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Part 10: Use of derivatives in central government

Central government: Results of the 2005/06 audits.

10.101
The area of financial instruments, and more specifically derivative financial instruments (derivatives), has an inherent degree of complexity. A natural consequence of this complexity is risk.

10.102
Some submissions to the Finance and Expenditure Committee during its review and consideration of the Public Finance (State Sector Management) Bill (the Bill) in 2004 specifically raised the issue of fiscal risk associated with financial market activity of the Crown, including the use of derivatives. We provided advice to the Committee on the use of derivatives by the Crown.

10.103
The new public sector legislation resulting from the BiIl in December 2004 introduced clearer parameters within which both government departments (departments) and Crown entities could enter into derivative transactions. The legislation applied from 1 April 2005 and comprised the following Acts:

  • the Crown Entities Act 2004 (the Crown Entities Act);
  • the Public Finance Amendment Act 2004 (the Public Finance Amendment Act);
  • the State Sector Amendment Act (No. 2) 2004; and
  • the State Owned Enterprises Amendment Act 2004.

10.104
The main restrictions around derivative use are in the Crown Entities Act and the Public Finance Act 1989.

10.105
The term “derivative transaction” is defined widely in section 136(1) of the Crown Entities Act and section 2 of the Public Finance Act. The definition lists many types of transactions, and allows for developments as financial markets continue to evolve. It includes foreign exchange transactions, which might not ordinarily be recognised as derivative transactions.

10.106
Common derivative transactions include “swaps”, “futures contracts”, “options”, and “forward agreements”.

10.107
Section 164 of the Crown Entities Act establishes a general rule that Crown entities are prohibited from entering into (or amending the terms of) derivative transactions, other than as provided under section 160 of the Crown Entities Act – that is, unless:

  • the Crown entity is permitted to do so by regulation;
  • approval is granted by the Crown entity’s Responsible Minister and the Minister of Finance;
  • the Crown entity’s own Act provides for derivative use; or
  • one of the exemptions contained in either of Schedule 1 or Schedule 2 of the Crown Entities Act1 applies.

10.108
The Crown Entities (Financial Powers) Regulations 2005 (the Regulations) were made by Order in Council on 21 March 2005 under section 173 of the Crown Entities Act.

10.109
Regulation 15 of the Regulations permits a Crown entity to undertake specified derivative transactions without further authority. The regulation permits classes of transaction that tend to arise in the ordinary course of business, and that fit with the general policy objective of limiting potential fiscal risk to the Crown and Crown entities. The permitted transactions include foreign exchange transactions and related futures contracts.

10.110
The Public Finance Act provides that the Crown must not enter into derivative transactions except as expressly authorised by any Act (section 65F). However, on behalf of the Crown, the Minister of Finance may enter into a derivative transaction if it appears to be necessary or expedient in the public interest to do so (section 65G).

10.111
The Minister of Finance has delegated to the New Zealand Debt Management Office (the NZDMO)2 the operational aspects of managing the Crown’s borrowing, investing, and derivative activities. The NZDMO is responsible for the efficient management of the Crown’s debt and associated assets within an appropriate risk management framework. Derivatives are used as a tool to protect the Crown from the interest rate risk associated with its borrowing and investment activities.

10.112
Departments have no ability, in their own right, to enter into derivative transactions. However, under delegations from the Minister of Finance and the Secretary to the Treasury, and subject to the Treasury having oversight through the Guidelines for the Management of Crown and Departmental Foreign-Exchange Exposure (the Guidelines),3 departments are able to enter into derivatives to manage their foreign exchange risk.

Scope

10.113
To gain a more thorough understanding of the level of risk borne by the Crown from the use of derivatives, we asked our appointed auditors to collect information from some public sector entities as part of the 2005/06 annual audits. We wanted to find out more about the level of derivative use, and about current policies and procedures to manage such use.

10.114
We sought to obtain assurance that derivatives were used to manage and reduce existing risk for the Crown, as opposed to increasing the Crown’s risk through speculation. We also wanted to assess whether the control environment surrounding derivative use was adequate.

10.115
Further, we sought assurance that the use of derivatives was within the parameters set out in the Crown Entities Act, the Public Finance Act, the Regulations, the Guidelines, and other relevant legislation.

