Europe’s corporate treasurers are conflicted over whether to shift existing trades with London-based bank counterparties to entities in the European Union and risk disrupting their hedge accounting arrangements, amid preparations for Brexit. Some are considering the alternative course of running parallel swaps books in two different jurisdictions – even if this is likely to compromise netting efficiency.
The uncertainty hinges on an exemption that would preserve the hedge accounting treatment for certain relocated trades. Opinion is divided on whether the exemption applies to swaps moved as a result of the UK’s departure from the EU.
“From an operational viewpoint it would be better if you had just one book with a banking group, however if that has an impact on hedge accounting then we probably won’t novate,” says a treasurer at a European corporate.
The UK is set to leave the EU on March 29, unless a transitional period is approved by lawmakers in both jurisdictions, in which case the UK would drop out of the EU’s single market in January 2021. In anticipation of the UK’s exit, global investment banks with trading hubs in London will transfer new business with EU clients to entities based in the bloc – for example in Frankfurt or Dublin – after London loses single market access. This will help them continue to service EU clients once the UK completes its exit, they hope.
But it leaves derivatives users in a quandary over how to manage existing swaps. One option is to shift the trades to the European Union in a process known as novation. This entails terminating the contract and reminting a fresh deal on identical terms except for the newly relocated counterparty. One problem with this approach is that, for swaps that serve as hedges, it jeopardises firms’ hedge accounting treatment.
Hedge accounting allows changes in the value of a financial instrument to be offset by the change in the value of a corresponding hedge in quarterly and yearly profit-and-loss statements. Once a swap is novated, the dealer or non-financial corporation would need to de-designate the trade as a hedge.
The novated swap could be re-designated as a hedge, but the overall process is cumbersome and operationally intensive, and derivatives users are keen to avoid it. Also, changes to hedge accounting risk introducing unwanted volatility into corporates’ profit-and-loss statements.
“There is very likely an issue in terms of continued hedge accounting,” says a treasurer at a second European corporate. “We are still clarifying that with our auditors but that is their current position. If it does there would be a high operational workload if we were to transfer our derivatives.”
Exemption proves the rule
Banks have been exploring alternative ways of transferring swaps in bulk from London to EU entities, via statutory methods. However, a more immediate source of relief may lie in an exemption for novated swaps contained in the new financial reporting standard, IFRS 9.
The standard states that the termination of a swap does not result in a break in hedge accounting if “as a consequence of laws or regulations or the introduction of laws or regulations, the parties to the hedging instrument agree that one or more clearing counterparties replace their original counterparty to become the new counterparty to each of the parties”. Changes to the hedge must also be limited only to those changes necessary to replace the counterparty.
It doesn’t make sense to de-designate if the hedge is economically equivalent and I believe the exemption for CCPs covers this issue
Pierre Wernert, Zanders
The exemption was originally designed for previously non-cleared swaps that became subject to the clearing obligation in the European Market Infrastructure Regulation and would therefore be required to be novated into a central counterparty (CCP). As the exemption was not designed for transfers resulting from Brexit and only refers to novated trades involving CCPs, it is not clear whether the exemption can be applied.
“I expect clients will really fight with the auditors on this if they have to de-designate hedges because the bank counterparty is only changing the contract to another entity,” says Pierre Wernert, a senior manager at consultancy Zanders. “It doesn’t make sense to de-designate if the hedge is economically equivalent and I believe the exemption for CCPs covers this issue.”
Audit firms are approaching the International Accounting Standards Board, which designs the IFRS rules, to reach a consensus view.
“There is an open issue as to whether novations from Brexit can meet the exemption in IFRS 9, which means you don’t have to de-designate the hedges,” says Sven Walterscheidt, senior manager in corporate treasury at PwC. “We have no final view yet. The audit firms have reached out to the standard-setters [IASB] to get their opinion but their response is outstanding.”
A spokesperson for the IASB says the standard-setter has not received any request for clarification from auditing firms and would not comment on whether transfers of derivatives resulting from Brexit qualified for the exemption.
A second consultant believes the exemption can apply to novations resulting from Brexit.
