FASB Net Settlement Provisions

FASB: Net Settlement Provisions

Derivatives Implementation Group

Statement 133 Implementation Issue No. A3

Title: Definition of a Derivative: Impact of Market Liquidity on the Existence of a Market Mechanism
[Previously titled: Net Settlement Provisions]
Paragraph references:
6(c), 9(b), 57(c)(2)
Date cleared by Board: February 17, 1999

QUESTION

Does the liquidity of the market for a group of contract affect the determination of whether under paragraph 9(b) there is a market mechanism that facilitates net settlement under paragraph 9(b)? For example, assume a company contemporaneously enters into 500 futures contracts, each of which requires delivery of 100 shares of an exchange-traded equity security on the same date. The contracts fail to meet the criterion in paragraph 9(a) because delivery of an asset related to the underlying is required. The futures contracts trade on an exchange, which constitutes a market mechanism under which the company can be relieved of its rights and obligations under the futures contracts. However, the quantity of futures contracts held by the company cannot be rapidly absorbed in their entirety without significantly affecting the quoted price of the contracts.

RESPONSE

No. The lack of a liquid market for the group of contracts does not affect the determination of whether under paragraph 9(b) there is a market mechanism that facilitates net settlement because the test in paragraph 9(b) focuses on a singular contract. The exchange offers a ready opportunity to sell each contract, thereby providing relief of the rights and obligations under each contract.

Paragraph 57(c)(2) elaborates on the phrase market mechanism that facilitate net settlement and states that "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." The possible reduction in price due to selling a large futures position is not considered to be a transaction cost under that paragraph.

Whether the number of shares deliverable under the group of futures contracts exceeds the amount of shares that could rapidly be absorbed by the market without significantly affecting the price is not relevant to applying the criterion in paragraph 9(b).

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.