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Over recent years, in the context of fast developing capital markets activities, the banking profession has been promoting ever more sophisticated OTC financial instruments thus satisfying its clients' search for value added instruments and services. The need for permanent pricing of such instruments together with their inclusion, for specialised management purposes, in global trading portfolios raised the question of the accounting valuation and treatment of such instruments.
In its Regulation 90-15 of December 1990 (as amended by Regulation 92-04 of July 1992) regarding the accounting treatment of interest rate or currency swaps, the Banking Regulation Committee ("Comite de la Reglementation Bancaire") listed various methods applicable to the calculation of the market value of interest rate or currency swaps used for the purpose of specialised management of trading portfolios. Basically, both the use of a replacement cost or the discounting of future cash flows (at market rates of interest and taking into consideration the counterparty risks and the discounted future management expenses) were acceptable. By extension, Regulation 90-15 was understood as a regulation opening the possibility of accounting for other derivatives (and in general for other structured OTC financial instruments) on the basis of a marked to market value, and the methods described in this Regulation, as generally considered to be applicable to the determination of the market value of other OTC structured financial instruments such as options or index swaps.
Yet structured OTC financial instruments can very often be analysed and decomposed into a combination of simple instruments. On this point, a question has often arisen for accounting purposes : should the market value of structured instruments be determined as the mere sum of the market values of its constituting simple instruments, or should the "added value" of the combination be taken into consideration in the determination of the market value of a structured instrument ? And moreover, when a bank tries to find a replacement cost on the market, how pervasive can counterparties pricing policies for this "added value" be ? The "added value", in this context, can be analytically calculated as the difference between the sum of the costs incurred by a bank to synthetically build a structured OTC instrument and the price at which the bank can sell the instrument (e.g. price for a warrant vs. price for the underlying option). On an economic standpoint, it is undefined if this "added value" represents an immediate gain for the seller (some remuneration like a one shot commission) or if this element is the financial counterpart to a longer engagement of the seller. Hence, a position has to be taken as to whether a profit had to be accounted for immediately or if it had to be deferred.
At this stage, answers are often very different from one financial institution to another. Choices range from an immediate accounting for this added value as a profit (the marked to market value of the structured instrument is accounted for and defined as the instrument's selling price) to a deferral of this profit recognition (the marked to market value of the instrument accounted for is defined as the mere sum of the market values of its constituting simple instruments and the recognition of the initial difference with the instrument's selling price is posted to the profit and loss account on a linear basis over the lifetime of the instrument)
Regulators have taken no definitive position on this point, for of course situations can be very different from one institution to another. But an important issue was addressed in Regulation 90-15 when the text clearly stated that :" The calculation of the market value shall be in conformity with the consistency principle. A clear and quantified description of the calculation shall be prepared and held at the disposal of the Banking Commission ...".
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about specific circumstances.
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