evaluate those characteristics by focusing on the depth of the market for the underlying overnight Treasury repo transactions that support the OIS rate based on SOFR.
BC15. While the OIS rate based on SOFR may not immediately meet the characteristics of widely recognized, quoted, and referenced given the lack of derivative transactions referencing that rate, this is similar to the situation that existed when the Board added the OIS rate based on the Fed Funds Effective Rate as a benchmark rate. At that time, as stated in paragraph BC8 of Update 2013-10, the OIS rate based on the Fed Funds Effective Rate was “evolving as a widely recognized and quoted rate” and “becoming more widely used in the U.S. financial market as an underlying basis for determining the interest rates of certain individual financial instruments.” Since the rate was added in 2013, the Board notes that available data indicate that there has been an increase in the volume of overnight index swaps based on the Fed Funds Effective Rate. The Board believes that it is reasonable to expect a similar development for derivatives based on the underlying SOFR rate.
BC16. The Board also notes that the benchmark rate concept in GAAP is meant to incorporate some flexibility into the guidance to allow the addition or the subtraction of benchmark interest rates if changes in the financial markets indicate that such a change is warranted. For the reasons discussed, the Board believes that the circumstances surrounding the introduction of the underlying SOFR rate into the marketplace warrant the addition of the OIS rate based on SOFR as a new U.S. benchmark rate for hedge accounting purposes at the current time. The Board understands that the ARRC’s transition plan also includes the planned introduction of a term rate based on derivatives referencing the underlying SOFR rates that reflects common borrowing intervals for cash instruments in 2021. The Board decided to limit its proposal to adding the narrow OIS rate based on SOFR (rather than a swap rate that contemplates SOFR-indexed borrowings with tenors greater than overnight) because the ARRC’s transition plan currently anticipates introducing just OIS swaps based on SOFR in the marketplace in the near term. An OIS is a specific type of interest rate swap in which the floating-rate reference index is an overnight rate, while a broader swap can have a floating leg based on any tenor, including tenors longer than overnight. In an OIS contract, parties agree to swap a floating interest rate based on an average of the overnight index rate in exchange for a fixed interest rate. The Board solicited feedback on whether to permit a more generic swap rate based on SOFR that would be comparable to the LIBOR swap rate.
BC17. In feedback on the proposed Update, stakeholders generally supported adding the OIS rate based on SOFR as a U.S. benchmark interest rate. A majority of respondents also supported a broader swap rate that would include a SOFR term rate, noting that this inclusion would further facilitate the development and acceptance of the SOFR term rate in the marketplace. Some respondents noted that this would avoid future standard setting when SOFR term rates become widely used.
BC18. In redeliberations, the Board decided to confirm its decision to add only the OIS rate based on SOFR as a benchmark rate in GAAP for hedge accounting purposes. The Board concluded that a swap rate based on a SOFR term rate does not at present meet the characteristics of a benchmark interest rate for several reasons. First, unlike a SOFR OIS swap that has a floating leg referencing the overnight SOFR rate based on actual overnight repo transactions, a SOFR swap that has a floating leg referencing a SOFR term rate would not be based on actual term repo transactions. Second, neither derivative nor cash instruments referencing a SOFR term rate exist. And, third, the Board observes the uncertainty about development of a swap rate based on a SOFR term rate given the FSB’s recent statement that indicated that more limited use of term rates would be compatible with financial stability. Therefore, the Board concluded that it would be premature to include the rate as a benchmark rate as part of the amendments in this Update. The Board plans to monitor the development of SOFR term rates in the marketplace and is prepared to consider a SOFR term rate when that rate emerges in the marketplace. The Board notes that the LIBOR swap rate continues to be an eligible benchmark rate.