29 April 2013

Risk.net: Banks fear loss of hedge accounting for CCP novations

If the new interpretation is applied retrospectively, market participants will have to break up existing hedge accounting relationships and create new ones, potentially resulting in earnings volatility, accounting experts warn.

"This is a very tricky situation. Before the publication of the exposure draft, there was a mixed bag of opinions on whether hedge accounting should be discontinued as a result of a novation, and there was no consistency in practice among auditors and banks. So there will be banks out there that may have to revisit and amend the accounting treatment on those trades. But as to whether this interpretation will apply retrospectively, it is still an open question", says one London-based hedge accounting expert at a large accounting firm.

Novations are used for a variety of reasons, but are also the mechanism on which the over-the-counter market's new clearing regime is based - a bilateral trade between two counterparties is replaced by a trade in which each counterparty faces either a clearing house directly or one of the clearer's member firms. Because this process will be unavoidable for companies that are subject to a clearing obligation, the IASB's interpretations committee for International Financial Reporting Standards was asked last November to clarify whether hedge accounting treatment would remain intact.

Hedge accounting is an exception to the principle that financial instruments should be marked to market with changes in value reported as profits or losses - a vital safe harbour for big derivatives users that would otherwise see hedges generating potentially big swings in earnings - but it comes with strict conditions attached. To qualify for the treatment, a derivative needs to be paired with an underlying exposure in a hedging relationship, and the hedge needs to be regularly tested for effectiveness.

The IASB's February exposure draft, called 'Novation of Derivatives and Continuation of Hedge Accounting', states that hedge accounting will be lost in the event of a novation because the original hedging instrument no longer exists. It provides an exception for trades that are novated to a central counterparty (CCP), but only where the novation is required by law or regulation. The draft doesn't clarify whether previously novated derivatives are affected.

As a result, market participants are looking for additional guidance. In a comment letter filed with the IASB on March 20, the International Swaps and Derivatives Association calls for past novations to be grandfathered.

The comment period for the exposure draft ended on April 2, and the IASB estimates it will finalise its stance at some point during the second or third quarter of this year. If the IASB does not back down, then dealers are hoping it will widen the scope of its novation rule so voluntarily cleared trades are also exempt. It is understood the IASB is aware of these concerns and is considering widening the scope of the amendment.

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