Death, Taxes and Black Swans
by Jiro Okochi, CEO and Co-founder, Reval
It is said that nothing in this world is certain except death and taxes. Reinforcing this idea of unpredictability are ‘Black Swan Events’, popularised by epistemologist Nassim Nicholas Taleb in his 2007 book, The Black Swan: The impact of the highly improbable. It makes sense, then, that as the year unfolds for corporate treasurers, we can only say for certain that something dramatically unpredictable will happen in the markets that will give treasurers one more headache.
The global financial crisis was, by Taleb’s definition, a Black Swan Event. One lesson we should have learned from the financial crisis — when it seemed like one-in-100-year events were happening every week and prices moved by more than two standard deviations over the course of a lunch break — is that volatility can occur swiftly and unexpectedly. So, unless treasurers think they are Warren Buffet, they would be foolish to forecast the market. Rather, their best bet is to hedge, at least against catastrophic events that can destroy their businesses.
Because we have experienced the devastating effects of extreme volatility, we know that it will be too late and too expensive to hedge when the ‘Black Swan’ does splash down somewhere and sometime in 2010. Therefore, as treasurers work to mitigate risk from the unpredictable, they will want to make sure they keep abreast of — and have a voice in — the ongoing regulatory developments involving the use of derivatives.
At the time of writing, it seems that non-financial corporations may not have to post margin for derivative trades; however, it is hard to imagine that banks won’t start requiring it anyway. Therefore, the costs of using OTC derivatives will most likely rise if the capital charges, margin requirements and clearing fees go up as anticipated with US legislation in 2010 and, presumably, with similar legislation from the European Commission. On the flip side of such regulation, companies may actually benefit from increased transparency and efficiency as business conduct rules may require dealers to show all profits earned on the transaction, even if un-cleared.
In addition to regulatory changes in the market, treasurers will also want to stay abreast of accounting changes for derivatives. Hedgers are anticipating the announcement of the discussion paper on the simplification of hedging under International Accounting Standard (IAS) 39. The discussion paper was originally slated for the fourth quarter of 2009 and pushed back to the first quarter of 2010, so any further delays will not be surprising. The US Financial Accounting Standards Board (FASB) had attempted a similar simplification project on FAS 133 over a year ago, and it was shelved as it created many new complications. In addition, companies were concerned about re-implementing FAS 133 again under the much touted International Financial Reporting Standards (IFRS) convergence path.
So will history repeat itself? In the US, our clients felt that the proposed changes under FAS 133R may have simplified the rules for passing the effectiveness testing, but change at this late stage may have caused more complications in other areas. One potential change under IAS 39 could be that fair value hedges will be treated more like cash flow hedges with OCI/hedge reserve management needed to manage the effective component of the derivative. Perhaps there will be fewer burdens on the front end of the hedge accounting workflow, but additional reporting would be needed to manage OCI. IFRS filers may also have to re-implement IAS 39 should convergence with US Generally Accepted Accounting Principles (GAAP) cause a change. Since there does not currently appear to be co-ordination on this front, the likelihood of gaps to GAAP is something we can confidently predict. Any major differences will be problematic for any multinational corporation that provides reporting under both standards and for everyone, should there be convergence, as that would mean re-implementing hedge accounting, which will be costly. Any changes most likely will not be effective until 2014, so there is still a way to go.
Despite pending accounting changes and reform requirements, treasurers will still have more reasons than not to hedge. Imagine the public flogging an airline would get for not hedging jet fuel with crude still way below the peak level of $140 a barrel, should oil get back above $100. If the global financial crisis has taught us anything, it is that unpredictable events will surely head our way — best to be ready rather than risk the unknown.