Variation Margin: Accounting for Derivatives (ASC 815)
Many over-the-counter (OTC) derivative contracts are now required by regulation to be cleared through a central clearing party (CCP) requiring variation margin payments by either party to provide credit protection from amounts owed under the contract. These variation margin payments have resulted in many questions regarding how it impacts the accounting for these derivative contracts under ASC 815 of U.S. GAAP.
Settlement (STM) or collateral (CTM)?
The biggest question concerning OTC derivatives cleared through a CCP that requires variation margin payments is whether such payments represent “settlement-to-market”, or STM or “collateral-to-market” or CTM. In other words, do the variation margin payments to the CCP relieve the transferor of those payments from its obligation under the OTC derivative, or is it simply a posting of collateral.
There has generally been minimal guidance on this issue, particularly from the FASB, as it is likely that they believe the general principles of recognition and derecognition of financial assets sufficiently addresses this issue. And in the end, it largely comes down to a question of “legality”. However, there have been some industry associations that have provided some insight. 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).
In addition, 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 applied to all derivatives they clear whereas the LCH changes continued to offer clearing arrangements that could be both STM and CTM, 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.
It is important to note that while these changes to the CME and LCH represent a large number of OTC derivatives, they are not the only CCPs. Therefore, derivatives clearing at other clearing houses will need to be analyzed and considered separately.
The bottom line for variation margin payments
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, or intermediate brokers, may have rules or legal agreements that impact how these cash flows are viewed. Also, other legal frameworks that might govern an entity’s transactions may also impact the overall assessment. Therefore, 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 as this is predominantly a question of the legal status and interpretation of those transfers.
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 (i.e., variation margin payment calculations may or may not align with the definition of fair value under ASC 820), 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. This may ultimately come down to an accounting policy choice that should be applied consistently.
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). Once again this is likely a policy choice that should be applied consistently and adequately explained in the disclosures itself.
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.
Conclusion
As you can see, there are a number of accounting and reporting considerations concerning these derivative transactions. Given the ambiguity in some of these issues, a clear and consistent approach to presentation, measurement, and disclosure will go a long way to properly accounting for these arrangements.
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Disclaimer
This post is for informational purposes only and should not be relied upon as official accounting guidance. While we’ve ensured accuracy as of the publishing date, standards evolve. Please consult a professional for specific advice.