10.116
Accordingly, we collected information from 165 public sector entities about:

  • their exposure to foreign exchange, interest rate, or commodity price risk;
  • their use of derivatives to manage each risk mentioned above, including quantification of the value, volume, and type of the derivative instruments being used, and the entities’ approach to managing the risks;
  • the controls, policies, and procedures in place surrounding derivative use – appointed auditors were asked to provide an overall assessment of the effectiveness of these controls, policies, and procedures;
  • departments’ foreign exchange policy;
  • Crown entities’ compliance with Part 4 of the Crown Entities Act and the associated regulations on derivatives; and
  • planning for, and implementation of, New Zealand equivalents to International Financial Reporting Standards (NZ IFRS) – in particular, the new hedge accounting requirements introduced under NZ IAS 39.

10.117
The 165 public sector entities surveyed are classified in Figure 10.1.

Figure 10.1
Classification of public sector entities

Entity typeNumber of entities
Crown entity 95
Government department* 41
State-owned enterprise 20
Other entities** 9
Total 165

* Includes Offices of Parliament.

** Other entities are entities that do not legally or logically fall under one of the first three categories. They include the New Zealand Superannuation Fund (the Guardians of New Zealand Superannuation is a Crown entity), the Government Superannuation Fund (the Government Superannuation Fund Authority is a Crown entity), the Reserve Bank of New Zealand, Air New Zealand, New Zealand Government Property Corporation, Leadership Development Centre Trust, New Zealand Fish and Game Council, New Zealand Game Bird Habitat Trust Board, and Road Safety Trust.

10.118
In the rest of this Part, we summarise then discuss our findings from the information we collected, and provide suggestions as to how the control environment surrounding derivative use in the public sector can be further enhanced to decrease potential risk to the Crown.

Findings and commentary

Foreign exchange risk

10.119
Eighty-six entities we obtained information from have exposure to foreign exchange risk, which is the risk that an entity is exposed to when it enters into a transaction denominated in a currency other than its functional currency. Foreign exchange risk could arise, for example, from purchasing goods or services from an overseas location.

10.120
Of those entities with exposure to foreign exchange risk, 58 had entered into derivative transactions to mitigate that risk.

10.121
Although it was more common for State-owned enterprises (SOEs) (13) and other entities (4) to enter into derivative transactions to manage foreign exchange risk, a significant portion of both departments (16) and Crown entities (25) also used derivatives to manage foreign exchange risk.

10.122
Figure 10.2 shows the estimated typical value and volume of derivative transactions used by entities in managing foreign exchange risk.

Figure 10.2
Value and volume of derivative use to manage foreign exchange risk

Estimated typical transaction value ($)Number of entities
0-5,000 3
5,001-100,000 11
100,001-1,000,000 22
1,000,001+ 22
Total 58

 

Estimated number of transactions each yearNumber of entities
0-20 33
21-100 14
101+ 11
Total 58

10.123
Thirty-six entities entered into relatively low-value transactions (less than $1 million for each transaction) that also happened to be low-volume (fewer than 100 transactions each year).

10.124
The remaining 22 entities had a typical transaction value of more than $1 million. Of these 22 entities, 15 carried out a relatively low volume of transactions annually. The seven remaining entities had both an estimated typical transaction value of more than $1 million, and entered into more than 100 derivative transactions each year. We consider these entities to be high users of foreign exchange derivative transactions. These entities included departments, an SOE, and other entities.

10.125
The relatively frequent use of larger value foreign exchange derivative transactions for particular entities is in line with our expectations. Without exception, the entities undertake transactions in foreign currency as part of their day-to-day operations. It therefore follows that they would be high users of derivative transactions to help manage their exposure to foreign exchange risk.

10.126
We noted no particular preference for one entity type to use foreign exchange transactions as a tool to manage foreign exchange risk. Rather, the activities and needs of the entity seemed to determine the level of use of foreign exchange derivatives.

Instruments used

10.127
The most common form of derivative instrument used to manage foreign exchange risk was forward foreign currency contracts, which were used relatively evenly by all entity types.

