The IASB has discussed the proposed narrow scope amendment to IAS 39 and IFRS 9 on novation of derivatives and continuation of hedge accounting. The amendment ED was initially drafted in response to the proposed laws and regulations that would mandate clearing of the over the counter (OTC) derivatives through a central counterparty (CCP).  These laws and regulations were expected to take place in different jurisdictions as part of the G20 commitment. The ED was prompted by the fact that if on novation previous OTC hedging derivatives were de-recognised prompting de-recognition and re-designation of existing hedging relationships, this would unduly penalise preparers. Given the urgency of the regulatory reforms and the potential impact on existing hedge accounting the ED was published as a narrow scope amendment with a tight 30 days comment period. The feedback received by the IASB, as presented by Staff was a majority support for the proposed amendment. However, most respondents questioned the scope of the proposal because they considered the scope ‘too narrow’ as well as some of the specific wording. This feedback was discussed in today’s session after which the IASB have agreed to make some changes.

On the first question of whether a specific amendment to existing IAS 39 and IFRS 9 is necessary all but one Board member voted ‘yes’. The Board re-confirmed their previous conclusion that without such amendment the novation of derivatives would meet the de-recognition requirements of IAS 39/IFRS 9 with original derivatives expiring and being replaced by new contracts. Under existing wording of the standards this would have an effect on whether the hedge could be continued.

The majority of the debate centred on the second question about the scope of the proposed amendment. Initially the Board was fairly evenly split on the Staff proposals. The Staff’s recommendation was three-fold:

1. to remove the scope requirement that novation to should be required by laws or regulation and in this way allow for voluntary novation to effect CCP clearing
2. to include in the scope of the amendments a novation to a party as part of indirect clearing to a CCP and
3. to maintain with the following rewording the requirement to limit any other changes to the hedging instrument on novation to those that are necessary to effect the replacement of the respective original counterparty with a central counterparty. Such changes are limited to those that are consistent with the terms that would be expected if the hedging instrument were originally entered into with the central counterparty. These changes include changes in the contractual collateral requirements, rights to offset receivables and payables balances with the central counterparty and charges levied by the central counterparty.  (The Staff paper clarified that this list is not meant to be exhaustive.)

On the first item a few members questioned whether in extending the scope to voluntary notations designed to affect CCP clearing the Board was moving away from its original intention that justified the short comment period. Some felt that voluntary novation in anticipation of legislative change was too wide. However these members would have accepted novation in response to enacted legislation that while only related to newly entered derivatives nonetheless made business sense to have all the derivatives on the same basis. Others felt that as long as the purpose of the legislation was achieved it did not matter whether it was voluntary or mandatory.

On the allowance of indirect clearing the Staff explained that in some jurisdiction it is not possible to transact directly with a CCP but for a few banks and that smaller corporates have to transact with the clearing members, or maybe even with the clients of the clearing members. However the process is done in the same as with a CCP with the same segregation of assets, back-to-back arrangements with the CCP and the same collateral requirements passed on from the original counterparties to the CCP. The Staff further clarified that on novation to affect indirect clearing to a CCP the original counterparties would be exposed (to the minimum extent possible and however briefly) to some of the risk of the intermediate counterparty (e.g. overnight fair value changes not offset by posting of collateral). However the Staff argued that under current wording of IAS 39 without the novation, the existing hedging relationships can be deemed effective even if they are not collateralised. In their view, such brief exposure to the credit risk of the intermediary due to the mismatch of collateral should not impact the analysis of whether the hedge is effective. Some Board members then raised a concern whether the amendment would be permitted to any novation that has somewhere down the indirect chain resulted in a CCP clearing. To that one member proposed to amend the Staff wording to restrict the scope only to those novations for which the purpose was to include the CCP (directly or not) and which would satisfy the regulatory requirements in the preparer’s jurisdiction on how to move to a CCP clearing. In other words, the novation could not be just any novation to include a CCP clearing. However, the Board then questioned whether this amendment would restrict voluntary novations (a decision they have already voted on). The Staff confirmed that their intention in this project was to address only the novations prompted by regulatory changes and they did not consider other scenarios. The majority of the Board were in agreement that novation to be in the scope of this amendment had to have an objective to affect CCP clearing (directly or indirectly) and did not extend the scope to novations with other counterparties for other reasons. The Board requested the Staff to bring the amended words for re-deliberation, which is likely to be taken off-line.

On the third question the Board tentatively unanimously agreed that the amendments should apply retrospectively and early application should be allowed as was proposed in the ED. The Staff clarified that these decisions do not impact on the validity of past accounting under the previous versions of the applicable standards but are intended to provide greatest relief possible going forward in the situations meeting the scope requirements where hedge accounting was not discontinued. Further, the Staff clarified that if in the past periods the entity discontinued its hedge accounting as a result of novation that would have met the scope of the amendment, such hedge cannot be re-instated.

Some of the words of the draft ED were discussed in more detail as part of the forth question. The Board members agreed unanimously with the Staff recommendations. In particular, the Board members tentatively agreed to reword the term ‘novation’ in a way that does not rely on the legal definitions that may vary across jurisdictions. The term could be reworded as a discharge or formal termination of the rights and obligations under the original contract and a substitution with a new contract.  The Board member tentatively agreed to replace the words ‘if and only if’ in the list of the scope criteria with the word ‘if’ so as not to imply that only novations under this ED would be allowed to continue hedge accounting since other novations were not considered in this project. Finally the Board tentatively agreed to include in the basis of conclusion an analysis of why the novation of the derivatives to a CCP would result in the derecognition of a hedging instrument.

On the fifth question the Board tentatively unanimously agreed that equivalent amendments to those for IAS 39 should be made to the forthcoming chapter of IFRS 9 on hedge accounting.

On the final sixth question all but one Board member tentatively agreed that additional disclosures should not be required. One Staff member argued that exposure to intermediate CP credit risk, however brief, in the case of indirect clearing is significant enough to require disclosure, and further that a change from having OTC derivatives to having derivatives cleared through a CCP should be disclosed. However, many considered that all the effects of changes in credit risk as a result of novation would be reflected in the financial statements as part of changes in fair value of the derivatives under IFRS 13. The Staff proposal of no disclosures was approved 13:1.