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Still Tinkering With FAS 133

The Financial Accounting Standards Board knows many of the provisions in Financial Accounting Standard 133 are quite unpopular in the corporate sector. Over the past few years, the accounting standards-setter has received hundreds of letters from raging corporate treasurers arguing that FAS 133 is onerous at best, and arbitrary and capricious at worst—particularly in its treatment of cross-currency interest rate hedges and intercompany derivatives.

FASB hasn't turned a deaf ear to the chorus of complaints. On March 3, it released "Accounting for Certain Derivative Instruments and Certain Hedging Activities—An Amendment of FASB Statement No. 133,” which seeks to redress many of the problems in the original incarnation of 133 as identified by the Derivatives Implementation Group.

There are four main areas in which FASB has tinkered: normal purchases and sales, the definition of an interest rate, foreign currency debt instruments and intercompany derivatives. In normal purchases and sales, FASB's new amendment proposes to expand 133's existing exemption for purchase or sale contracts that cover "normal” quantities to include many more purchase and sale contracts. The exemption will be applied as long as it is probable that the contracts will not settle and will result in physical delivery. The amendment stipulates, however, that the exemption does not extend to sales and purchases of financial instruments or derivatives.

In addition, the exemption will kick in only if the quantity is expected to be used or sold over a reasonable period in the normal course of business, and if the contracts are denominated in the functional currency of one of the parties to the contract (or the currency in which contracts are routinely denominated). Excluded from the exemption would be contracts that require cash settlement—such as futures—or that periodically call for cash settlements of losses and contracts that have a price based on an underlying index unrelated to the asset. The proposal also says net settlement should be rare and would call into question the classification of such contracts as normal purchases and sales.

In terms of the definition of interest rate risk, the proposal changes 133's approach, which permits hedgers to hedge risk selectively when holding, issuing, acquiring or selling financial instruments, as long as the market interest rate component includes sector spreads, or the spreads over the risk-free interest rate that borrowers in particular sectors regularly incur. The new proposal says risk components can be hedged using a benchmark interest rate—either the rate paid on U.S. Treasury obligations or the Libor swap rate. (In non-U.S. markets, government borrowing rates or interbank-offered rates can be used instead.)

In addition, the benchmark rate must be specially identified as part of the designation and documentation at the beginning of the hedging relationship. Also, if the variable cash flows of a recognized asset or liability are explicitly based on an index other than a benchmark rate, the designated hedged risk cannot be the risk of the changes in cash flows resulting from changes in the benchmark rate. The benchmark rate should also not reflect a greater credit risk than the hedged item, and use of different benchmarks for similar hedges should be rare and must be justified.

The proposal also says that foreign currency debt instruments qualify as hedged items. Under the extension, a compound derivative, such as a cross-currency interest rate swap, can be used to hedge both interest rate and foreign currency risk in a single hedged item. The result, FASB hopes: reduced volatility resulting from differences in the rates used to measure the hedged item and the derivative. Although the carrying amount of the debt is still translated at the spot rate in effect at the balance sheet date, the debt's carrying amount would be adjusted by changes attributable to local currency interest rates, solving the spot vs. forward anomaly.

In terms of intercompany derivatives, the proposal offers some relief. Under the previous version of 133, intercompany hedges didn't qualify as hedges, and the rule didn't permit hedging on a group of dissimilar items. Thus, says Deloitte & Touche (see box next page), a long yen to sterling exposure couldn't be a hedge target, since the net position would be a group of dissimilar items. Under the new proposal, however, treasury centers are permitted to enter into contracts with third parties that would The Financial Accounting Standards Board knows many of the provisions in Financial Accounting Standard 133 are quite unpopular in the corporate sector. Over the past few years, the accounting standards-setter has received hundreds of letters from raging corporate treasurers arguing that FAS 133 is onerous at best, and arbitrary and capricious at worst—particularly in its treatment of cross-currency interest rate hedges and intercompany derivatives.

FASB hasn't turned a deaf ear to the chorus of complaints. On March 3, it released "Accounting for Certain Derivative Instruments and Certain Hedging Activities—An Amendment of FASB Statement No. 133,” which seeks to redress many of the problems in the original incarnation of 133 as identified by the Derivatives Implementation Group.

FASB seeks to redress many of the problems in the original incarnation of 133 as identified by the Derivatives Implementation Group.

