The Emerging Issues Task Force’s recent approval of the overnight index swap (OIS) rate as a benchmark interest rate in the US is expected to be approved soon by the Financial Accounting Standards Board, providing users of collateralized interest-rate swaps with a more flexible tool to achieve hedge accounting.
“This change is really aimed to help institutions minimize P&L volatility, which dovetails nicely with the corporate objective in using OTC derivatives,” said Krishnan Ilyengar, vice president of global solutions at Reval.
The EITF, which deals with timely accounting issues, proposed in January to include OIS as a benchmark interest rate (see related story here), and its approval June 11 means the FASB will address the issue at its June 26 meeting, when its approval is expected.
The demand for derivative financial instruments that are indexed to the Overnight Interest Swap (OIS) rate has increased in recent years, partly because it is a “better reflection of the cost of funding for collateralized derivatives,” said Sherif Sakr, a partner in Deloitte’s financial accounting, valuation and securitization practice.
“The ability to designate OIS as a benchmark hedge could reduce or eliminate hedge accounting ineffectiveness, particularly when the fair value of the derivative hedging instrument is determined based on OIS discounting,” Mr. Sakr said.
OIS discounting for collateralized derivatives has become the market convention for many financial institutions. However, generally accepted accounting principles (GAAP) in the US currently permit only Libor and the US Treasury rate to be used as benchmark interest rates for hedge accounting purposes. Consequently, the expanded use of OIS for collateralized derivatives has resulted in additional ineffectiveness when applying hedge accounting, stemming from the basis-difference in discounting conventions for the derivative hedging instrument and the hedged item.
“The introduction of OIS as a benchmark interest rate will provide additional flexibility to many organizations applying hedge accounting, will better reflect the economics of the hedge, and will add more transparency to the accounting and financial reporting,” said Mr. Sakr. He added that the inclusion of OIS is optional, and that market participants can continue using the existing benchmark interest rates depending on the facts and circumstance of each of their hedge relationship.
Until the arrival of Dodd-Frank, corporates often did not have to post collateral for their over-the-counter swaps, especially if they have a broader business relationship with the bank counter party. Most swaps must now be cleared, requiring margin to be posted. And while corporate end users are exempt from clearing, the banking regulators are currently proposing to require banks to demand collateral from corporate customers past a certain market-to-market threshold.
Mr. Ilynengar said corporates have hesitated following the rest of the swap market to discounting using OIS precisely because it was not recognized as a benchmark, and corporates place a strong emphasis on reducing earnings volatility. The inclusion of OIS could also make using cleared swaps and exchange-traded derivatives more attractive. “This change should help accelerate the adoption of OIS discounting by corporate end users,” he said.
EITF issues go directly to the FASB to be ratified and avoid the draft and comment period applied in the typical accounting standard making process. Although uncertain now, the new rule is likely to be effective starting in the latter half of this year.