IFRS 9 drives appetite for long-dated hedges in Asia

New accounting standard helps manage mark-to-market volatility of long-term trades

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The long haul: a key driver behind this trend is that the cost of hedging has dropped significantly

New accounting rules are driving the uptake of long-dated forex hedges among Asian corporates, as growing geopolitical concerns heighten currency volatility.

“We are seeing a lot of volatility in the currency markets at the moment, and so by changing the tenor of hedges we can save on the mark-to-market costs of hedging,” says a senior manager in the Asian treasury department of a larger corporate. “I run a very large book, close to US$2 billion, so the savings can be significant.”

Bankers say the introduction of International Financial Reporting Standard 9 (IFRS 9) for financial instruments has encouraged more long-term hedging, because it has simplified the accounting recognition of hedges.

One banker says his firm has seen hedges with a tenor of at least two years jumping by 50%, compared with the same period a year earlier. Another says the volume of hedges put on with a three-year or longer tenor increased by as much as 40% in 2018, compared with the year before.

While Chinese firms have been responsible for much of this rise, the trend has also been seen elsewhere in Asia. Trade tensions between the US and China, along with the UK’s imminent departure from the European Union are being blamed for current shocks in currency markets, especially between the US dollar and the renminbi (see figure 1).

Asian firms historically used short-dated swaps of a year or less to hedge their currency exposure. Many maintained positions of only one or two months and rolled the hedges as necessary.

This can be expensive though, in terms of the settlement fees that banks charge. It can also leave firms exposed to volatility in the market and force them to roll hedges in adverse market conditions.

But lengthening the tenor of hedges does not automatically eradicate the accounting impact of moves in the underlying exchange rates. Cross-currency swaps have to be recorded on the balance sheet at fair value, with any changes being marked up in the profit-and-loss account. As a result, a long-term trade could inject volatility into the company’s accounts.

In the past, this has acted as a deterrent for firms wanting to put on longer-term hedges. However, IFRS 9, which was implemented in most Asian jurisdictions at the start of 2018, provides a way of smoothing this volatility over a period of time by offsetting any changes in the derivative position with changes in the underlying asset it is being used to hedge.

“If you enter into a hedge, which is then marked to market through earnings, that could be perceived as worse than not managing your risk, as a negative derivative impact may be viewed in isolation, rather than in conjunction with the underlying risk,” says Nik Tandy, director of thought leadership at HSBC in Asia.

“But as companies have begun managing their risks more effectively, they have also started to gain a better appreciation of hedge accounting, and this has encouraged them to enter more hedges because the negative perception is removed when both the hedge and underlying are effectively reported together,” he adds.

Option premium can now essentially be amortised rather than expensed on a mark-to-market basis, making the use of options as hedging products far more attractive
Nik Tandy, HSBC

Although hedge accounting is not a new concept – it was possible under IFRS 9’s predecessor, International Accounting Standard (IAS) 39 – the criteria for what constitutes an eligible hedge have been made simpler, says Tandy.

“Hedge accounting has been around for a while, but under the previous accounting standards it was more complicated to implement, with complex technicalities that often led to potentially misleading reporting outcomes,” he says.

“The new rules of IFRS 9 that are easier to understand and implement, coupled with better understanding of hedge accounting in general, has created an environment where longer-term hedges are easier to manage from a reporting perspective,” adds Tandy.

Good timing

The new IFRS 9 implementation of hedge accounting is particularly helpful for introducing optionality into long-dated hedges, since unlike IAS 39, it allows companies to account properly for the time value of an option by allowing the costs to be spread across the lifetime of the trade.

“Option premium can now essentially be amortised rather than expensed on a mark-to-market basis, making the use of options as hedging products far more attractive,” says Tandy. “We've seen clients put on a number of hedges using option-based products, particularly on renminbi-US dollar liabilities, with the ability to achieve hedge accounting and spread any option premium an important factor in that decision.”

However, dealers recognise it may take companies a while before they are fully on board with hedge accounting.

“A lot more corporates are showing interest in hedge accounting than those that can actually do it because of their internal processes,” says Jerry Li, head of fixed income and currencies for greater China at Deutsche Bank.

“Not everybody has the necessary infrastructure in place: the risk-capture system, the accounting management approval process, that kind of thing. So, whilst companies are certainly displaying a willingness to do this, they clearly need more support and more education,” he adds.

However, for companies who have the infrastructure, market conditions are increasingly favourable for putting on long-term hedges. The cost of hedging has fallen significantly as swaps curves have flattened. For example, a year ago, it would have cost 300-400 basis points to put on a three-year hedge between the US dollar and the offshore renminbi; now the cost has fallen to under 100bp.

“The swap curve is very flat at the moment, and so I think it makes perfect sense for our clients to lock in their exposure costs so they don’t have to worry about the exposure at a later date and can just get on with running their business,” says Li.

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