Almost a year ago, I posted a blog related to variation margining on centrally cleared derivatives and its impact on accounting and reporting ( check out that post here). At the time, very little guidance had been issued on the matter, but participants in some of my training courses were asking questions. Well, I’m back again to give an update on the accounting for derivatives under ASC 815 (FAS 133). Specifically, where things stand on variation margining for derivative contracts, as there has been some developments over the past twelve months!
ISDA Steps Up to Help
As I noted in my previous post, there was minimal guidance on whether variation margining cash flows to a central clearing house represented “settlement” of the outstanding derivative contract or simply a posting of “collateral”. In May 2016, the International Swaps and Derivatives Association (ISDA) issued a whitepaper, Accounting Impact of CCP’s Rulebook Changes to Financial Institutions and Corporates (May 2016) which was followed by discussions between the ISDA and SEC Office of the Chief Accountant. These discussions culminated in the issuance of an ISDA Confirmation Letter on January 4, 2017 which provides clarity to the ISDAs and SEC’s view of variation margining, specifically at two of the largest central counterparties (CCPs) or clearing organizations: The Chicago Mercantile Exchange (CME) and LCH.Clearnet Limited (LCH). Two accounting firms have issued very useful summaries on the confirmation letter. Follow the following links to EY’s To the Point and Deloitte’s Financial Reporting Alert for these summaries.
Settlement or Collateral?
The CME and LCH have both amended their rulebooks to clarify that variation margin payments may be viewed as settlements of the derivatives exposure and not the posting of collateral. These changes are supported by legal opinions from their external counsel, resulting in a change in the legal characterization of these cash flows.
The CME amendments are effective as of January 3, 2017 and apply to all derivatives they clear. LCH changed its rules in 2016, but the changes were not mandatory, meaning that entities could elect to change the characterization of their derivative contracts from “collateral-to-market” (CTM) to “settled-to-market” (STM), or continue to characterize variation margin cash flows as CTM. As these rule changes only apply to the CME and LCE, derivatives clearing at other clearing houses will need to be analyzed and considered separately.
The Bottom Line
How does this confirmation and clarification impact the valuation of and reporting for derivatives cleared through a CCP? In other words, what does it mean for us accountants? The following are some items to consider:
- “Legal” for one may not be “legal” for all – Although the external legal counsel for CME and LCH have determined the variation margin cash flows are legally settled, this may not always be the case for all transactions entered by all entities. As already mentioned, these rulebook changes were specific to derivatives cleared by the CME and LCH. Other clearing organizations may have rules that impact how the cash flows are viewed. Also, other legal frameworks that might govern an entity’s transactions may also impact the overall assessment. Each entity should consult their own legal counsel to determine the appropriate treatment for their variation margin cash flows to ensure proper treatment given their own specific circumstances.
- Net presentation – If variation margin cash flows are viewed as “settlement”, then they should be considered within the same “unit of account” as the outstanding derivative, itself, for purposes of valuation and presentation. This means that the variation margin payments should be presented “net” with the derivative and the resulting fair value of the combined instrument should generally be zero, or an amount close to zero, each day. Unlike in the past where consideration needed to be given to the balance netting requirements in ASC 210-10, “settled” payments would be required to be booked directly against the derivative, regardless of these netting rules.
- Hedging is all clear – Although variation margining may be viewed as “settlement” of the derivative, the SEC confirmed that this is a form of “partial settlement” and, therefore, does not impact the ongoing hedge accounting when using a derivative subject to these rules. The confirmation letter clarifies that existing hedging relationships are not at risk of falling out of hedge qualification because of the variation margin payments. Also, these payments would not impact hedge qualification under the shortcut method.
- Unrealized or realized gains and losses? – Questions have arisen regarding whether variation margin payments should result in a reclassification of unrealized gains and losses on derivatives to realized gains and losses. This determination may also impact the way income taxes are determined. The confirmation letter did not elaborate or clarify these issues and therefore consultation with tax professionals may be necessary to determine proper classification and tax obligations.
- Disclosures – The ISDA and SEC also clarified how these rule changes impact derivatives disclosures. They clarified that the disclosure requirements within ASC 815 continue to apply to these instruments through the term of the contracts (i.e. daily settlements does not change or reset the contractual terms of the instrument). Also, variation margin cash flows that represents “settlement” would not be subject to the collateral disclosure requirements (as these cash flows represent settlement and not collateral). One unresolved issue, however, is whether these “settlement” cash flows would be subject to the rollforward disclosure requirements related to Level 3 fair values in ASC 820-10-50-2(c)(2).
- Regulatory capital – One potential benefit related to these rule changes could be on an institution’s regulatory capital requirements. Presumably, if the variation margin payments represent settlement and, therefore, derivatives carry a fair value of zero (or close to zero), the capital charge for these instruments will be significantly reduced compared to its previous treatment. Although this was not confirmed by the SEC or ISDA, it is certainly something financial institutions will want to consider.
So, that about does it. Consider yourself updated, for the time being, on variation margining on centrally cleared derivatives. If you have any questions or want to share your thoughts, send me an email. It would be great to hear your experiences on this evolving issue.
This post is published to spread the love of GAAP and provided for informational purposes only. Although we are CPAs and have made every effort to ensure the factual accuracy of the post as of the date it was published, we are not responsible for your ultimate compliance with accounting or auditing standards and you agree not to hold us responsible for such. In addition, we take no responsibility for updating old posts, but may do so from time to time.
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