By John Hintze
New swap futures products offer an efficient hedging tool with many of the benefits of over-the-counter derivatives, including hedge accounting.
Although exempted from clearing, corporates may want to monitor the impact of the most recent swap-clearing deadline on new swap futures products. If they gain liquidity, as anticipated, they may provide an efficient hedging tool with many of the benefits of over-the-counter (OTC) swaps, including hedge accounting.
The June 10 deadline required upwards of 300 US investment managers to begin clearing swaps, dealers were asked to do so in March. Exchanges that have introduced swap futures products expect the complexity and uncertainty of the new clearing paradigm to prompt reconsideration of the established and well-understood futures market. Especially since the products’ new features make heretofore highly standardized futures contracts more swap-like and able to satisfy swap end-users’ bespoke needs.
Shifts showing
There are already indications of a shift. Trade volume and open interest has increased recently for the Chicago Mercantile Exchange’s deliverable swap futures (DSFs) and the Eris Exchanges’ Standards and Flexes swap futures. And some companies are beginning to test futures contracts in significant ways.
In an April earnings call, Ken Steele, chief financial officer of Hatteras Financial, said the REIT’s hedging efforts had recently added $600 million in interest-rate swaps and the swap-equivalent of $200 million in Eurodollar futures contracts. Mr. Steele listed the futures benefits as lower margin requirements, greater liquidity, easier market access, and more transparent pricing.
“So we’ve put on a couple of trades to mimic some swaps and we’re going…to compare those and see which performs better,” Mr. Steele said.
Under the Dodd-Frank regulatory regime, OTC swaps carry significantly higher margin requirements and fall short of futures contracts on the other factors mentioned by Mr. Steele. However, swaps can be tailored to meet a high degree of “effectiveness” with the hedged item’s terms, and so achieve hedge accounting under current US accounting standards. Then volatility resulting from the changing market values of the hedge and the hedge item need not be recorded in earnings—essential for many corporates.
With respect to Eurodollar futures, Mr. Steele said the company “can get hedge accounting on them, but it’s pretty difficult.”
a hurdle to hedge accounting
One significant cause of “ineffectiveness” that can preclude hedge accounting is timing risk. Typical futures contracts and also the DSF and Eris’ cash-settled Standards swap future have quarterly expiration dates that may not match end-users’ long-term exposures, although the Flexes contract does enable matching up those dates.
Another significant source impacting both OTC swaps as well as the Flexes contract has been the shift to the overnight indexed swap (OIS) discounting for collateralized hedging derivatives. Although many financial firms have moved over since the credit crisis, and corporates are anticipated to follow, current US accounting standards allow discounting for the hedged item using only the Libor and Treasury benchmarks.
Sherif Sakr, a partner at Deloitte, said that when the spread between the Libor and OIS curves is tight, the ineffectiveness “noise” is relatively minor. “But when the spread widens, similar to what happened during the credit crisis…the amount of volatility could increase significantly” and would have to be recorded in earnings as ineffectiveness, he said.
To achieve hedge accounting, the fair value of the hedging derivative must offset the fair value of the hedged item within an 80 percent to 125 percent range. Many companies, however, want to eliminate that volatility altogether,
Mr. Sakr said, and the ability to discount both the hedging instrument and the hedged item using the same OIS curve would at least eliminate potential ineffectiveness resulting from a basis difference in the discounting convention.
“If we wanted to swap fixed-rate debt into floating, we probably would not be able to use futures contracts, because we want to achieve hedge accounting to avoid having mark-to-market valuations running through the income statement,” said Tony Altobelli, assistant treasurer at Google.
Nevertheless, Mr. Altobelli added, futures contracts could provide significant benefits. Exchanging collateral with an exchange’s clearing unit should significantly reduce counterparty risk—an issue that boards of directors have focused on. And futures contracts might be especially useful to manage investment portfolio risk, because new positions or hedges can be executed quickly, and they’re probably going to be more liquid than OTC derivatives.
accounting difficulty remains
A corporate with a portfolio devoted mainly to fixed-income could potentially short a futures contract to hedge the overall portfolio against the risk of rising rates, Mr. Altobelli said, but the difficulty in achieving hedge accounting remains problematic.
