FASB Definition of a Derivative Effect of Offsetting Contracts on the Existence of a Market Mechanism That Facilitates Net Settlement

FASB: Definition of a Derivative: Effect of Offsetting Contracts on the Existence of a Market Mechanism That Facilitates Net Settlement

Derivatives Implementation Group

Statement 133 Implementation Issue No. A15

Title: Definition of a Derivative: Effect of Offsetting Contracts on the Existence of a Market Mechanism That Facilitates Net Settlement
Paragraph references: 9(b), 57(c)(2), 261
Date cleared by Board: December 6, 2000
Date revision posted to website: March 8, 2004
(Revised March 13, 2002)

QUESTION

Does the ability to enter into an offsetting contract, in and of itself, constitute a "market mechanism that facilitates net settlement" as defined by paragraph 9(b) of Statement 133? In other words, is an offsetting contract, by its very nature, viewed as relieving a party of all rights and obligations under the original contract, or does it instead impose a different set of new rights and obligations?

BACKGROUND

Paragraph 9(b) of Statement 133 states that a contract meets the net settlement criteria in paragraph 6(c) if there is a market mechanism that facilitates net settlement, for example, an exchange that offers a ready opportunity to sell the contract or enter into an offsetting contract. Paragraph 57(c)(2) states that the term market mechanism is to be interpreted broadly. Any institutional arrangement or other agreement that enables either party to be relieved of all rights and obligations under the contract and to liquidate its net position without incurring a significant transaction cost is considered net settlement.

Statement 133 Implementation Issue No. A21, “Existence of an Established Market Mechanism That Facilitates Net Settlement under Paragraph 9(b),” provides detailed guidance about what constitutes an established market mechanism that facilitates net settlement under paragraph 9(b) of Statement 133. It also identifies the four primary characteristics that an established market mechanism as contemplated by paragraph 9(b) must have. Assume a broker-dealer stands ready to buy and sell a non-exchange-traded commodity forward contract that would relieve either party to the contract of its obligation to make (or right to accept) delivery of the commodity and its right to receive (or obligation to make) payment under the contract by arranging for a broker-dealer to make or accept delivery and paying the broker-dealer a commission plus any difference between the contract price and the current market price of the commodity. That arrangement is considered a market mechanism under paragraph 9(b). In contrast, an agreement whereby the broker-dealer will merely make (or accept) delivery on behalf of an entity is not viewed as a market mechanism that relieves the entity of its rights and obligations under the contract and is thereby not viewed as a market mechanism.

For example, Party A contracts to sell a commodity such as iron ore to B at a fixed price, and B offsets its purchase contract by entering into a separate contract to sell the same commodity to C at a different fixed price, instructing A to deliver directly to C. If A fails to deliver to C, C will legally look to B for remedy, not A. Even absent failure to perform, B will still pay A, and C will pay B, even though A may deliver directly to C. Assume the contracts in this series have an underlying and a notional and, therefore, they will at any given point in time have a positive or negative fair value.

For the purposes of this question, assume that the contract would not qualify for the normal purchases and sales exception under paragraph 10(b) (as amended). Also, assume that the asset associated with the underlying is not readily convertible to cash under paragraph 9(c).

RESPONSE

No. Consistent with paragraph 57(c)(2) and the guidance in Implementation Issue A21, the ability to enter into an offsetting contract, in and of itself, does not constitute a market mechanism because the rights and obligations from the original contract survive. The fact that an entity has offset their rights and obligations under an original contract with a new contract does not by itself indicate that their rights and obligations under the original contract have been relieved. The guidance in this issue applies to contracts regardless of whether the asset associated with the underlying is financial or nonfinancial. In addition, the guidance in this issue applies regardless of whether the offsetting contract is entered into with the same counterparty as the original contract or a different counterparty, unless an offsetting contract with the same counterparty relieves the entity of its rights and obligations under the original contract, in which case the arrangement does constitute a market mechanism.

The example arrangement discussed in the Background section does not constitute a market mechanism because Party B is not relieved of its rights and obligations from the original contract. The original contract survives and is not actually sold. The offsetting contract carries a new set of legal rights and obligations; however, those rights and obligations generally offset, rather than relieve, the original contract's set of legal rights and obligations. In contrast, a mercantile exchange that trades futures contracts offers a ready opportunity to enter into an offsetting contract that can precisely cancel the rights and obligations of another futures contract (because the counterparty legally is the futures exchange itself), and thus the mercantile exchange does constitute a market mechanism.

The above response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.