OTC Hedges Versus Exchange Traded Versus Centrally Cleared

One outcome of the financial crisis has been a push to have over-the-counter (OTC) derivatives centrally cleared. Central clearing is where an entity steps between a buyer and seller to take the position. Essentially, the central counterparty (CCP) clearing house becomes the buyer to every seller and the seller to every buyer. This means that two transactions are created; a buy and sell between the buyer and the CCP, and a buy and sell between the CCP and the bank.

The advantage of having a contract centrally cleared is that reporting of the positions becomes more transparent, so that overall credit risk is reduced and more easily managed as institutions interact with only the CCP. It is proposed that only standardised financial contracts be centrally cleared. However, without a clear definition of the criteria used to determine what ‘standardised’ means this poses a challenge for companies. For many corporations which use derivatives only for hedging purposes, centrally cleared contracts simplify the number of counterparties they would need to deal with, but also require the management of margin or collateral. This benefit will need to be weighed against the cost of transacting in the OTC market. Both the definition of standardisation and the margin requirements will likely determine whether most organisations can, or will, enter into derivative transactions.

The implications of clearing and standardisation from a hedge accounting perspective are significant. Using standardised contracts may pose a challenge if the contract eligible for central clearing does not hedge the risk appropriately. This will lead to ineffectiveness, although not necessarily an ineffective hedge.

Exchange Traded Derivatives

Although employing exchange traded derivatives (ETDs) is not a commonly used strategy when hedging foreign exchange (FX) and interest rate risk, it has been used by corporations seeking to hedge commodity risk. With the pending new requirements surrounding OTC derivatives, there may be a shift to even more hedging with exchange traded futures and/or options.

The advantages of using exchange traded contracts (ETCs) are transparency and, in some cases, liquidity. The disadvantages can include lack of contracts to hedge the specific risk, insufficient knowledge of which contracts to use, posting margin and, again in some cases, liquidity.

For the advantages listed above, having price transparency makes it easier for an organisation to comply with fair value requirements, as it reduces the challenge of meeting the requirements of independent pricing for derivative contracts. In some cases ETDs may provide the liquidity necessary to enter into a position, although this will depend on the maturity date of the risk being hedged or the available quantity of derivatives required for specific hedging needs. For this reason, liquidity is also listed as a disadvantage. 

The disadvantages of using exchange traded instruments can be summarised as two key areas:

  1. Having the right contract available to hedge the risk.
  2. The cost compared to hedging with OTC contracts.

The most important thing for a company to consider will be whether or not the contract is available to hedge the risk. The underlying challenge is that derivative contracts are standardised; futures and options having standard maturity dates are an example. As designed, ETCs do not provide a company with flexibility and this presents a challenge when hedging a risk that does not fall on, or near enough, to a standardised maturity date. This may be fine when organisations use mark-to-market accounting for derivatives, but when applying hedge accounting standards auditors may not accept this timing difference.

Also, organisations will need to acquire the necessary knowledge to determine which contracts to use and how and where to execute. This challenge may be met by a bank/counterparty to structure the deal, but there may be additional costs associated with this service.

Finally, there may be a requirement to post and maintain margin. Organisations that transact in the exchange traded arena will need to ensure that adequate margin is posted when the contract is executed, as well as the future needs for posting additional margin if a position moves unfavourably. However, the opposite is true where excess margin can be withdrawn. This will require companies to ensure adequate liquidity is available. Again, this is another service that could be managed by a bank/counterparty if the resources are not available internally.

For organisations applying hedge accounting, the advantages do not outweigh the disadvantages. The critical issue for these organisations is specifically determining if the ETCs are available to manage the risk effectively, and ensuring that the timing of the risk being hedged and settlement of the contract are within a certain period. 

Hedge Accounting

The accounting of derivative instruments at fair value creates a common issue for organisations that hedge risks using derivatives. Specifically organisations may face an accounting mismatch between the derivative instrument, which is measured at fair value, and the underlying exposure being hedged, as underlying exposures are typically recognised as assets or liabilities that are accounted for on a cost or an amortised cost basis, or as future transactions that have yet to be recognised.

This accounting mismatch results in volatility of the financial statements, as there is no offset to the change in the fair value of the derivative instrument. Hedge accounting provides this offset by effectively eliminating, or reducing, the accounting mismatch. For more information on hedge accounting, FinancialCad Corporation (FinCad) and KPMG have produced a joint whitepaper entitled ‘Hedge Accounting Made Easy: What You Need to Know About Hedge Effectiveness Testing, Credit Value Adjustments and the Latest Regulations’.

For hedge accounting, using ETCs means that the necessary data to run the tests is readily available. However, the methodology and automation required to run tests on reporting dates will still need to be found from a vendor or built internally. As outlined above, there are advantages and disadvantages of using centrally cleared or ETCs, versus OTC ones. With respect to hedge accounting the main challenge will be with the use of standardised contracts, which are likely to have standard maturities and notionals. This makes it more difficult to enter into a contract that will perfectly hedge the risk and may lead to ineffectiveness; that is it will be a less-than-perfect hedge.

Also, for forecast transactions, in many cases the risk being hedged needs to be within a couple of days of the derivative being used. At this point, it is uncertain if derivatives will be available to satisfy this need. Consider the example of a firm commitment. Typically to hedge the firm commitment a forward contract is used which matches, in its notional amount, the maturity date and other features the risk identified. Since the firm commitment can be modified as more information is made available, we are told by participants that auditors will accept the hedge as long as the derivative and firm commitment mature within a few days of each other. Beyond this it becomes a harder challenge for auditors to accept this as a valid hedge, under hedge accounting standards. This is just one of the uncertainties that auditors will need to provide guidance for as financial regulations become clearer.

So what is an organisation to do in the interim? As it is still uncertain what types of instruments will be standardised, or what the features of these instruments will be, many organisations will maintain the status quo. However, as regulations evolve, readers are encouraged to continue to expand their knowledge while also verifying the stance their accounting advisors and external auditors take on the latest position. Effectively managing hedges is critical for a treasurer, especially if an organisation is complying with hedge accounting standards, so investigating this area is essential.

174 views

Related reading