FASB to consider adding OIS rate as hedge accounting benchmark

Industry says action is imperative as hedges could be rendered ineffective by the market's switch to OIS discounting

The Financial Accounting Standards Board (FASB) will consider adding the federal funds rate to the benchmark interest rates allowed in its fair value accounting regime, following industry calls for the rules to be updated to reflect the pivotal role overnight interest rates have assumed in over-the-counter derivatives markets since the financial crisis.

At the next meeting of the FASB's Emerging Issues Task Force (EITF) on January 17, the body will discuss for the first time adding the rate – which is the basis for the overnight indexed swap (OIS) market in the US – to the two existing benchmarks, Libor and US Treasury rates.

The subject was added to the agenda of the meeting after industry representatives submitted a letter to the EITF's last meeting on November 27, urging it to act. The letter is not public, but a copy was obtained by Risk. It was co-authored by the accounting committees at the International Swaps and Derivatives Association and the Securities Industry and Financial Markets Association (Sifma), as well as Pennsylvania-based interest rate risk advisory firm, Chatham Financial.

"The growing pervasiveness of exposure to the federal funds rate... makes it imperative that the hedging literature includes the federal funds rate as a benchmark interest rate in the US," the letter states.

A full-scale review of fair value accounting rules is currently under way – part of what the FASB calls the accounting for financial instruments (AFI) project – but the letter argues it would be quicker to address the topic separately, which it says could enable the FASB to reach a decision within the first quarter of 2013.

This is an issue in the US that should be looked at now

The problem relates specifically to hedge accounting, which sets out the conditions under which changes in a derivative's market value do not need to be reported as profits or losses - a critical protection for many corporate hedgers in particular. But in order to achieve hedge accounting, firms have to show effectiveness - changes in the value of a derivative have to closely match those of a hedged item. That requires a derivatives user to identify the exposure it is hedging - for example, the interest rate risk on a bond. As things stand, the rules - Financial Accounting Standard 133 - do not recognise the federal funds rate as a source of interest rate exposure

That has two implications. First, it means some existing hedges may not be effective – since the crisis, the market has stopped discounting cash-collateralised interest rate swaps using Libor and has instead switched to OIS, with the relevant overnight rate being determined by the currency of the collateral being posted. For trades collateralised with US dollars, that would be the federal funds rate. In these situations, the mismatch between the discount rate on the swap and the underlying interest rate risk that hedgers are allowed to specify – Libor or a US Treasury yield – may mean the hedge fails the effectiveness test. With collateralisation now more common and mandatory clearing due to take effect for many US derivatives users in 2013, the problem will become more serious, the Isda/Sifma letter warns.

The second implication is for swaps referencing the federal funds rate, which would also struggle to achieve hedge effectiveness – the letter notes this is a growing market, with risk managers seeking to avoid volatility in Libor rates that is driven by concerns over bank credit and funding risks.

The bottom line is that FASB needs to step in, says Clark Maxwell, managing director for accounting services at Chatham Financial in Pennsylvania. "This is an issue in the US that should be looked at now. It is narrow in scope, probably would not have an impact on any other accounting standard, and just saying that OIS is also permissible as a benchmark interest rate in the US would solve a lot of problems," he says.

"Sometimes, the FASB seems loathe to make any changes around hedge accounting, perhaps because it knows the board will address this as part of the broader AFI project. But that process could take a while and it's unlikely in the US that it will pick up the hedge accounting portion of the project until the third quarter of 2013," Maxwell adds. The project is being co-ordinated with the International Accounting Standards Board (IASB), which produces accounting rules that are used in many countries outside the US.

In an emailed statement, a spokesperson for the FASB notes that "at this point, the FASB has not yet begun its redeliberations on hedge accounting, which is part of its broader, joint project with the IASB to improve accounting for financial instruments. The FASB plans to again take up the issue of hedging once decisions on the classification and measurement phase of the AFI project have been completed."

 A feature exploring efforts to permit OIS benchmarking under US hedge accounting rules will appear in the January issue of Risk