Hedge accounting for the masses: How futures and FASB changed hedging forever
In this article
Highlights
- New principles-based FASB hedge accounting guidelines make it easier to designate derivatives as hedges and avoid earnings volatility.
- The new portfolio layer approach makes it possible to hedge complex portfolios simply.
- Unlike LIBOR, the vast majority of SOFR (Secured Overnight Financing Rate) risks can be hedged effectively with standardized, widely traded swaps and swap futures, allowing hedgers to avoid expensive, customized swaps.
- Recent growth in Eris SOFR Swap futures brings interest rate hedging to a wider audience, enabling financial institutions to transact hedges in an open, transparent futures market with easy onboarding, competitive trade execution and removal of bank counterparty risk.
- Detailed case studies demonstrate ledger-level accounting detail for designating Eris SOFR Swap futures as cash flow and fair value hedges.
Interest rate volatility and concerns over risk limits have given financial institution leaders cause to be worried. Perhaps more than ever, CEOs, CFOs and Treasurers are compelled to consider hedging with financial derivatives to address these worries. They should be pleased to find that developments in accounting standards and new hedging instruments have substantially reduced previous hurdles to implementing hedges with straightforward hedge accounting treatment.
Historically, hedging interest rate risk meant trading OTC interest rate swaps and designating the positions as hedges under hedge accounting guidelines. Doing so effectively reduces earnings variability caused by the default “mark-to-market” treatment of the hedge. Both steps – trading derivatives and applying hedge accounting – can be complex and costly, involving cumbersome documentation and expert analysis.
Recent developments in each of these areas, however, allow financial institutions to trade standardized derivatives in a transparent market and apply hedge accounting with ease. These advances markedly decrease the cost and complexity of hedging with financial derivatives, increasing its availability and contributing to hedging activity.
Trading interest rate swaps (swaps) has become more accessible through the emergence of Eris SOFR Swap futures from CME Group. With Eris SOFR, financial institutions can replicate the exposure of OTC SOFR-based swaps with the reduced documentation, lower costs and transparency of a liquid, listed futures product. Whereas traditional futures are typically short-dated and require hedgers to “roll” from one quarterly contract to another – rendering them ill-suited for hedge accounting – Eris SOFR Swap futures can be held for the multi-year lifetime of the swaps they replicate.
Launched in 2020, Eris SOFR surged in trading activity and open interest in 2023 as SOFR replaced LIBOR (London Inter-Bank Offered Rate) as the pre-eminent U.S. interest rate benchmark. SOFR reduces the complexity of hedging for financial institutions, who can now achieve effective hedges with standardized derivatives, and no longer face the same tradeoffs between customization and cost-effectiveness that they faced with LIBOR.
Likewise, applying hedge accounting to swaps and futures has been streamlined by several recent Accounting Standards Updates (ASUs) from the Financial Accounting Standards Board (FASB). By increasing flexibility and decreasing the process burden, these guidelines enable financial institutions to align the economic objectives of hedging with straightforward accounting outcomes. In particular, the introduction of the “portfolio layer approach” for fair value hedging in 2017 and its refinement in 2022 takes what was a quantitatively intensive process and renders it a straightforward documentation exercise.
The rapid rise of U.S. interest rates starting in 2022 and the subsequent failure of multiple banks in early 2023 have shone a spotlight on the importance of managing interest rate risk for firms that borrow and lend. This paper explores how recent advances enable financial institutions to unlock the value of hedging while mitigating earnings volatility, and the adjoining case studies demonstrate real-world applications of cash flow and fair value hedge accounting using Eris SOFR.
Trading swaps is now more accessible: Eris SOFR Swap futures
Eris SOFR offers interest rate swaps in listed futures contracts
The introduction of Eris SOFR Swap futures in 2020 broadened the accessibility and transparency of interest rate swaps by making them available in a listed futures form. The product’s unique construction integrates the economics of a swap with the simplicity and ease of futures, reducing counterparty risk due to the robust margin and clearing processes at CME Group.
