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Derivatives

SEC Throws Spanner In Structured Note Industry

The Securities and Exchange Commission has cast a shadow over the multi-billion dollar structured note industry by ruling that investment banks cannot book upfront profits on the instruments.

The Securities and Exchange Commission has cast a shadow over the multi-billion dollar structured note industry by ruling that investment banks cannot book upfront profits on the instruments. The decision has blindsided investment bankers who had thought they could book profit on transactions in which they could show an "observable" difference in price between products they sell and instruments they can use to hedge these positions.

The commission showed its hand in a recent speech given by John James , a professional accounting fellow in the office of the chief accountant of the SEC, at an American Institute of Certified Public Accountants conference in Washington, D.C. James' interpretation of a recent accounting rule, known as DIG B6, is regarded as being the official position of the SEC. James did not return calls by press time.

James said the accounting rule "does not include any notion that provides for recognition of a dealer profit or day one gain [on structured notes]." U.S. accounting rules, however, allow dealers to take upfront profit on standalone derivatives in certain circumstances. "An entity may recognize dealer profit at the inception of the contract if the fair value is supported by a quoted market price, other current observable market transactions or other observable market data," explained James.

Bankers said this will encourage structurers to use special purpose vehicles to get around the anomaly of being able to take profits on standalone derivatives but not on structured notes. Despite the new SEC ruling, derivatives houses may be able to book an upfront profit on structured notes by issuing them through special purpose vehicles. This development appears to run contrary to the thrust of regulation since the collapse of Enron , which has been aimed at reducing the use of off balance sheet entities.

Derivatives houses may also be able to use the new interpretation to hide losses, according to one banker. This is because they could sell a loss-making derivative as part of a structured note and amortize the loss over the life of the note, which could be as much as 30 years.

 

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