There are four main areas in which FASB has tinkered: normal purchases and sales, the definition of an interest rate, foreign currency debt instruments and intercompany derivatives. In normal purchases and sales, FASB's new amendment proposes to expand 133's existing exemption for purchase or sale contracts that cover "normal” quantities to include many more purchase and sale contracts. The exemption will be applied as long as it is probable that the contracts will not settle and will result in physical delivery. The amendment stipulates, however, that the exemption does not extend to sales and purchases of financial instruments or derivatives.

In addition, the exemption will kick in only if the quantity is expected to be used or sold over a reasonable period in the normal course of business, and if the contracts are denominated in the functional currency of one of the parties to the contract (or the currency in which contracts are routinely denominated). Excluded from the exemption would be contracts that require cash settlement—such as futures—or that periodically call for cash settlements of losses and contracts that have a price based on an underlying index unrelated to the asset. The proposal also says net settlement should be rare and would call into question the classification of such contracts as normal purchases and sales.

In terms of the definition of interest rate risk, the proposal changes 133's approach, which permits hedgers to hedge risk selectively when holding, issuing, acquiring or selling financial instruments, as long as the market interest rate component includes sector spreads, or the spreads over the risk-free interest rate that borrowers in particular sectors regularly incur. The new proposal says risk components can be hedged using a benchmark interest rate—either the rate paid on U.S. Treasury obligations or the Libor swap rate. (In non-U.S. markets, government borrowing rates or interbank-offered rates can be used instead.)

In addition, the benchmark rate must be specially identified as part of the designation and documentation at the beginning of the hedging relationship. Also, if the variable cash flows of a recognized asset or liability are explicitly based on an index other than a benchmark rate, the designated hedged risk cannot be the risk of the changes in cash flows resulting from changes in the benchmark rate. The benchmark rate should also not reflect a greater credit risk than the hedged item, and use of different benchmarks for similar hedges should be rare and must be justified.

The proposal also says that foreign currency debt instruments qualify as hedged items. Under the extension, a compound derivative, such as a cross-currency interest rate swap, can be used to hedge both interest rate and foreign currency risk in a single hedged item. The result, FASB hopes: reduced volatility resulting from differences in the rates used to measure the hedged item and the derivative. Although the carrying amount of the debt is still translated at the spot rate in effect at the balance sheet date, the debt's carrying amount would be adjusted by changes attributable to local currency interest rates, solving the spot vs. forward anomaly.

In terms of intercompany derivatives, the proposal offers some relief. Under the previous version of 133, intercompany hedges didn't qualify as hedges, and the rule didn't permit hedging on a group of dissimilar items. Thus, says Deloitte & Touche (see box next page), a long yen to sterling exposure couldn't be a hedge target, since the net position would be a group of dissimilar items. Under the new proposal, however, treasury centers are permitted to enter into contracts with third parties that would offset, on a net basis for each currency, the foreign exchange risk arising from multiple internal derivative contracts. This privilege applies only to cash-flow hedges of a forecasted borrowing, purchase or sale of an unrecognized firm commitment—and not to cash-flow exposures related to recognized foreign currency-denominated debt instruments.

FASB offered a 30-day comment period for the new proposals, which ended on April 2. For more information on the changes, see www.fasb.org or www.fas133.com.

How It Works

Deloitte & Touche has issued an accounting "heads up” that offers some examples of FAS 133's effects on corporate treasurers.

Normal purchases and sales

Operating under the old FAS 133 rules, Indulge Yourself Inc., an international bakery, buys wheat under forward delivery contracts to meet its normal operating requirements. Although each forward contract permits Indulge Yourself to assign the contract to other wheat buyers for cash (de facto net settlement), Indulge Yourself always takes physical delivery of the wheat. The wheat supplier must agree to any assignment, but the contract stipulates that permission will not be unreasonably withheld. Under FAS 133, the assignment mechanism constitutes a market mechanism that facilitates net settlement. Even though quantities under the contract are "normal,” Indulge Yourself should account for the forward as a derivative, hedging its forecasted wheat purchase.

The new proposal would extend the exemption to many normal purchases and sales contracts, including those entered into by Indulge Yourself in this example.

Interest rate risk

Operating under the old FAS 133 rules, Mid City Finance has originated a fixed-rate, 10-year loan that it plans to sell in three months. At origination, the loan was priced to bear interest at the prevailing Treasury interest rate plus 150 basis points. To hedge the interest rate of the loan, Mid City entered into a pay fixed, receive floating interest rate swap. At the sale date, risk-free interest rates have not changed, but because of an oversupply of similar loans, new loans are priced to yield the prevailing Treasury rate plus 200 basis points.

