FASB Definition of a Derivative Existence of an Established Market Mechanism That Facilitates Net Settlement under Paragraph 9(b)

FASB: Definition of a Derivative: Existence of an Established Market Mechanism That Facilitates Net Settlement under Paragraph 9(b)

Derivatives Implementation Group

Statement 133 Implementation Issue No. A21

Title: Definition of a Derivative: Existence of an Established Market Mechanism That Facilitates Net Settlement under Paragraph 9(b)
Paragraph references: 9(b), 57(c), 260–262
Date cleard by Board: March 13, 2002
Date posted to website: April 10, 2002

QUESTION

What constitutes an established market mechanism that facilitates net settlement under paragraph 9(b) of Statement 133?

BACKGROUND

Paragraph 9 states, in part:

    Net settlement. A contract fits the description in paragraph 6(c) if its settlement provisions meet one of the following criteria:

  1. One of the parties is required to deliver an asset of the type described in paragraph 9(a), but there is a market mechanism that facilitates net settlement, for example, an exchange that offers a ready opportunity to sell the contract or to enter into an offsetting contract.

Paragraph 57(c) states, in part:

    A contract that meets any one of the following criteria has the characteristic described as net settlement:

(2)    There is an established market mechanism that facilitates net settlement outside the contract. 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’s basis for conclusions (paragraphs 260 and 261) states, in part:

    The Board focused in the Exposure Draft on whether there is a mechanism in the market for net settlement because it observed that many derivative instruments are actively traded and can be closed or settled before the contract's expiration or maturity by net settlement in active markets.

    Respondents observed that the phrase mechanism in the market was unclear and could lead to different interpretations in practice. They asked whether only an organized exchange would constitute the type of market mechanism that the Board had in mind, or whether a willingness of market participants to enter into such a contract in the over-the-counter or other markets would require that the contract be viewed as a derivative instrument. This Statement responds to those questions by indicating in paragraph 57(c)(2) that the Board intends market mechanism to be interpreted broadly to include any institutional arrangement or side agreement that permits 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.

RESPONSE

Statement 133 indicates in paragraph 57(c)(2) that the term market mechanism should be interpreted broadly. That indicates that market mechanisms may have different forms. However, regardless of its form, an established market mechanism as contemplated by paragraph 9(b) must have all four of the primary characteristics described below. In addition, entities should consider the indicators below each of the primary characteristics in determining whether a method of settling a contract qualifies as an established market mechanism under paragraph 9(b). All of the indicators need not be present for an entity to conclude that a market mechanism exists for a particular contract.

  1. It is a means to settle a contract that enables one party to readily liquidate its net position under the contract. A market mechanism is a means to realize the net gain or loss under a particular contract through a net payment. Net settlement may occur in cash or any other asset. A method of settling a contract that results only in a gross exchange or delivery of an asset for cash (or other payment in kind) does not satisfy the requirement that the mechanism facilitate net settlement as contemplated by paragraph 9(b).

    As discussed in Statement 133 Implementation Issue No. A3, "Impact of Market Liquidity on the Existence of a Market Mechanism," the assessment of whether a market mechanism exists under paragraph 9(b) should be performed on an individual contract basis, not on an aggregate-holdings basis.

    The following are indicators that primary Characteristic 1 is met:

    • Access to potential counterparties is available regardless of the seller’s size or market position.

    • Risks assumed by a market maker as a result of acquiring a contract can be transferred by a means other than by repackaging the original contract into a different form.

  2. It results in one party to the contract becoming fully relieved of its rights and obligations under the contract. A market mechanism enables one party to the contract to surrender all future rights or avoid all future performance obligations under the contract.

    Contracts that do not permit assignment of the contract from the original issuer to another party do not meet the characteristic of net settlement in paragraph 9(b). With respect to contracts that permit assignment, as discussed in Statement 133 Implementation Issue No. A7, "Effect of Contractual Provisions on the Existence of a Market Mechanism That Facilitates Net Settlement," an issuer must assess the substance of an assignment clause to determine whether it precludes the assigning party from being relieved of all rights and obligations under the commitment. If it is reasonably possible or probable that the counterparty will withhold permission to assign the contract, the issuer is prevented from accessing any market mechanism that may exist. As a result, the contract does not meet the characteristic of net settlement in paragraph 9(b). However, for contracts where there is no impediment to assignment (because it is explicitly permitted by the terms of the contract or assignment is allowed with the counterparty’s permission and it is remote that the counterparty will withhold permission to assign the contract), an assessment must be made regarding the existence of a market mechanism under paragraph 9(b).

    Statement 133 Implementation Issue No. A15, "Effect of Offsetting Contracts on the Existence of a Market Mechanism That Facilitates Net Settlement," indicates that 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 (unless an offsetting contract with the same counterparty relieves the entity of its rights and obligations under the original contract). Generally, the offsetting contract carries a new set of legal rights and obligations, which offset, rather than relieve, the original contract’s set of legal rights and obligations.

    The following are indicators that primary Characteristic 2 is met:

    • There are multiple market participants willing and able to enter into a transaction at market prices to assume the seller’s rights and obligations under a contract.

    • There is sufficient liquidity in the market for the contract, as indicated by the transaction volume as well as a relatively narrow observable bid/ask spread.1

  3. Liquidation of the net position does not require significant transaction costs. For the purposes of assessing whether a market mechanism exists under paragraph 9(b), an entity should consider transaction costs to be significant if they are 10 percent or more of the fair value of the contract.

  4. Liquidation of the net position under the contract occurs without significant negotiation and due diligence and occurs within a time frame that is customary for settlement of the type of contract. A market mechanism facilitates easy and expedient settlement of the contract. As discussed under primary Characteristic 1, those qualities of a market mechanism do not preclude net settlement in assets other than cash.

    The following are indicators that primary Characteristic 4 is met:

    • Binding prices for the instrument are readily obtainable.

    • Transfers of the instrument involve standardized documentation (rather than contracts with entity-specific modifications) and standardized settlement procedures.

    • Individual contract sales do not require significant negotiation and unique structuring.

    • The closing period is not extensive because of the need to permit legal consultation and document review.

EFFECTIVE DATE AND TRANSITION

The effective date of the implementation guidance in this Issue for each reporting entity is the first day of the first fiscal quarter beginning after April 10, 2002. If an entity had not accounted for a contract as a derivative in its entirety but is required to do so, the entity shall account for the effects of initially complying with the implementation guidance in this Issue prospectively for all existing contracts as of the effective date of this Issue and for all future transactions. In that case, the effects of initially applying this guidance should be reported as a change in accounting principle. If a contract that would not be accounted for as a derivative instrument under this Issue was previously accounted for as a derivative instrument, that accounting treatment shall not be changed. That is, for those contracts, this Issue applies prospectively only to transactions after the effective date.


__________________
1A bid/ask spread is the difference between the highest price a buyer will pay to acquire an instrument and the lowest price at which any investor will sell an instrument.


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.