SEC Recommends Changes in Accounting for Derivatives

Wednesday, May 16, 2012 Print Email

The Securities and Exchange Commission has passed along a request to the Financial Accounting Standards Board that it consider making changes in how to account for derivatives contracts designated as hedging instruments. The request comes at a time of heightened scrutiny of the derivatives market in the wake of JPMorgan Chase’s admission of a $2 billion loss tied to trading in credit default swaps. The bank has claimed the trades would not have violated the so-called Volcker Rule in the Dodd-Frank Wall Street Reform and Consumer Protection Act, which bans proprietary trading by commercial banks, but allows for some exceptions, as in the case of hedging activities.

JPMorgan Chase CEO Jamie Dimon has admitted that the bank “made a terrible, egregious mistake,” but said the trades were covered by the hedging exception and thus did not violate the Volcker Rule, named after former Federal Reserve chairman Paul Volcker, who recommended the ban on proprietary trading. The rule has not yet gone into effect, as the SEC has not yet finished the regulatory process and defined the extent of the hedging exception.

In a letter dated May 11 to Dan Palomaki, chairman of the Accounting Policy Committee at the International Swaps and Derivatives Association, SEC chief accountant James Kroeker said the SEC has asked FASB to examine making changes in some of the standards.

“We have requested that the FASB consider the accounting for a change in counterparties when a derivative contract is designated as a hedging instrument in a hedge relationship as a part of their existing project on financial instruments,” he wrote. He CC’ed FASB chair Leslie Seidman in the letter, along with Public Company Accounting Oversight Board chairman James Doty.

The main subject of the letter deals with an arcane matter involving the accounting treatment of what happens during mandatory clearing of certain derivatives contracts under Dodd-Frank, which could result in the novation of the contracts underlying the transactions, causing a change in the counterparties to the contract. Palomaki’s group had asked for the Office of the Chief Accountant's view regarding the accounting impact under U.S. GAAP, if any, of a novation of a bilateral OTC derivative contract to a central counterparty "on the same financial terms."

“Specifically you have asked about whether the novation of a derivative contract (that has been designated as an accounting hedge) to a central counterparty would result in the termination of the original derivative contract and associated hedge relationship, such that the use of hedge accounting subsequent to novation would require the designation of a new hedging relationship,” wrote Kroeker, who heads the SEC’s Office of the Chief Accountant.

In response to that request, he replied, “The staff of OCA would not object to a conclusion for accounting purposes that the original derivative contract has not been terminated and replaced with a new derivative contract, nor would the staff object to the continuation of existing hedging relationships when there is a novation of a derivative contract to effect a change in counterparties to the underlying contract, provided that other terms of the contract have not been changed, in any of the following circumstances:

"• For an OTC derivative transaction entered into prior to the application of the mandatory clearing requirements, an entity voluntarily clears the underlying OTC derivative contract through a central counterparty, even though the counterparties had not agreed in advance (i.e., at the time of entering into the transaction) that the contract would be novated to effect central clearing.

"• For an OTC derivative transaction entered into subsequent to the application of the mandatory clearing requirements, the counterparties to the underlying contract agree in advance that the contract will be cleared through a central counterparty in accordance with standard market terms and conventions and the hedging documentation describes the counterparties' expectations that the contract will be novated to the central counterparty.

"• A counterparty to an OTC derivative transaction who is prohibited by Section 716 of the Act (or expected to be so prohibited) from engaging in certain types of derivative transactions novates the underlying contract to a consolidated affiliate that is not insured by the FDIC and does not have access to Federal Reserve credit facilities."

Kroeker also noted that changes to the terms of the OTC derivative contract that are a direct result of the novation of the contract to the central counterparty would not preclude the continuation of hedge accounting. "For example, contractual collateral requirements of the original contract may change as a direct result of the novation, because the original counterparties must now comply with the contractual collateral requirements of the central counterparty," he wrote.

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