Many industrial companies are increasingly centralizing their hedging activities within a dedicated treasury unit as part of their financial risk management. In this context, a so-called back-to-back hedging strategy is often implemented. Here, the underlying risks at the level of operating entities are hedged through internal derivatives with the central treasury unit, while the central treasury unit externalizes the derivatives accordingly. Over the life of the hedging relationship, business developments may require further adjustments (novation) to the designated hedging instruments. It is essential to pay close attention to the approach taken and the specific implications associated with such adjustments. Examples of business-driven changes during the term include ending relationships with financial institutions in a particular jurisdiction or organizational changes within the central treasury unit. Depending on the risk management strategy in place, these adjustments (novations) may also involve derivatives designated as hedging instruments in hedge accounting relationships. This raises the question: what are the implications of novations for hedge accounting, and under what conditions can existing hedging relationships continue under IFRS 9?
Under IFRS 9, derivatives are subject to the general provisions for financial instruments. As a result, the general derecognition rules for financial instruments also apply to derivatives. Derivative financial instruments, such as forward exchange contracts or interest rate swaps, involve reciprocal payment obligations depending on the value of the underlying. Thus, derivatives can be classified as either financial assets or financial liabilities. When assessing the derecognition of derivative financial instruments, both the criteria for financial assets and those for financial liabilities must be considered.
A practical example of a derivative novation is the voluntary (i.e., not regulatory-driven) transfer to a group’s central treasury company (for example, Group Company T). In this scenario, the original bilateral contract between the two initial parties is terminated and replaced by two new, independent contracts. As a result, there is now a contract between the central treasury company (Group Company T) and one of the original parties (for example, Group Company A), as well as a second contract between the central treasury company (Group Company T) and the other original external counterparty (for example, Bank A). Based on the structure of the novation, it is concluded that the previous contractual relationship, including all reciprocal rights and obligations, has ceased, and new, substantively independent payment claims and obligations now exist with the central counterparty. Since the previous contractual position with the original counterparty has been replaced by qualitatively and legally different obligations with a new counterparty, the derecognition criteria for both financial assets and financial liabilities are met. In the context of hedge accounting, this leads to the question of how a novation affects the continuation of existing hedging relationships.
Against this backdrop, the IASB decided to tie the continuation of hedge accounting in connection with novations to one specific exception. This exception allows hedge accounting to continue if a novation is directly attributable to statutory or regulatory requirements or results from such regulations. The relevant provisions in IFRS 9.6.5.6 specify the conditions for this exception. According to these, a hedging relationship is not terminated if, due to legal or regulatory requirements, the original counterparties agree that one or more clearing counterparties will become the new contractual parties. It is crucial that all parties clear through the same central counterparty and that changes to the contract are limited to what is strictly necessary. Permissible adjustments include those related to collateral, netting rights or fee structures, provided these are typical in a central clearing context. Other, more extensive contractual changes – such as to maturities, payment dates or calculation bases – generally result in the termination of the hedging relationship.
If a novation does not occur for a specific reason covered by the exception in IFRS 9.6.5.6, the existing hedging instrument must be examined for derecognition under IFRS 9.3.2.1 et seq. in conjunction with IFRS 9.3.3.1 et seq. Particular attention must be paid to the transfer of contractual rights and obligations. If the contract terms provide for a release from contractual rights and obligations, this typically triggers derecognition. For example, replacing the counterparty and releasing contractual rights and obligations generally leads to derecognition of the original derivative under the general rules. As a result, the previous hedging instrument would no longer exist legally or economically, which inevitably leads to the termination of hedge accounting, including undesirable accounting effects. The termination of the hedging relationship and subsequent re-designation of a hedging relationship with the novated derivative may result in additional ineffectiveness due to a lack of matching critical terms.
Whether a novation simultaneously means the end of an existing hedging relationship has also been the subject of extensive debate in IFRS standard-setting. Under IFRS 9.6.5.6, hedge accounting must generally (prospectively) be discontinued if the hedging instrument expires, is sold, terminated or exercised. However, a replacement or rollover of the hedging instrument does not constitute termination, provided it is part of the company’s documented risk management strategy. In addition, any changes in risk management objectives related to the novation of derivatives must be assessed. Switching from a decentralized to a centralized hedging strategy via a central treasury unit can be seen as a change in risk management objective under IFRS 9.B6.5.26(a), which may also argue for terminating the hedging relationship.
Whether the exception can be extended to “voluntary” novations was discussed during the consultation process for the Exposure Draft “Novation of Derivatives and Continuation of Hedge Accounting” (2013). Many respondents argued that a novation may be economically compelled even if not legally required, for example, in anticipation of regulatory changes or for operational simplification. However, the mere possibility of future legal changes is not sufficient to justify the continuation of hedge accounting. For hedging relationships that continue after novation, all other IFRS 9 requirements remain fully applicable. Changes in the credit quality of the new counterparty or in collateral terms must still be reflected in the derivative’s fair value and in the measurement of ineffectiveness. Once a hedging relationship has been terminated, it cannot be retrospectively re-designated.
If derecognition of the designated hedging instrument is the result, hedge accounting must be discontinued at the time of novation. When applying cash flow hedge accounting, the amount recognized in OCI (other comprehensive income) at the time the hedging relationship ends must be frozen1. The amount previously recognized in OCI may no longer be adjusted prospectively and must be reclassified in accordance with the underlying transaction and the general hedge accounting rules (IFRS 9.6.5.12 in conjunction with IFRS 9.6.5.11(d)). Subsequently, the (novated) derivative may be designated as a new hedging instrument in a new hedging relationship, as permitted under the general hedge accounting options. Depending on the novation, the hedging instrument may already have a market value at the time of designation (old rate basis) or may start with a market value of zero (new rate basis).
The approach taken in the novation has a significant impact on the future effectiveness of the (new) hedging relationship. At the start of any hedge accounting designation, it is essential to ensure that the features of the underlying transaction are calibrated to current market conditions. If effectiveness is measured using the hypothetical derivative method, the hypothetical derivative must be calibrated to a market value of zero at inception (IFRS 9.B6.5.5). Depending on the risk hedged, the novation performed and the hedging strategy, different sources of ineffectiveness may arise. To minimize the impact on hedge accounting, the following questions should be considered before novation:
- Under what conditions and in what form will the novation take place?
- Does the novation trigger derecognition of the hedging instrument?
- Can hedge accounting continue?
- In the case of re-designation, what details must be considered (for example, designation on a spot or forward basis)?
Each case must be assessed individually to determine whether hedge accounting can continue. The Finance and Treasury Management team is happy to support you in evaluating the contractual structure and accounting consequences.
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1 It is assumed that the other components of the hedging relationship remain unchanged (IFRS 9.6.5.12).