“That mark-to-market [volatility] will likely flow through the income statement when quarterly earnings are reported,” Mr. Altobelli said. “If it’s a sizable portfolio, the mark-to-market could be pretty high.”
OTC swaps will continue to allow corporates to achieve effective hedges, but they’re likely to be more expensive. The Commodity Futures Trading Commission proposes imposing derivative-volume thresholds to be determined by each swap dealer, over which market participants must pony up margin. In addition, dealers’ higher swap-related reporting costs and capital requirements under Basel III are anticipating wider transaction spreads, all resulting in higher costs to swap end-users.
acceptable volatility?
Ultimately, swap users will weigh the benefits of the OTC and exchange-traded markets in the context of their needs. Life insurers already explain swap-related volatility in earnings to investors as a part of doing business and may find swap futures’ other benefits attractive enough to make the switch. Others may choose to explore, as Hatteras Financial appears to be doing, whether some additional volatility in earnings is acceptable.
Hatteras Financial has opted to use longstanding Eurodollar futures. The current versions of swap futures launched by the CME and Eris Exchange last December are designed to provide at least some benefits found in swaps, and the market appears to be recognizing that, if slowly. DSF volume plunged in April but otherwise has climbed steadily since December to reach an average daily volume of approximately 6000 trades in May through the 31st, and open interest of 53,040 contracts, or $5.3 billion, on that date.
As of May 31, open interest for Eris swap futures was $3.1 billion, of which $2 billion was in Flexes, said Kevin Wolf, Eris’s chief business and product development officer. He added that $9.9 billion in contracts traded between late February and May 31, of which approximately $900 million was Flexes, which market makers began supporting later than the Standards version.
Flexes, which along with Standards are cleared through the CME, provide flexibility in choosing dates and coupons, and they can be held to maturity, eliminating the rollover risk of traditional futures contracts. No other futures provide this level of customization and the opportunity to achieve favorable hedge accounting, Mr. Wolf said.
Like cleared swaps, Flexes require margin based on five-day VAR, and while that’s higher than Eris Standards’ two-day VAR margin, it is half the margin required for the uncleared swaps that corporates have tended to use. Their flexibility should enable users of Flexes to reduce if not eliminate basis risk, a major step toward achieving hedge accounting.
Margin for other cleared swaps can be based on VAR between 3 and 7 days, depending on the specific clearinghouse, and futures can dip as low as one day.
Ineffectiveness drivers
The Eris Exchange and risk-management technology provider Reval published a revised white paper in April that noted additional “drivers of ineffectiveness” in the Flexes contract, including the OIS and Libor mismatch.
Krishnan Iyengar, vice president of global solutions at Reval and a paper author, said the Financial Accounting Standards Board is anticipated to approve OIS as a third benchmark to discount the hedge item soon, potentially removing that obstacle to achieving hedge accounting.
The Flexes’ patented price alignment interest (PAI) component allows the futures contract to replicate the economics of a bilateral swap by synthetically passing the interest on overnight collateral from the net receiver of the collateral to the net payer. The white paper notes, however, that interest on collateral is excluded from the assessment and measurement of ineffectiveness in a swap hedging relationship, as it does not influence the swap’s fair value.
the necessary component
The Eris Flexes contact, instead, does include that component in the calculation of fair value, and so it will be a driver of ineffectiveness in the hedge accounting calculation.
“The amount of accounting ineffectiveness that [it] will drive in a hedging relationship will likely not cause an entity to lose hedge accounting for entities that perform more sophisticated forms of assessment,” such as regression analysis, according to the white paper. “Importantly, an entity will recognize the same amount of net income on the income statement.”