By Joseph Neu
Not to be lost among the Exposure Drafts the FASB has recently released on valuation of financial instruments and credit impairments, is a soon-to-be-exposed decision by its Emerging Issues Task Force (EITF) Issue No. 13-A to include the Fed Funds Effective Swap Rate—or Overnight Index Swap (OIS) Rate—as a benchmark interest rate for hedge accounting purposes. This move, announced at the January 17 EITF meeting, is a significant step for institutions that wish to kill LIBOR in the wake of rate-setting scandals without adverse hedge effectiveness consequences. But even more so, the EITF decision is a sign of the times, as much of the market has moved to collateralized swap transactions, part of an emerging trend called the “futurization of swaps” to which the OIS discount curve is better suited.
Accordingly, treasurers who have not fully considered switching to OIS and collateralized swaps should think again about doing so. And, fortunately, when the FASB issues guidance reflecting the EITF decision later this year, the accounting will be on your side.
EITF 13-A
Under current hedge accounting, Topic 815, hedgers are allowed to hedge the change in value or cash flows attributable to a change in the benchmark interest rate separate from changes due to the credit spread (a limited bifurcation of risk). In the US, only the interest rates on direct US Treasury obligations and, for practical reasons, the LIBOR swap rate, were deemed hedgeable benchmark interest rates for accounting purposes.
As the EITF minutes note, the FASB had considered including Fed Funds-OIS in its prior deliberations leading to its March 2010 hedge accounting changes, but felt that two benchmark alternatives were sufficient. That decision proved short-sighted, as the EITF minutes make clear:
“In the aftermath of the financial crisis and the increase of collateral agreements between financial counterparties, practice is evolving such that financial institutions have begun using a discount curve for valuation of derivatives based on the Overnight Indexed Swap (OIS) curve rather than LIBOR.”
When the FASB implements this EITF consensus, hedgers will be allowed to select the OIS benchmark for new hedges and redesignated hedge contracts on a prospective basis. The OIS selection will not impact similar hedges already on the books that designate LIBOR as the benchmark interest rate. This would allow corporate treasurers to migrate their swap valuations and hedge designations away from LIBOR as they join the ranks of banks, broker-dealers and other high-quality obligors embracing this aspect of swaps futurization.
Swaps futurization
The basic reason that OIS is better than LIBOR is that OIS discounting better reflects the exposure of financial counterparties using fully collateralized credit support mechanisms: they are exposed to the overnight risk that their counterparty cannot meet its next-day collateral obligation and not the full obligation for a particular instrument.
This also suggests that counterparties that do not fully collateralize their swap trade are paying a premium for their additional risk, and some part of this premium is reflected in their being quoted based off a LIBOR benchmark rate. A traditional 5-10bps OIS-LIBOR spread can spike to 365bps.
Posting collateral and switching to OIS would be the most straightforward way to avoid this on swaps transactions going forward. It is also the way the world is moving.
The swaps futurization trend, which was only sped up by Dodd-Frank and other derivatives reforms, is causing standardized derivatives contracts to move to centralized exchanges and act more like futures, but it will also see less-standard contracts collateralized like futures or become futures to benefit from perceived better regulatory and trading environments. Interest rate swaps should be subject to collateralization, if not futurization, either way.
Thus, the FASB EITF decision, once implemented to do away with the hedge ineffectiveness noise, makes for a convenient transition. Its gives treasurers who have not embraced swaps collateralization a few months to get comfortable with it and start down the path of the future.