10.128
Forward foreign currency contracts are one of the two transaction types that departments are permitted to use under the Guidelines to cover foreign exchange exposure, the other being spot foreign exchange contracts.4

10.129
Forward foreign currency contracts are also one of the least complex forms of derivative transactions, and are therefore relatively easy to use.

Risk management policy

10.130
We sought information about entities’ foreign exchange risk management policy. Information provided about such policies varied according to the size and nature of the business of the entity.

10.131
A common approach was for entities to hedge a certain percentage of individual purchases and/or commitments of more than a pre-set limit. For example, the Guidelines require departments to state the transaction exposure limit for each individual currency, and says that the limit must not exceed $100,000. Therefore, the policy could require hedging of all exposures of more than $100,000.

10.132
We noted that many entities have differing limits for committed exposures and budgeted exposures, individual commitments and aggregate commitments, and types of transaction – for example, whether the exposure resulted from borrowing, capital expenditure, or operating expenditure.

10.133
Entities dealing frequently in currencies or with high levels of currency exposure have detailed hedging policies with specific details and limits relevant to the entity.

Interest rate risk

10.134
Fifty-seven entities we obtained information from had borrowed or invested.

10.135
Twenty-nine entities had also entered into derivative transactions to manage the associated interest rate risk.

10.136
It was more common for entities to enter into derivative transactions associated with borrowing than investing.

10.137
Further analysis by entity type revealed that nine SOEs that had invested or borrowed also used derivative transactions to manage the associated interest rate risk. However, at the other end of the scale, only one department (the NZDMO) used derivative transactions for this purpose.

10.138
The frequent use of derivative transactions by SOEs was expected (more so than other types of entities), given that SOEs are required to operate successfully as profitable businesses in the same way as privately owned companies.

10.139
There are no laws or regulations that prevent an SOE from entering into derivative transactions. Accordingly, if an SOE Board sees the use of derivatives as supporting its quest to make a profit, then such instruments may be used by the SOE at its discretion.

10.140
Departments, on the other hand, have no ability, in their own right, to enter into derivative transactions, except in specific circumstances to manage their foreign exchange risk. This means we would expect to see less use of derivatives from this type of entity. As discussed above, the NZDMO is an exception.

10.141
Figure 10.3 shows the estimated typical value and volume of derivative transactions used by entities in managing interest rate risk.

Figure 10.3
Value and volume of derivative use to manage interest rate risk

Estimated typical transaction value ($)Number of entities
0-5,000 -
5,001-100,000 1
100,001-1,000,000 11
1,000,001+ 16
Total 28

 

Estimated number of transactions each yearNumber of entities
0-20 17
21-100 5
101+ 6
Total 28

10.142
Entities with an estimated typical transaction value of between $1 million and $10 million were mostly Crown entities, and they generally enter into a low volume of transactions each year.

10.143
Sixteen entities had a typical transaction value of more than $10 million. Most of these entered into a low volume of transactions each year, with only 6 of those 16 entities entering into more than 100 transactions annually. These entities included Crown entities, other entities, and the NZDMO. We consider these entities to be high users of interest rate derivatives.

10.144
The high users are in line with our expectations. They each have high levels of borrowing and/or investment, and derivatives are used as a tool to protect the entity from the interest rate risk associated with its borrowing and/or investment activities.

Instruments used

10.145
We noted that a range of derivative instruments are being used to manage interest rate risk, and that the most common are interest rate swaps. Interest rate options and forward rate agreements were also relatively common.

Risk management policy

10.146
We sought information about interest rate risk management policy. A common approach taken with respect to liabilities was the establishment of hedging ranges for different maturity profiles, for example:

  • Hedge x% (say 50-100%) of exposures maturing within 12 months;
  • Hedge x% (say 40-80%) of exposures maturing within 12-36 months; and
  • Hedge x% (say 0-60%) of exposures maturing within 36-60 months.

10.147
A common way of managing interest rate risk on assets was using short-term investments (that is, less than 12 months) to enable the entity to take advantage of high interest rates and maximise interest income.

10.148
Some entities use derivatives (in this case, interest rate based) as part of their core business or as investment tools, as opposed to risk management tools. The investment managers’ policies for these entities varied, but the derivative activity always operated within the pre-set investment guidelines in question to balance the portfolio and/or manage interest rate exposure.

