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Changes to Derivative Novation Consequences

There is great news coming out of last week’s EITF meeting: Changing counterparties would NOT necessarily stop hedge accounting.

In practice, when derivatives are novated from one counterparty to another, it has been considered a change in critical terms – which requires a dedesignation. Many users do a simultaneous dedesignation/redesignation; however, those using shortcut hedge accounting must then move to long-haul, and those already using long-haul introduce ineffectiveness.

Proposal D, which received eleven of twelve votes, does NOT require an automatic dedesignation. Proposal E, which was also discussed, states that novation to a counterparty with equal or better credit would NOT necessitate a dedesignation. Discussion on Proposal E was favorable; however, some felt that measuring the change in credit would introduce complexity. It was also pointed out that current rules state that counterparties must be probable of performing in order to maintain hedge accounting.

The transition was also considered and everyone supported a prospective approach after the approval date of the guidance. Retrospective approaches were considered, and it was decided that the exposure draft should include questions about retrospectively applying the new guidance particularly in relation to shortcut hedge accounting.

Disclosure requirements were briefly discussed and the staff recommended (and all twelve voters agreed) that the current disclosures in 250-10-50-1A and 250-10-50-2 are sufficient. This guidance requires a description of the indirect effects of a change in accounting principle for both interim and annual financial statements.

Relief for the impact of novations on hedge accounting should be out in exposure draft form soon – stay tuned.