Not a typical futures contract: Well suited for hedge accounting
Eris SOFR is unique: Its innovative design involves matching the economic performance and the multi-year life of swaps, making the product well suited for hedge accounting – a distinctive feature among futures contracts.
Eris SOFR Swap futures can be used as hedges in place of interest rate swaps because they possess the same fixed and floating cash flows that drive the economic performance of swaps. In fact, a side-by-side comparison of the net present value and fixed-for-floating cash flows between Eris SOFR and a comparable OTC interest rate swap shows that the economics are nearly identical. Due to these swap-like cash flows, as we demonstrate in the accompanying case studies, using Eris SOFR allows a hedger to track the hedge’s income/expense over time on the income statement as an offset for interest rate risk exposures facing the financial institution. For example, in fair value hedges, Eris SOFR enables users to observe changes in SOFR driving fair value remeasurement, which will counterbalance the change in fair value of an institution’s hedged exposures. Critically, the IM required for an Eris SOFR position is typically 60 – 70% lower than the IM required for a cleared swap as computed by CME CORE margin tool.
Better than OTC interest rate swaps: Less documentation, more competitive pricing
As a hedging instrument, Eris SOFR offers multiple advantages over swaps. First, Eris SOFR enables cost-effective, straightforward access to a broad array of participants. Any firm with an account at a CME Group FCM (Futures Commission Merchant) can transact Eris SOFR with any other CME Group participant, which is especially valuable for smaller firms who struggle to gain cost-effective access to OTC swap counterparties.
ISDA Master Agreements (ISDAs) are contractual arrangements between a swap dealer and end user and are needed to trade OTC swaps. ISDAs are complex and can take months to negotiate. For financial institutions with an existing FCM relationship, adding Eris SOFR likely requires no additional legal documents. For those new to hedging with cleared derivatives like futures, setting up a new futures FCM relationship involves signing a clearing agreement. As they are generally standardized, futures clearing agreements may require as little as 1 – 2 weeks to complete. This onboarding process takes less time, and has considerably less cost, than is generally required to trade OTC swaps.
Financial institutions with more than $10 billion in assets are subject to mandatory clearing of interest rate swaps, but frequently find the cost of such clearing arrangements prohibitive. The cost structure FCM’s clearing futures like Eris SOFR, however, is often significantly lower than for swaps, enabling them to pass these savings on to clients. For example, whereas the minimum fees FCM’s charge clients for clearing interest rate swaps can amount to $180,000 or more annually, many FCM’s offer client clearing of Eris SOFR Swap futures with no monthly minimums.
Transparent, competitive pricing
The second area where Eris SOFR differentiates itself from swaps is transparent, competitive execution. Financial institutions who trade OTC interest rate swaps are limited to the bank counterparties with whom they have ISDA documentation. With limited counterparties, market participants frequently report transacting swaps at price levels one to three basis points (bp) from mid-market, and sometimes considerably more. This spread of 1 – 3 bp from mid-market can contribute substantially to the cost of hedging, adding as much as $135,000 to the cost of a $100 million 5-year swap.
Eris SOFR Swap futures, on the other hand, trade anonymously in an open market on the CME Globex electronic trading platform. Multiple market makers and other counterparties compete on price by posting actionable bids and offers, often resulting in trades at spreads of one-quarter to one-third of a basis point from mid-market. And instead of having counterparty risk with a bank, the trades are backed by a central counterparty, CME Clearing.
Exhibit 1 is a screenshot from the Eris Innovations homepage showing the best bid and ask prices for the front-month Eris SOFR contracts as of February 2024. Note the tenors of 1 – 10 years, the bid and ask futures prices, and the quantity of contracts (BidQty and AskQty, each contract is $100,000 notional) available at the best bid and ask.
Exhibit 1: Eris SOFR Swap futures trade in an open market with transparent, competitive prices