Commodity price risk

10.149
We obtained information on each entity’s exposure to other forms of risk, such as commodity price risk, which is the risk an entity is exposed to from fl uctuating commodity prices. Examples of commodities are electricity, gas, and various forms of metal.

10.150
Commodity price risk exposure was less prevalent, with only 32 entities having had exposure at some point. Eight of the entities had managed this risk through the use of derivatives.

10.151
Further analysis of these entities revealed that, of the eight, five (including three SOEs) used derivatives to manage risk on electricity prices.

10.152
As expected, none of the departments surveyed had undertaken commodity derivative transactions.

10.153
Figure 10.4 shows the estimated typical value and volume of derivative transactions used by entities in managing commodity price risk.

Figure 10.4
Value and volume of derivative use to manage commodity price risk

Typical transaction value ($)Number of entities
0-5,000 3
5,001-100,000 4
100,001-1,000,000 -
1,000,001+ 1
Total 8

 

Number of transactions each yearNumber of entities
0-20 4
21-100 1
101+ 3
Total 8

10.154
Apart from one entity that enters into fewer than 20 commodity derivative transactions each year with an estimated typical transaction of more than $10 million, entities had transactions with a relatively low value (up to $1 million). Three of those entities with low-value transactions – two SOEs and one other entity – entered into more than 100 commodity derivative transactions each year.

Instruments used

10.155
Options and swaps were the most commonly used derivative transactions. Futures were also used to manage commodity price risk.

Risk management policy

10.156
The approach that entities took to the management of commodity price risk varied according to the industry each entity operated in.

10.157
In all cases, hedging of commodity price risk was carried out to manage risk by providing certainty of costs associated with the operations of the entity.

Derivatives policy and procedures

10.158
Most users of derivatives had a separate derivatives policy in place.

10.159
This finding is encouraging, as a specific policy for derivative use mitigates the associated risk by providing entities with clear parameters to follow when entering into such transactions. Interestingly, 10 entities that had not used derivatives had a derivatives policy in place anyway.

10.160
The main themes we noted in the various policy documents included:

  • clearly defined authorisation procedures;
  • clear documentation of staff responsibilities surrounding the use of derivative instruments – with a focus on segregation of duties (which means the initiator of the transaction is separate from the person approving the transaction and the person responsible for settling the transaction);
  • pre-set transaction limits, above which governing body approval is required; and
  • the requirement for regular (say, monthly) reporting of all open derivative positions to the governing body and senior management.

10.161
However, we noted that four entities that were users of derivative transactions (all of them Crown entities) did not have a separate policy on derivative use. In most cases, the use of derivatives was limited to the purchasing of forward foreign exchange contracts of a minor nature that were executed under the general disbursements policy of the entity.

10.162
We expect all entities that use or plan to use derivative instruments to prepare and adopt a specific derivatives policy that clearly outlines individual responsibilities, controls, and procedures to be followed when entering into derivative transactions.

10.163
We assessed the effectiveness of the combined controls, policies, and procedures (where in place) of each entity on derivatives activity, as we consider that it is the environment in which derivatives are used, rather than the actual use of derivative instruments, that determines the level of risk an entity is exposed to.

10.164
As we expected, we found that the controls, policies, and procedures for derivative activity to be effective in most entities. However, we identified three instances where controls and procedures for derivative use were not as specific as we would expect, particularly around authorisation of derivative transactions. These three instances related to entities that had only a few minor derivative transactions. Nevertheless, we would expect these entities to make the necessary changes to improve their controls and procedures.

Government departments – foreign exchange policy

10.165
We questioned departments about foreign exchange policy documents. We were interested first in whether, in line with the requirements of the Guidelines, departments had a foreign exchange policy document in place and, if so, whether the policy complied with the Guidelines.

10.166
Of the departments, 56% did have a foreign exchange policy. In the other 44%, the lack of a foreign exchange policy was because the departments in question did not enter into foreign currency transactions or, if they did, had minimal exposure that was immaterial. This is in accordance with the Guidelines.