Because Treasury rates have not changed substantially, the change in the fair value of the swap is nominal. But because spreads have widened on similar loans, the fair value of the loan, reflecting interest rates, has declined. Mid City would have to recognize this ineffectiveness in current earnings (the difference between the decline in the fair value of the loan resulting from interest rates vs. the nominal change in the fair value of the swap). If spreads change significantly, Mid City might conclude that the swap is ineffective as a hedge and would have to suspend hedge accounting.

But under the new proposal, Mid City could designate the risk component of the loan being hedged as a benchmark interest rate, making a major source of the hedge's ineffectiveness disappear. Because the risk being hedged is based on the exact same index that markets use to price the derivative, their respective changes in value should be identical.

Foreign currency debt

Operating under the old FAS 133 rules, EverRich.com issues fixed-rate bonds denominated in euros. It swaps each coupon payment and the final principal payment from euros into U.S. dollars, resulting in synthetic U.S. dollar floating-rate debt. No special hedge accounting is permitted because the debt is periodically adjusted via earnings. The carrying amount of the euro debt is translated at the spot rate at each balance sheet date. The swap is measured at fair value, or the discounted rate of the expected cash flows based on the forward curve. The difference between these two measurements do not perfectly offset, resulting in income volatility. EverRich.com might use two derivatives, paying floating and receiving fixed in a euro interest rate swap, accounting for this as a fair-value hedge, and then paying floating U.S. dollar-Libor and receiving floating euro-Libor, marking this transaction to fair value.

Under the new proposal, however, a compound derivative such as the cross-currency interest rate swap described earlier can be used to hedge both interest rate and foreign currency risk in a single hedged item. EverRich.com would account for the cross-currency interest rate swap as a fair-value hedge in three steps:

  1. It would adjust the carrying amount of the debt for changes attributable to the benchmark interest rate (probably euro-Libor). The adjustment would be included in net earnings.
  2. It would translate the carrying amount, adjusted in step 1, to U.S. dollars using the spot rate of exchange at the balance sheet date. This would be included in net earnings.
  3. It would mark the cross-currency interest rate swap to fair value, and the adjustment would be included in net earnings.

For a copy of Deloitte & Touche's "heads up,” titled "Frazzled? FASB Proposes To Amend FAS 133,” contact Robert Canaan at 212-436-2906 or see www.dttus.com.

ISDA Tackles Commodities, Credit and Collateral

March is usually a busy time at the International Swaps and Derivatives Association, and this year was no exception. The industry watchdog made a number of important announcements to coincide with its annual conference, held this year in Amsterdam.

Commodity derivatives definitions

Most recently, ISDA published an updated definition of commodity derivatives. The "2000 Supplement to the 1993 ISDA Commodity Derivatives Definitions,” an update of its 1993 edition, expands the list of price sources for petroleum-based commodities and natural gas, adds definitions of price sources for electricity and pulp, and provides greater coverage of European price sources. The new supplement applies to a whole range of cash-settled commodity swaps, options, caps, collars, floors, swaptions and other cash-settled transactions. Existing confirmations and agreements that incorporate the 1993 definitions are not affected by using the new 2000 supplement without specific agreement to the contrary by the parties to the transaction.

Credit support provisions

ISDA also issued an exposure draft called the "2000 ISDA Credit Support Provisions,” which consolidates and upgrades credit support documentation. ISDA set a 60-day comment period, and is planning discussion meetings and other educational events in Asia, Europe and North America over the coming months. The final document is expected to be published sometime in the fourth quarter of this year.

The new provisions are based on six objectives: to shorten the time it takes to process collateral arrangements, to provide a practical dispute resolution procedure, to broaden the role of collateral documentation to motivate risk-reducing behavior, to reduce elective and variable components of collateral documentation, to simplify definitions and documentation language, and to streamline the structural architecture of collateral documentation.

Collateral

Last month, ISDA also announced the results of a recent survey on collateral called the "ISDA Collateral Survey 2000,” which provides details and insights as to why collateralization has emerged as a key tool increasingly being used to mitigate credit risk in the over-the-counter markets. The survey estimated the number of collateralized counterparties at between 1,500 to 2,500 at present, and the total reported signed collateral agreements at 12,000. The survey's 46 respondents reported a 39 percent increase in the number of collateral agreements they transacted in 1999 over 1998 and projected another 34 percent increase this year. In 1998, says ISDA, collateral in circulation stood at $175 billion to $200 billion, and the 2000 survey indicates that figure may be larger today.

