IAS 39 — Novation of derivatives under EMIR legislation

Date recorded:

The Committee considered a request to clarify whether an entity is required to discontinue hedge accounting in a circumstance where the hedging instrument is novated from one counterparty to another following the introduction of new regulations.

The specific fact pattern in the submission relates to a circumstance in which over-the-counter (OTC) derivatives that are designated as hedging instrument under IAS 39 are required to be novated to a central counterparty (CCP) by new legislation. This circumstance arose following the adoption of the Regulation on OTC derivatives, central counterparties (CCPs) and trade repositories (the European Market Infrastructure Regulation - EMIR) by the European Commission.

As described in the submission, the effect of novation to a CCP is that a CCP becomes the new counterparty to two new derivative contracts; one with each of the original parties to the original derivative contract, instead of the original parties remaining counterparties to each other via the original bilateral contract. Given this environment, the staff analysed two interpretations with respect to applying the derecognition requirements to the novation – those being that the novation either meets or does not meet the derecognition requirements.

The staff believed that the change from one contract between parties A and B to two contracts between A and CCP and B and CCP cannot be ignored. On the basis of its analysis, which considered the requirements in paragraphs 17(a) and AG57(b) of IAS 39 associated with the derecognition criteria for financial assets and financial liabilities when the derivative involves bi-directional payments between parties, the staff believed the novation of the contract resulted in derecognition of the original derivatives pursuant to IAS 39. Further, the staff observed the decision of the Committee in its discussion about Greek Government Bonds (GGBs). The Committee noted that paragraph 40 of IAS 39 sets out that a substantial modification of terms shall lead to the derecognition of the original financial liability and the recognition of a new financial liability, and it concluded that if the paragraph is applied by analogy to the case of restructuring GGBs, the restructuring would result in derecognition. In this particular case, the staff believed the novation to a CCP constitutes a “substantial modification of terms” as referred in paragraph 40 of IAS 39 because the counterparty is a crucial element in terms and conditions of an agreement and the counterparty changes due to the novation.

The staff noted that this issue has arisen from a specific legislative change and that the effect of the change is likely to be widespread. It acknowledged many may desire to see hedge accounting continued, but given its analysis, it believed this would require a change to IFRSs. In addition to asking the Committee if it agreed with its analysis of the issue, the staff asked the Committee whether it was interested in recommending to the IASB that it make a narrow-scope amendment to IAS 39 to deem such a regulation/legislation-led novation to be an exception to the requirement to discontinue hedge accounting.

Committee members expressed no objections to the staff analysis or recommending to the IASB that it should make a narrow-scope amendment to IAS 39. However, there were different views on what recommendation should be taken to the IASB. While some Committee members preferred that the narrow-scope amendment follow closely the fact pattern outlined in the submission out of fear of any unintended consequences in suggesting a more broad scope exception principle, others preferred a more general principle in order to avoid a selective accounting exception which may be relevant in many forms around the world.

This debate led to general questions by Committee members regarding what ‘general principles’ would apply to any proposed narrow-scope amendment (assuming the scope of the amendment extended beyond the specific fact pattern in the submission). Committee members expressed multiple thoughts on relevant principles which should be included, such as both parties to the hedging instrument are required to novate and legislation or regulations compel novation.

Following the debate, the Committee tentatively agreed with recommending to the IASB that it should consider this issue as a narrow-scope amendment to IAS 39. The Committee intends to highlight some of its views to the Board on the principles which could be discussed in any amendment (as outlined above).

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