10.167
We identified five instances where the foreign exchange policy document did not comply with the Guidelines, and had not been approved by the Minister of Finance and the responsible Minister. In three of these cases, non-compliance was because the document had not been updated to take account of updates to the Guidelines. The remaining two cases were because the document was silent in areas where the Guidelines are not silent. In one of these two cases, the policy document is in the process of being updated to include the missing information.

Crown entities – compliance with the Crown Entities Act 2004

10.168
We were encouraged to see that all Crown entities surveyed, with the exception of one, were aware of, and in compliance with, the requirements of Part 4 of the Crown Entities Act and the associated regulations on derivatives. The one exception noted was minor in nature and is awaiting Ministerial approval.

New Zealand equivalents to International Financial Reporting Standards – planning and implementation

10.169
For financial reporting periods beginning on or after 1 January 2007, all New Zealand reporting entities, including public sector entities, will be required to apply New Zealand equivalents to International Financial Reporting Standards (NZ IFRS) when preparing their financial statements.

10.170
Applying NZ IFRS will result in a change to a number of current accounting policies, with a resulting effect on the financial statements.

10.171
One such change relates to hedge accounting.5

10.172
Hedge accounting is where the related changes in fair value of a financial asset or financial liability are offset against each other. To use hedge accounting, an entity must meet and follow specific criteria, particularly around documentation and effectiveness testing.

10.173
As the criteria are somewhat onerous, we were not surprised to find that 85% of the entities we surveyed were not intending to adopt hedge accounting under NZ IAS 39. Many of these entities simply did not use derivatives, and those that did foresaw the costs of adopting hedge accounting as being more than the benefits to be derived.

10.174
It was reassuring to note that the 24 entities that do plan to adopt hedge accounting also expect to satisfy the criteria for doing so for their first set of financial statements under NZ IFRS.

Conclusions

10.175
We examined the level of derivative use and the related policies and procedures of entities in the public sector, and are satisfied that the management and use of derivatives reduce risk to the Crown.

10.176
Entities identified as high users of derivatives clearly have specific business purposes for doing so, which centre on managing risk.

10.177
We looked at the control environment surrounding derivative use, and found that most entities have a clear and concise derivatives policy in place as part of an effective overall control environment surrounding derivative use.

10.178
We identified four instances where an entity was a user of derivatives but did not have a derivatives policy in place. We expect those entities to develop and implement a detailed policy to be followed when entering into derivative transactions.

10.179
There were three instances where entities did have a derivatives policy, but the surrounding procedures and controls when entering into derivative transactions were not specific enough. We expect these entities to update their policies and procedures.

10.180
We were encouraged to see that all departments that had entered into foreign currency derivatives had a documented foreign exchange policy.

10.181
Five departments identified with an out-of-date or non-compliant foreign exchange policy document should update their policy to bring it into line with the requirements of the Guidelines.

10.182
All Crown entities, with one minor exception, complied with Part 4 of the Crown Entities Act and the associated regulations on derivatives.

10.183
Finally, we were reassured to note that the 24 entities that plan to adopt hedge accounting under NZ IAS 39 expect to satisfy the criteria for doing so for their first set of financial statements under NZ IFRS.

10.184
Because of the onerous requirements surrounding the adoption of hedge accounting under NZ IAS 39, we encourage those entities to obtain assurance over their hedging relationships, documentation, and effectiveness testing well in advance of their first reporting date under NZ IFRS.


1: The various Crown entities are differently affected by the new derivative requirements. The Treasury provides guidance at www.treasury.govt.nz/notindexed/cerrfp-table-jan05v3.xls to help determine how individual Crown entities are affected.

2: The NZDMO is a branch of the Treasury. However, for the purposes of this Part, it has been treated as a separate department.

3: The Guidelines were last updated in November 2003 and can be found on the Treasury website at www.treasury.govt.nz/publicsector/fxexposure/default.asp.

4: Spot foreign exchange contracts are used for not more than two-business-day settlement. This is used where a department needs to buy or sell currencies immediately (for example, to pay an invoice) – see paragraph 35(i) of the Guidelines.

5: NZ IAS 39: Financial Instruments: Recognition and Measurement, paragraphs 71-102.

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CoverCentral government: Results of the 2005/06 audits

ISBN 0-478-18174-4