One-off cash compensation on collateralised derivatives due to the transition from EONIA to €STR

What is the issue?

During the second half of 2019, the methodology for calculating EONIA was modified. EONIA was redefined as €STR plus a fixed spread of 8.5pbs for a transition period that will end on 31 December 2021. After that time, it is envisaged that EONIA will cease to be published and will transition to be €STR – although, at the time of writing (January 2020), there is still some uncertainty over the precise details of the transition.

The transition from EONIA to €STR is expected to result in a change to the interest rate paid on cash collateral held for certain Euro collateralised derivatives (from €STR plus a fixed spread of 8.5pbs to €STR flat) that is expected to be implemented in 2020¹. When fair valuing collateralised derivatives, standard market practice is to use a discount rate that reflects the interest rate paid on the collateral. Accordingly, the change in the interest rate paid on the cash collateral will affect the fair value of the underlying derivatives. To compensate for this effect, it is expected that a one-off cash compensation payment between the parties will be made on the date of the change.

This In brief considers the accounting consequences of the above, in particular for:

● the one-off cash compensation; and

● the effect on pre-existing hedge accounting relationships that reference EONIA (in particular, when a derivative affected by the change is part of a hedging relationship).

Example

Bank A holds a portfolio of derivatives with a central counterparty. The derivatives are ‘collateralised to market’ (that is, the collateral is accounted for separately from the derivatives)² and are subject to a cash collateral agreement. At 31 December 2019, the collateral is remunerated based on EONIA which, given the reforms in 2019, is set to be €STR plus a fixed spread of 8.5pbs. It is expected that, in mid-2020, the central counterparty will change the remuneration rate from EONIA (that is, €STR plus 8.5pbs) to €STR flat and apply cash compensation payments for derivatives outstanding at the date of the change. The cash compensation offsets the effect of the change in the collateral interest rate on the fair value of the derivatives.

Does the one-off compensation payment relate to the derivative or the collateral? Will such compensation impact the fair value of the derivative as at earlier reporting dates?

The one-off cash compensation payment relates to the derivative, because the payment compensates the holder of the derivative for the change in the derivative’s fair value that arises as a consequence of the change in the interest rate on the collateral. As such, bank A may book the one-off cash compensation payment against the fair value of the derivative (rather than spread it forward). To the extent that the one-off payment compensates for the change in fair value, this will result in no net gain or loss on the derivative at the time of the payment. Consistent with this approach, to the extent that the one-off payment will compensate for the fair value impact of the change in the collateral interest rate when it happens, we do not expect the one-off compensation payment to have an impact on the derivative’s IFRS 13 fair value as at reporting dates before the change is made (including 31 December 2019).

If hedge accounting is applied, what impact (if any) will there be on the measurement of the hedged item, and will ineffectiveness arise?³

Since cash compensation is paid on the derivative hedging instrument but not on the hedged item, ineffectiveness will arise either at the time of the change or over time, depending on the particular facts and circumstances. The timing of the impact will depend on whether the discount rate used to calculate the change in fair value of the hedged item is changed, and it should be considered separately for cash flow and fair value hedges.

Cash flow hedges – Should the discount rate used to calculate the fair value of the hypothetical derivative be changed?

This will depend on whether the hedge documentation identifies the discount rate as a particular risk-free rate that is impacted by the change.

For example, if the hedge documentation specified the discount rate as ‘the risk-free rate as measured by the rate paid on an equivalent collateralised derivative’, the discount rate used to calculate the fair value of the hypothetical derivative will need to be updated. The resulting gain or loss, which is not offset by any compensation, will cause one-off ineffectiveness at the time of the change that will need to be recognised in the income statement (subject to the normal ‘lower of’ test for a cash flow hedge).

Conversely, if the hedge documentation does not specify a particular discount rate (but, for example, references only ‘a risk-free rate’), an entity would need to exercise judgement in deciding whether to update the discount rate. Management should consider past practice in similar situations (for example, when the market transitioned from discounting collateralised derivatives using a rate based on LIBOR to one based on OIS). If the discount rate is not updated, the resulting ineffectiveness will arise and be recognised over time (subject to the normal ‘lower of’ test for a cash flow hedge).

Fair value hedges – Should the discount rate used to calculate the change in the fair value of the hedged item attributable to the hedged risk be changed?

Similar considerations apply to fair value hedges, regarding following the hedge documentation or exercising judgement where the hedge documentation does not specify a particular discount rate. However, entities should bear in mind that, although the change in value of the hedged item is determined separately from the hedging instrument, the objective is to measure the change in the fair value of the hedged item attributable to the hedged risk using market participant assumptions. 

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_{1 For derivatives that are collateralised to market, this interest is referred to as ‘Price Alignment Interest’ or ‘PAI’; for derivatives that are settled to market, it is referred to as ‘Price Alignment Amount’ or ‘PAA’. See, for example, LCH’s Circular No 4052 – Transition to €STR discounting in SwapClear.}

_{2 The first question below does not arise for ‘settled to market’ derivatives, since for such derivatives the collateral is not accounted for separately from the derivative.}

_{3 The guidance provided in this section applies to both ‘collateralised to market’ and ‘settled to market’ derivatives}

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