“If the only change is the company’s bank counterparty switching from one legal entity to another, then it should not trigger a designation for hedge accounting in my opinion from the company’s perspective,” says Zwi Sacho, head of the European hedge accounting and advisory team at consultancy Chatham Financial.
As for external auditors, their interpretation of the exemption will have a large bearing on whether the novation results in a break to hedge accounting. Any divergence of views between client and auditor could result in confusion.
“The firms themselves have their own accounting manuals and so do external auditors,” says Andrew Spooner, the lead partner of Deloitte’s IFRS financial instruments practice. “The question is whether this type of arrangement is covered by their existing guidance. Deloitte has the view where if the counterparty moves a derivatives trade within their group, then that doesn’t result in a break.”
This view is by no means uniform, though. As Sacho says: “I do see situations where external auditors have gone down the draconian route of saying that companies need to de-designate because their counterparty has changed to another legal entity even within the same banking group.”
If a firm’s auditors conclude novations do result in a break to hedge accounting, the first corporate treasurer says firms are unlikely to ask banks to novate their positions.
A capital manager at a global investment bank says: “The enthusiasm of anyone to spend money to actually migrate positions is zero if they can avoid it. Major clients generally say, ‘Why would I spend any money changing stuff?’”
Trapped in a net
Both non-moving banks and corporates are keen to keep all of their derivative trades with a single banking group together in a single entity to avoid disrupting netting sets. Netting enables trades with the same counterparties to be offset against each other.
“There are trade-offs between different sorts of risks and workload as well as the benefits of having all our trades with the European entity,” says the second corporate treasurer. “At the moment we are still assessing this.”
For banks, disrupting netting sets would result in higher capital requirements from not being able to net positions with the counterparty and therefore not reducing their credit exposure to the counterparty. Although corporates are not capital regulated, they may still prefer to keep netting sets together to avoid disrupting back-office functions in setting their own internal limits for the amount of business they do with one counterparty.
However, corporates may reason that splitting their netting sets is the lesser of two evils, compared with the far more undesirable consequences of having to re-designate swaps for hedge accounting.
“A de-designation of your whole or a large amount of your hedged portfolio is most certainly an event which does not happen on a regular basis,” says Walterscheidt at PwC. “The amount of operational burden that places on firms really depends on the extent of automation and how large a firm’s book is.”
Corporates may be able to avoid the break in hedge accounting if they have documented their intention to roll over and novate the hedge in their risk management objective before executing the trade. However, it is not clear whether corporates would have had the foresight to include the provision upon execution, especially for longer-dated instruments that were executed before the UK’s vote to leave the EU.
A de-designation of a swap would also introduce volatility into firms’ P&L statements. Hedged swaps are perfectly offset, and any price swings do not show up in the profit and loss reports. Once the swap is not a hedge, price swings must be booked.
As corporates’ revenues are typically not driven by volatility of financial instruments, it could become awkward for them to explain to investors that unpredictable swings in their P&L were due to a derivative and not their core business.
“Corporates want to be able to explain their P&L volatility,” says Wernert of Zanders. “You don’t want to have volatility from something you cannot control like derivative market value movement resulting from interest rate volatility.”
Even if a firm re-designates the hedge, it might still result in volatility in the P&L statement. Under hedge accounting treatment, a designated trade is compared with a hypothetical swap that is taken from prevailing market prices.
As the underlying value of the swap moves away from the rate or price agreed in the existing hedge, the value of the existing hedge will be “off-market” compared with the hypothetical derivative. The hedge can still qualify for hedge accounting but the “off-market” difference has to be booked into P&L statements.
New hedges are automatically “on-market”, which means the price of the instrument is exactly the same as a hypothetical instrument in the market. In this case, its fair value is booked as zero.
“If a hedge does have to be re-designated, then in the future they may get some hedge ineffectiveness because their new swap wasn’t entered into on-market with a fair value of zero,” says Spooner of Deloitte. “That is where the accounting problem can arise. It would result in P&L volatility in future periods that you were not expecting.”
Editing by Alex Krohn