Derivative Risk Management in the Spotlight

by Jiro Okochi, CEO and Co-Founder, Reval

Most practitioners in the art of hedge accounting realise that derivative risk management and hedge accounting are inextricably linked. In fact, with companies facing a difficult mix of volatile markets and new and evolving rules from accounting standards bodies and government agencies, no longer can treasurers say (or think): “To hell with the accounting, I’m just going to hedge.” In this, Reval’s third annual TMI Guide, I am very excited to present a special focus on derivative risk management and its necessary relationship to the changing regulatory environment for derivative users. From changes by the FASB and IASB to the fall-out from OTC derivative reform, the new environment for derivative end-users is bringing risk management and compliance front and centre.

A decade after hedge accounting standards were created, both domestic and international standards boards are considering major changes that, in a few years, could put everyone back to square one with a potential re-implementation. Described as a ‘simplification process’, the exposure draft on financial instruments issued in the US by the Financial Accounting Standards Board (FASB) adds complications from the proposed loss of short-cut and critical terms match and through major steps towards fair value accounting. Meanwhile, the International Accounting Standards Board’s long-awaited Phase III project addressing hedge accounting has not, at this writing, yet appeared, and it remains to be seen if ultimately more convergence occurs with FASB or if there will be more of a meandering around the current gaps.

For many controllers, change is not synonymous with simplification. Still, regardless of how the accounting standards may be amended over the next few years, the challenge will remain for many companies to understand their true risk. Finding the true exposure, measuring it, understanding what to use for hedging and who to hedge with are many of the relevant topics addressed by our contributing authors. For those who have a handle on measuring the exposure, the challenge can still be in modeling the exposure for hedge accounting assessments, especially for commodities. Unfortunately, hedge accounting for commodities is not addressed by the FASB’s proposed changes to ASC 815. Companies still cannot hedge a benchmark component of the commodity risk (the copper in the copper pot or the rubber in the tyre).

From our global seat, there is still evolution in the understanding, implementation and re-implementations of standards. It is fascinating to observe the advanced tips and techniques experienced corporations are deploying to minimise P&L volatility and the basic challenges many new regions are facing as they become first time compliers of IAS 39. As countries in Asia come online with IAS 39, we are hearing the same responses and cries of disbelief that we heard in the US and in Europe many years ago.

Regardless of how the accounting standards may be amended over the next few years, the challenge will remain for many companies to understand their true risk.

Companies are also facing changes in the regulatory environment from global financial reform efforts. More than two years after the downfall of Lehman and the brink of financial collapse, the US has passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. Now, over the next 360 days, regulators have the task of completing studies and writing rules. For the most part, non-financial end-users have been able to get exemptions that would allow them to continue their use of customised hedges without being forced to exchange trade them or clear them, which would have added costs to post and maintain margin requirements. However, there still remains the underlying concern that the rise in dealer costs in terms of reserve capital to support the business, margin requirements, regulatory reporting requirements and other costs will be passed back to the end-user, either through wider bid offers or even transaction fees.

No one should really be too surprised that the cost of using derivatives has to increase, although no one likes to pay more for anything. The big question will be whether the market is willing to bear the additional costs (by accepting wider bid offers that at least will be more transparent for standardised products) and any new fees from swap dealers, or if swap dealers will take costs out of their profit margins to support the business or to stay competitive. It’s very hard to predict today, especially since capital requirements and margining costs have not been clarified at the time of this writing.[[[PAGE]]]

The optimistic side of me hopes that the new legislation will bring back to the market companies that did not use derivatives because of the lack of regulation and transparency in the market. So perhaps like the OTC equities markets, where bid offer spreads went from, in some cases, one dollar to pennies, more liquidity will be created over time and bid offers will not widen. At minimum, Warren Buffet won’t be able to call derivatives ‘weapons of mass destruction’ any more.

With the financial reform comes more risk in the form of regulatory and reporting risk. In the US, the challenge for swap dealers, financial entities and major swap participants will be the possibility of having to ensure compliance with the US Securities and Exchange Commission (SEC), US Commodity Futures Trading Commission (CFTC) and the associated Prudential Regulator (i.e., the  Fed, OCC or FDIC) as well as any international regulatory requirements. Frankly, this aspect of reform could make several current primary swap dealers (approximately 180) reconsider whether it is worth making markets in derivatives if that function is not a major component of their business. Given that the top five banks in the US hold about 97% of the outstanding derivative volume today, the market stands to lose many of the regional bank players who have the credit lines to middle market companies and small banks. Of course, these end-users could go to an exchange or have the instruments cleared to remove the credit risk, but they may not be able to use customised products.

The regulatory reporting requirements as a result of reform may in fact pale in comparison with the headaches around reporting for hedge accounting. In addition to the reporting requirements for financial entities to register and comply with the new law, one of the big challenges will be the potential need to demonstrate the hedging of commercial risk. Does this sound familiar to the cornerstone of hedge accounting compliance? For corporate end-users to potentially qualify for any exemptions from exchange trading or clearing, one of the requirements is to show that the OTC derivative instrument is mitigating commercial risk.  

It remains to be seen how the regulators will define commercial risk for interest rate, foreign exchange and commodity risk, but even if it is a broad-based definition, it would be prudent for most end-users to provide as much documentation as possible to defend the hedge should the regulator investigate. Fortunately, most corporations will be able to leverage risk management policies, hedge accounting at-inception documentation and effectiveness assessments to prove that commercial risk is being mitigated. For those not bothering with hedge accounting, the legislation may be the impetus to start complying as the risk of being forced into exchange-traded or cleared instruments can be very costly to come up with the initial and variation margin.

I would like to thank again all of our esteemed authors who took the time to participate in this year’s publication and hope that whether you are a first-time practitioner of hedge accounting or risk management or an experienced veteran, you find the articles that follow to be valuable and interesting to read.