Netting and Offsetting: Reporting derivatives under U.S. GAAP and under IFRS May 2012 The paper is intended to give the reader an insight into the different offsetting requirements under IFRS and U.S. GAAP and their impact on the new Basel III Leverage Ratio. ISDA believes that net presentation, in accordance with U.S. GAAP, provides the most faithful representation of an entity’s financial position, solvency, and its exposure to credit and liquidity risk. Individual derivative transactions that are subject to enforceable master netting agreements should be eligible for netting in the balance sheet on the basis that such financial statement presentation is most faithfully representative of an entity’s resources and claims and provides the most useful information for investment decisions. For further information, contact: Antonio Corbi [email protected] ©2012 International Swaps and Derivatives Association, Inc. 2 Authorship: The author of this paper is Antonio Corbi, B.Sc. (Econ), M.Sc. (Econ), FCCA, MCSI, ISDA’s Assistant Director, Tax and Accounting. He would like to thank the following for their contributions: Tom Wise and Dan Palomaki, co-chairs of ISDA’s European and North America accounting policy committees; Peter Sime, ISDA’s Head of Risk and Research; and Matthew Cary Esposito, member of ISDA’s North America accounting policy committee. Abbreviations: CCP Central Counterparty CDS Credit Default Swap BCBS Basel Committee on Banking Supervision BoE Bank of England FASB Financial Accounting Standards Board FPC Financial Policy Committee FSB Financial Stability Board FX Foreign Exchange G20 The Group of Twenty1 GNFV Gross Negative Fair Value GPFV Gross Positive Fair Value IASB International Accounting Standards Board IFRS International Financial Reporting Standards MNA Master Netting Agreement NCCE Net Current Credit Exposure OCC United States Office of the Comptroller of the Currency OTC Over-the-Counter Repo Repurchase and Reverse Repurchase transactions The Boards The Board of the IASB and the Board of the FASB U.S. GAAP U.S. Generally Accepted Accounting Principles VaR Value at Risk 1 The G20 is the international economic forum, which includes 19 country members and the European Union, that represents around 90 per cent of global GDP, 80 per cent of global trade and two-thirds of the world’s population. Netting and Offsetting: Reporting derivatives under U.S. GAAP and under IFRS May 2012 3 Table of Contents Executive summary .................................................................................................................. 4 Background ............................................................................................................................... 6 1) Reporting ‘net’ vs. ‘gross’ .................................................................................................. 8 2) Fundamental concepts: netting, offsetting and set-off .................................................. 9 2.1) Set-off ............................................................................................................................... 9 2.2) Netting ............................................................................................................................. 10 2.3) Offsetting ........................................................................................................................ 13 2.4) A risk management tool ................................................................................................. 13 2.5) Existing offsetting models ............................................................................................. 13 3) Why are derivatives different? ........................................................................................ 14 4) How derivatives are managed .......................................................................................... 15 4.1) Main characteristics ....................................................................................................... 15 4.2) Portfolio management .................................................................................................... 17 4.3) Cash flows ...................................................................................................................... 17 5) The efficacy of netting and collateral as risk mitigation techniques.......................... 19 5.1) Systemic Risk ................................................................................................................. 19 5.2) Volatility ......................................................................................................................... 20 5.3) Liquidity and collateral .................................................................................................. 21 6) Two different accounting models ................................................................................... 22 6.1) Scope ............................................................................................................................... 22 6.2) The IFRS offsetting model ............................................................................................ 23 6.3) The U.S. GAAP offsetting model ................................................................................. 25 6.4) Differences between IFRS and U.S. GAAP ................................................................. 26 6.5) Specific application guidance ........................................................................................ 28 6.6) Advantages and disadvantages ...................................................................................... 29 7) Common offsetting disclosures ....................................................................................... 30 7.1) Scope ............................................................................................................................... 31 7.2) Disclosures ...................................................................................................................... 31 8) Un-weighted leverage ratio .............................................................................................. 32 ANNEX .................................................................................................................................... 34 Netting and Offsetting: Reporting derivatives under U.S. GAAP and under IFRS May 2012 4 Executive summary Historically, the Europe-based International Accounting Standards Board (IASB) has permitted significantly less balance sheet offsetting than the U.S.-based Financial Accounting Standards Board (FASB). This paper sets out the key differences between these approaches and explains the reasoning that leads to the current position. The terms of netting, offsetting and set-off are often used to express the same notion but they are very different concepts. A better understanding of the terminology and the way in which derivatives are traded, managed and settled provides an understanding of why U.S. GAAP accounting standard setters have consistently agreed to reporting derivatives net rather than gross on the balance sheet and why this differs from reporting under International Financial Reporting Standards (IFRS). The paper covers the following topics: • Why is netting/offsetting an issue? • Differences between securities, loans, receivables and derivatives • Portfolio management • The Interest Rate Swap and Credit Default Swap markets • The efficacy of netting and collateral as risk mitigation techniques • The offsetting rules under U.S. GAAP and IFRS • Criteria for derivatives and repo markets • New offsetting disclosures • The new Basel III Leverage Ratio The paper is intended to give the reader an insight into the different offsetting requirements under IFRS and U.S. GAAP and their impact on liquidity, collateral and the new Basel III Leverage Ratio. The paper articulates the reasons ISDA favours reporting derivatives ‘net’ instead of ‘gross’ on the face of the balance sheet. ISDA believes that net presentation, in accordance with U.S. GAAP, provides the most faithful representation of an entity’s financial position, solvency, and its exposure to credit and liquidity risk. Individual derivative transactions that are subject to enforceable master netting agreements should be eligible for netting in the balance sheet on the basis that such financial statement presentation is most faithfully representative of an entity’s resources and claims and provides the most useful information for investment decisions. The basis for our view is that, upon termination of transactions subject to a master netting arrangement, the individual derivative receivables do not represent resources to which general creditors have rights and individual derivative payables do not represent claims that are pari- passu to the claims of general creditors. Upon termination of a contract by the nondefaulting party, derivative asset “resources” are unavailable to satisfy other claims; further, the net termination amount (including the collateral amounts) under the Close Out Netting provisions Netting and Offsetting: Reporting derivatives under U.S. GAAP and under IFRS May 2012 5 of the ISDA Master Agreement is not subject to stay under bankruptcy laws which govern the most significant capital markets, unlike other claims. Accordingly, we believe that the current U.S. GAAP principles are superior. The paper is recommended for anyone seeking a deeper understanding of the practical application of the offsetting