What are the benefits and challenges of applying the critical terms match approach?

Critical Terms Match (CTM), aka The Shortcut Method, is used when the terms of a hedged item and derivative you wish to hedge match 100%. This alignment deems the hedge 100% effective, allowing changes in fair market value (FMV) to be periodically booked after designation without requiring periodic effectiveness testing. The key terms include: -Trade, effective, and maturity dates - Interest rate/Index - Accrual basis and interest calculation periods - Holiday calendars and business day conventions CTM is only permissible for interest rate hedges and is not allowed under IFRS accounting standards.

The Critical Terms Match (CTM) approach ensures that the terms of a trade finance contract match exactly with those in the letter of credit (LC), reducing discrepancies and minimizing risks. Its benefits include enhanced compliance, smoother transactions, and increased trust between stakeholders. However, it can be time-consuming, requiring careful attention to detail, and may lead to higher administrative costs. Additionally, the strict adherence to matching terms can limit flexibility, making it challenging to accommodate changes in the deal. Overall, while CTM helps mitigate risks, it can complicate and slow down the process.

Applying the critical terms match (CTM) approach starts with identifying the hedging instrument and the hedged item, and documenting key terms like notional amounts, maturity dates, and interest rates. For example, if you're hedging a fixed-rate loan with an interest rate swap, ensure both have matching payment schedules. Regularly verify that these terms remain aligned. If market conditions change, communicate with your counterparty to quickly renegotiate terms. For instance, during a volatile market, a drop in interest rates might require adjusting the hedge. Ensure your team is well-trained in both hedge accounting and the CTM approach. Regular training sessions can prevent errors and keep your team updated on best practices.

Using the critical terms match approach in my Treasury management journey has been effective. It helps me handle risks better and cash flow well, giving me peace of mind. While it can be challenging to ensure data accuracy and handle complex financial matters, mastering this method has empowered me to make smarter financial decisions and stay resilient in any situation.

Using Critical Terms Match (CTM) can reduce downstream hassle for periodic valuations and potential noise in P&L, especially for fair value hedges. Additionally, it may eliminate the need for certain systems to monitor hedge accounting, simplifying monthly and quarterly reporting.

If you're using critical terms match, you’d better have a straightforward hedge relationship (laughs). CTM is intended for use with simple variable and fixed rate relationships where no adjustments are anticipated. The moment a change in the relationship occurs, de-designation is inevitable. Re-designation will be necessary, employing a new method of assessment for a late-term strategy, which will incur a P&L impact due to the initial de-designation.

Under both standards, documenting the hedge relationship and the risk management objective is essential for monitoring the use of the derivative and the hedged item. This includes specifying the elected method for retrospective and prospective analysis. If the Critical Terms Match (CTM) is selected, it's crucial to ensure accuracy to avoid reassessment of the hedge's life to date and potential ineffectiveness being posted in P&L, as audits may opt for a quantitative approach. Note that CTM is not permissible under IFRS 9

For derivatives that are designated in qualifying hedging relationships (both fair value and cash flow) with an excluded component (a component excluded from the assessment of hedge effectiveness), an entity is permitted to recognize, as a component of other comprehensive income, differences between the changes in fair value of the excluded component and initial amounts recognized under a systematic and rational method in earnings.

When implementing the critical terms match (CTM) approach, consider the importance of robust internal controls and regular audits. Ensuring that all documentation is accurate and up-to-date is crucial. For instance, during an internal audit, we discovered discrepancies in the terms documentation which, once corrected, significantly improved our hedge effectiveness. Building strong relationships with your financial counterparts is also essential. Regular communication with banks and other financial institutions can provide early insights into market shifts and facilitate smoother renegotiations of terms if needed. This proactive approach helps in maintaining the effectiveness of your hedging strategy despite changing market conditions.