The survey reported a 39 percent increase in collateral agreements transacted in 1999 and projected another 34 percent increase this year.

The survey also found that such risk management concerns as credit limits have been driving the development of collateral management as an established discipline with a well-defined framework of responsibilities and objectives. Collateralization's important business benefits—principally credit risk management, expanded credit capacity, increased liquidity and economies of capital costs—are another important impetus.

Principal constraints to the further expansion of collateralization include legal uncertainty, infrastructure limitations, lack of expertise and the narrowness of collateral eligibility tables, according to the survey. In light of these challenges, the survey reaches three conclusions and recommendations. First, efforts to eliminate legal uncertainty regarding the enforceability of netting and collateral agreements need to be maintained to promote the global use of collateral. Second, risk management systems and procedures should be rigorously applied to all aspects of collateral management. Third, automated technology solutions are necessary as programs expand and become more sophisticated.

ISDA also released a report called "Collateral Arrangements in the European Financial” that offers recommendations to reform the existing legal structure in European Union member states that create obstacles to the effective use of collateral. Lack of legal certainty for collateralizing transactions to reduce credit risk seriously and needlessly impedes the amount of business that could otherwise be done, ISDA says. Despite legislative improvements in recent years, the current laws and rules throughout the EU relating to the use of collateral remain, in many instances, complex as well as inconsistent, impractical or out-of-date. The consequences are inefficiency, higher cost and increased risk for Europe's financial markets.

The report offers nine principles to help bring about a new, more effective framework for collateral: rules and procedures for implementing and maintaining a collateral arrangement should be simple, clear and cost-effective; cumbersome existing formalities such as registration, notification, filing and similar requirements should be abolished; a collateral taker should be free to deal with the collateral until required to return it; a giver of pledge collateral (the pledgor) should be protected from the insolvency of the taker of that collateral (the pledgee); the law governing the creation and priority of the collateral arrangement should be the law chosen by the parties to it, and where no law is chosen by the parties, the governing law should be the law of the place where the collateral is held; collateral held through an intermediary being deemed held where the intermediary maintains the account, register or other official record representing such collateral; the legal nature of a party's holding of securities in a clearing system should be clarified; collateral arrangements should be protected from the rights of third parties; and "top up” deliveries of collateral under mark-to-market collateral arrangements should be protected from avoidance under preference and similar insolvency rules.

Capital adequacy

Earlier in the month, the association published its response to the Basel Committee's proposal to change its capital adequacy framework. ISDA says it is encouraged by the fact that regulators are seeking to align more closely, and to ensure directional consistency between, regulatory capital charges and economic capital. While the current Capital Accord has been a major contributor to the enhanced stability of the global banking system, it is at odds with best risk management practice today. In this respect, the Basel Committee's proposal to allow banks to use internal ratings as a basis for setting their capital requirements could go a long way toward ensuring that economic risk underpins regulatory capital charges.

The association urges regulators to consider whether capital requirements are the appropriate tool against all forms of risk.

But the conceptual framework behind the new proposals should be detailed further, says ISDA. While the Basel Committee suggests that banks should hold capital against a plethora of risks, its precise objective in setting regulatory capital charges in the first place is not stated clearly. Moreover, the breakdown of the risks between the committee's three pillars (minimum capital standards, supervisory review and market discipline) are not fully substantiated, and the parameters of the minimum capital requirements are not determined precisely.

With this in mind, ISDA proposed a modified approach, based on four principles:

  • Regulatory capital rules should be minimum standards below which some form of intervention may be warranted. Minimum capital requirements should not themselves necessarily be the target for banks' own economic capital management.
  • Continued use of standardized rules for minimum regulatory capital requirements is appropriate, provided revisions reduce the existing large divergence between the way standardized rules and banks' internal economic capital calculations treat the risks of a given asset or transaction. Directionally, regulatory capital and internal economic capital calculations should respond the same way to increases and decreases in risk.
  • The revised rules should strike an appropriate balance between simplicity and accuracy.
  • Insofar as possible, key assumptions underlying capital rules should be clear.

