A recent flurry of attention on the impact of new accounting regulations, Financial Accounting Standards 133 and International Accounting Standards 39, has highlighted two key questions. First, why should any accounting regulation affect derivatives trading? And second, has there been a significant change in trading?
Accounting Regulation: How It Affects Trading
The first question is the easiest to answer as the two regulations are aimed at forcing all derivatives to be reported on the balance sheet. The way in which this is done can have major implications on the volatility of a company's income statement. Clearly this is something all companies want to eliminate or at the least, minimize.
How FAS 133 & IAS 39 Could Impact The Market
It is harder to get a clear picture of whether there has been an impact on trading. There have been two papers written recently which indicate slightly differing views. First the Association of Financial Professionals survey of its members concluded derivatives volumes have decreased in the short term but may increase in the longer term. In contrast a Bank for International Settlements survey concluded there was no change, with some markets appearing to have slowed down slightly while others had shown healthy growth.
To understand why there has been so much talk about the impact on derivatives we should look at the regulations themselves. Both the FAS 133 and the IAS 39 regulations impose a large burden on the reporting companies. Neither goes as far as imposing full fair value accounting but they have created a far more complex interim world where fair value must be managed closely with cost accounting. Both regulations force all derivatives trades to be reported at fair value unless they fall into a narrow band of exemptions that mainly cover illiquid trades where a true fair value cannot be calculated. This is the first hurdle.
For most large banks this has not proved to be onerous because they have had the in-house systems and experience to cope with this, but for the smaller banks and other institutions, such as corporates, this has been a costly and painful experience. They had to evaluate systems and increase their knowledge through a mixture of training and hiring. Many have even brought in personnel who not only are familiar with the concept of fair value or mark to market, but also have specialized experience in implementing the new regulations.
The Small Print Of Implementation
With some understanding of the fundamental points of FAS 133 and IAS 39 the institutions then progress further into the detail of the rules. At this point the following areas need to be addressed:
* Can timely and accurate fair values be produced for all the
derivatives currently being used and those planned in the
future?
* Can the derivatives and their associated assets or liabilities
be processed on a single system? If not, what are the
implications of systems integration? Any discrepancies
produced between these systems will flow through as
volatility on the income statement. Can the organization
live with this?
* Can the underlying trades be easily linked with their
associated derivatives hedges and then monitor and
manage the relationship through time?
* Can the system cope with implementing not only the
clients' own interpretation but also any future changes to
that or the underlying regulations?
* The regulations only allow hedge accounting once all the
relevant documentation has been produced. Can this be
done easily at the trade's inception?
* Can existing hedge relationships be entered and managed?
* Can all of the required types of hedging relationships be
entered? Simple one-to-one relationships will need to be
managed as well as more complex situations such as one
asset hedged by more than one derivative or visa versa or,
situations with many assets being hedged by many
derivatives.
* Some derivatives will require the separation of the
components of fair value. Can the time value and intrinsic
values be split from the fair value of an option?
* It is required that a hedge is proved effective and also that
any ineffectiveness identified. Can this be done with ease?
* How easily can movements between other comprehensive
income (OCI) and income be handled?
* Can all the relevant hedge types be designated in the
regulations?
* Can the accounting and economic perspectives be viewed?
Companies have had to review their existing systems and make some hard choices about whether their current systems are up to the job. If they are not they will have to decide whether they can cope manually with the volumes involved or whether they can live with some, or all, of the items flowing straight through on to their income statements.
Prior to June of last year when FAS 133 came into force there where many claims the new regulations were so onerous that a significant number of end-users would stop hedging with derivatives in order to avoid issues of implementation. Clearly this would have a large impact on the derivatives market as a whole.
The Story So Far
The U.S. regulation, FAS 133, became mandatory for financial statements produced for financial years beginning after June 2000. As most U.S. companies start their financial years in January the biggest group of reports so far produced in accordance with the new regulations were issued for the end of March 2001. It is too early to see the results yet as many institutions may be reviewing their experiences to see where they may improve things in the medium to long term. Even so, there have been some interesting surveys and results on this issue.
The Bank for International Settlements survey claimed interest-rate swaps trading had shown a slowdown in growth, but the cross-currency swaps market showed a healthy increase in volumes. The Association of Financial Professionals showed that although the respondents said their use of derivatives had dropped between 8% and 17% there was also an indication the long-term picture may be very different. A third of respondents stated they did not use derivatives to manage prospective debt issuance prior to FAS 133 but plan to do so in the future. If this is the case, then the use of derivatives for hedging purposes may actually increase in the future.
Conclusion
Contrary to initial feelings, these new regulations may even help increase derivatives volumes in the long run by highlighting the prudent use of the instruments in risk management and forcing many people to rethink their use.
What is very clear is analysts and reporting companies must be wary of the way in which derivatives are reported and the statements may be interpreted. Both sides must be educated and have the relevant tools available to report or analyze the numbers.
This week's Learning Curve was written by Neil Taylor, director in client services Europe at Principia Partners in London.
