Accounting ramifications related to centrally cleared derivatives
FINANCIAL REPORTING INSIGHTS |
Entities that enter into over-the-counter derivatives that are required to be centrally cleared typically make variation margin payments to a margin account to provide credit risk protection to the other party to the transaction. On a given day, the party to the derivative that is in a loss position will post payments to that account, equal to that loss position, for the benefit of the other party. Historically, the margin account related to these payments has been legally structured and documented as collateral by the clearing exchanges and such contracts have been referred to as “collateralized to market.” Certain clearing exchanges have begun to legally structure and document these payments for derivatives they clear as settlements of the derivative exposures, referred to as “settled to market” or “STM.”
Two of the major exchanges, namely the Chicago Mercantile Exchange (CME) and LCH.Clearnet Limited (LCH), recently began structuring certain contracts as settled to market, and other exchanges may follow suit. It is our understanding that effective January 3, 2017, CME contracts are now structured as settled to market. We also understand that in 2016 LCH began permitting entities to elect settled-to-market contracts, rather than instituting them across the board. A change in the legal characterization of margin payments from collateral to settlement has accounting and disclosure ramifications for impacted entities’ financial statements as early as 2016.
On January 4, 2017, the International Swaps and Derivatives Association (ISDA)’s Accounting Policy Committee issued a confirmation letter to the Office of the Chief Accountant of the SEC related to an ISDA whitepaper and follow-up submissions on the accounting impact of these changes. Per the confirmation letter, it is the ISDA’s understanding that the SEC staff does not object to the following conclusions:
- “The changes to the rulebooks of LCH and CME, as supported by legal opinions from external counsel, should result in the presentation of variation margin amounts as settlement of the derivative exposure and not collateral against it because the timing, amount, and uncertainty of cash flows related to the STM derivative contract is considered a single unit-of-account for purposes of applying the accounting and presentation guidance in ASC 815.
- The derivative disclosure requirements in ASC 815 would continue to apply for STM derivative contracts given that STM derivative contracts remain term instruments and that daily settlement of the derivative exposure does not change or reset the contractual terms of the instrument. Such disclosures would be applicable over the remaining term of the STM derivative contract.
- The disclosure requirements in 815-10-50-4B(b), regarding cash collateral disclosures, should not be applied to variation margin amounts for the STM derivative contracts.
- The de-designation and re-designation of existing hedging relationships under ASC 815 would not be required solely because of the amendment described in the Submission to the respective CME and LCH rulebooks.
- The daily settlement of the derivative exposure through daily payment or receipt of variation margin amounts for the STM derivative contracts described in the Submission would not require a daily de-designation and re-designation of hedging relationships under ASC 815.
- The inclusion of price alignment amount and variation margin in the single unit-of-account with the derivative exposure would not prohibit application of the “short-cut method” under ASC 815.”
For those entities impacted by these changes, there will be several accounting ramifications to consider that are not explicitly mentioned in the above conclusions. Given that derivative exposures are legally deemed to be settled such that the settlement payments and related derivative are considered to be a single unit of account, we would expect the derivative carrying amounts to be at or near zero. This will impact the balance sheet for those reporting entities that did not qualify or elect to net derivative carrying amounts with collateral as permitted under ASC 210-20 in certain cases, and could impact capital ratios and other metrics. In addition, given that derivative exposures are deemed to be settled rather than collateralized, this could potentially impact the timing of tax deductions and taxable income as well as other financial statement line item presentation if the determination is made that it is appropriate to characterize all changes in fair value as realized (rather than unrealized) gains and losses. As it relates to hedge accounting, the settlements are not deemed to extinguish or modify the derivatives and therefore hedges involving the derivatives would not need to be continuously de-designated and re-designated as the settlements occur. Additionally, the changes will not preclude entities from electing the short-cut method for qualifying hedges with interest rate swaps.
We encourage entities that are the counterparty to contracts cleared through an exchange to put forth the necessary efforts to verify and continuously monitor the legal structure of their contracts and viewpoints on the financial statement presentation and tax ramifications for those for which the legal structure has changed to settled to market. Keep in mind that while changes occurring in 2017 should not be reflected in the financial statements until the change is effective, it may be necessary to disclose the impact as a subsequent event in the 2016 financial statements.