David Glassco is CEO of FinancialCAD Corporation, a leading provider of online financial application services.
Throughout the United States, banks, investment and auditing firms, and corporate treasuries are facing compliance challenges with FAS 133, a new accounting rule affecting the record-keeping and reporting of financial derivatives. FAS 133 compliance can be stringent and exacting on financial organizations, causing some even to reduce or cease their derivatives activities. Eventually, however, thousands of firms and companies that understand the benefits of derivatives will have to not only apply these new requirements organization-wide, but have the requisite tools in place to service their clients, as well.
Wall Street sell-side firms, for example, will have to quickly and economically help their clients adjust to FAS 133, as will auditing firms that provide services to corporations, pension funds and other buy-side market participants using derivatives. Also, corporations face the complex task of developing FAS 133 accounting software applications that must interact with enterprise-wide treasury systems. These enterprises, which number in the thousands, are now required to account for and measure their derivatives and hedging activities using special methodologies dictated by this new, comprehensive standard.
The Risk of Unreadiness
Because of the daunting task of industry-wide FAS 133 compliance, many firms and corporations have opted to curtail or even eliminate entirely their derivatives underwriting and trading activity for the short term. This approach, however, carries its own set of risks.
Firms that decide to stop using derivatives because they are not prepared to comply with FAS 133 could lose strategic advantages that typically result from prudent risk management. Among the impacts of not using derivatives to hedge positions could be a higher cost of funds, a lower price at which commodities are sold, or more difficulty competing in foreign markets. For U.S. companies, earnings volatility will likely increase and relative competitive strength decrease for enterprises that stop using derivatives because of FAS 133.
Financial Accounting Standard 133, known as FAS 133, was established by the Financial Accounting Standards Board (FASB), an authoritative developer of standards for financial accounting and reporting in the United States. This new standard requires all organizations that use derivatives and report financial information under U.S. Generally Accepted Accounting Principles (GAAP) to record on balance sheets the fair market value of all derivatives, along with all changes in market value reported as profits or losses on income statements.
This will require organizations that use derivatives to mark to market historically all derivatives positions as of financial reporting dates. It also will require organizations to perform prospective hedge effectiveness tests for derivatives on their books and, throughout the life of each derivative instrument, retrospective hedge effectiveness tests as well.
The Need for Technology Solutions
FAS 133 compliance is enormous in its size and scope, and many companies do not have the necessary combination of derivatives subject-matter expertise, access to historical market data and the time to devote to managing all of the complexities required in building internal compliance systems to engage in automated accounting and reporting of this magnitude. Companies need systems that are secure, open, can scale from one user to an entire enterprise, and that offer permissioned access points for members of a sell-side or auditing firm to provide information for clients about the derivatives that they are using.
Controllers and financial accountants working in any business that uses derivatives will require upgraded systems and work procedures to ensure FAS 133 compliance. Also, derivatives traders will be required to assist in historical market data valuations and in proving qualification for hedge accounting treatment.
Sell-side firms can expect a significant slow-down in the use of derivatives until market participants successfully integrate the use of FAS 133 compliance support systems into their daily work routines. Failure to have access to the necessary systems could result in the elimination of use of some or all types of derivatives, which could impact financial performance and even job security for many people.
Firms will need to be able to provide prospective hedge effectiveness test results in proposals to clients that involve providing derivative-based risk management solutions. In addition, effectiveness test results may have to be made available to clients securely online.
Auditors providing auditing services to any business that uses derivatives will require business systems to enable staff to verify client compliance with FAS 133. Failure to do so could expose the firm and partners to unnecessary professional business risks.
Benefits of FAS 133 Compliance
Effective derivative activity can and does increase a companys competitive strength. It would be reasonable to expect much less earnings volatility among corporations, pension funds and other buy-side market participants that use derivatives, especially with the deployment of effective hedging practices and the ability to qualify for hedge accounting treatment.
Investors may experience earnings volatility in the short term, but over time FAS 133 compliance will result in much higher quality risk disclosure. This, most professional users of derivatives agree, will help create a stronger financial system over the long term.
Also, compliance officers in financial services firms can expect fewer fraudulent sales practices complaints under active FAS 133 compliance, since adhering to the standard provides a strong framework for industry-wide disclosure, measurement and management of risk throughout a financial organization.
Clearly, the financial industry needs a comprehensive solution to the FAS 133 problem, with both online and enterprise-wide applications for financial organizations and their multiple client companies. These include corporate controllers and financial accountants, as well as securities traders at corporations and financial services companies. It also includes Wall Street sell-side firms that need to efficiently transition their clients to FAS 133, auditing firms that provide services to companies using derivatives, and corporations that need FAS 133 compliance applications to interact seamlessly with their enterprise-wide treasury systems.
Banks also can benefit from accurate, independent and comprehensive financial instrument valuation and risk management solutions that FAS 133-compliant software can provide. This may include mark-to-market and hedge effectiveness testing for interest rate swaps on their books, or to deal with commercial loans that are pooled and hedged with basis swaps.
As daunting as FAS 133 compliance may be, successful financial organizations realize that readiness is ultimately not an option. Thousands of firms, corporations, banks and auditing businesses that understand the benefits of derivatives will eventually need to implement a technology solution that is comprehensive and highly integrated to help them successfully leverage their assets now and into the future.