The association also urges banking regulators to consider carefully whether minimum capital requirements are the appropriate tool against all the forms of risk under consideration, even if the overall level of credit risk capital is reduced. Only credit risk, ISDA believes, warrants a minimum capital charge in the banking book.

If regulators want to keep the banking system from reducing capital levels, minimum standards are not the appropriate tool, given that banks in most countries already operate above the minimum level of required capital. Regulators should review the consistency of banks' capital levels with the amount of risk embedded in their activities as part of the supervisory review, as outlined in the second pillar of the proposed framework.

ISDA also says the Basel Committee should refrain from imposing capital charges for operational risk or other risk types as a means of maintaining existing capital levels. ISDA does not believe that charging against operational risk is sensible, since this risk should normally be addressed by adopting proper systems and controls. Establishing a minimum capital charge against operational risk could lead to arbitrage, and runs the risk of discouraging the development of adequate controls, in particular if the charge applied bears little relation to the underlying risk.


Bank Derivatives Use Declines

In the final months of the preparation for Y2K, bank derivatives usage dipped, according to the Office of the Comptroller of the Currency. In notional terms, U.S. commercial banks held $34.8 trillion in derivatives contracts at the end of the fourth quarter of 1999, compared with $35.7 trillion in the third quarter. Moreover, notional volumes in futures, options and forwards fell to $16.8 trillion, a level not seen in nearly two years.

"The decline...was primarily due to a slowdown in financial transactions during the fourth quarter as bank customers had front-loaded their financing activities in previous quarters in preparation for Y2K,” says Mike Brosnan, deputy controller for risk evaluation at the OCC. In the third quarter, he says, banks "paid to sleep well.”

Meanwhile, the U.S. banking industry's total credit exposure to derivatives was $396 billion on December 31, 1999, up from $387 billion in the third quarter. But, measured against bank capital, the credit exposures of the seven biggest players in the derivatives markets decreased to 264 percent in the fourth quarter, down from 272 percent in the third quarter and 294 percent in the second quarter. In the fourth quarter, banks charged off $141 million resulting from credit losses on off-balance-sheet derivatives, up dramatically from the third quarter but nowhere near the $445 billion charged off during the third quarter of 1998.

Notional Derivatives Exposures By Commercial Banks

Credit derivatives usage continued to grow explosively, reaching a record notional value of $287 billion, up $53 billion from the previous quarter.

For a copy of the OCC's report, see www.occ.treas.gov.


Another Way to Trade Hedge Funds On-Line

The hot war for hedge fund e-commerce is getting more intense every day. HedgeWorld (www.hedgeworld.com) and HedgeFundNet (www.hedgefund.net) were launched last year with grand visions to transform the secretive world of hedge funds. Then, in February, yet another rival joined the fracas when PlusFunds(www.plusfunds.com) went live.

The site, started by a group of buy-side and sell-side players operating out of New York and the Caymans, offers investors unprecedented access to the wheeling and dealing of hedge funds in the form of real-time, tick-by-tick valuations of hedge fund assets as well as daily portfolio risk analysis, verified by third parties. Say fund X sells a huge chunk of its Microsoft holdings or Microsoft shares skyrocket in value on a given day. PlusFunds would instantly reflect those changes in its reporting of the fund's net asset value. And when investors are moved to buy or sell a participating fund, they can do so via a direct link to the Bermuda Stock

Exchange, which trades hedge funds electronically, 22 hours a day, six days a week.

Given hedge fund managers' predilection for secrecy, how is this possible? PlusFunds says it is able to preserve funds' privacy by providing what it calls benign transparency: PlusFunds show real-time changes in the value of a particular fund, but the actual positions aren't disclosed. So far, more than 40 participating funds with assets of more than $20 billion have joined PlusFunds.

The business arrangement is a quid pro quo. Participating hedge funds agree to clone themselves as offshore funds administered by ProFunds, which ships trading data to Advent Software for portfolio management, Ernst & Young for net asset value calculation and Standard & Poor's for risk analysis. In return, PlusFunds provides its fund customers worldwide exposure to investors, and provides investors direct links to the Bermuda Stock Exchange, where they can trade the funds electronically. Trades conducted via PlusFunds are cleared by Euroclear and Cedel; the site simply acts as an intermediary in the transactions, collecting a 1 percent fee on the trades.

The site lets accredited investors—individuals with more than $1 million to invest and institutional players with $5 million to invest—join for free.

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