What is a Derivative? Part 4 Net Settlement continued

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Let's get into net settlement. Last week I laid out the three forms of net settlement:

contractual, market mechanism, and readily convertible to cash.

Contractual Net Settlement

You would think that contractual net settlement would be fairly obvious. The contract will state that the counterparties will settle the contract by one of them paying the difference between a fixed price and the current market price and the other paying the difference between the contractual market price and the current market price. The counterparties don't both actually make payments; the two amounts are "netted" and the one in a loss position pays the other. This is how most swaps are structured.

Once again, it is the commodity contracts that muck up your day. The contract terms may not mention the above scenario. That is when you have to go look at the default clauses. Commodity contracts generally have two different sets of default clauses.

1. Force majeure - These are defaults that are either out of the company's control or macroeconomic events. Examples would be hurricanes, flooding, or a major strike. This default clause is almost always symmetrical, meaning the contract is net settled as described above in the event that an event of force majeure occurs. Force majeure default clauses do not trigger contractual net settlement and do not make the contract a derivative because the cause of the default is out of the company's control.

2. Regular default clauses - These defaults are completely under the control of the counterparty defaulting. Some examples are bankruptcy, or failure to pay. These default clauses are normally asymmetrical, meaning the defaulting party can not profit from defaulting.

The problem occurs when the regular default clauses are symmetrical. When the regular default clause says the parties will net settle upon a default event, the contract then contractually net settles and is subject to the derivative accounting rules in FASB 815.

When evaluating a commodity contract, you need to look at the default clause to make sure it is asymmetrical. You should also scan the other clauses in the contract to make sure someone didn't sneak any contractual net settlement language into the contract.

Market Mechanism

A market mechanism is a way to settle the contract outside of the contract. Some examples include the NY Stock Exchange (NYSE), the Intercontinental Exchange (ICE), and over the counter trades (OTC). (The OTC is a less formal exchange where contracts aren't actually traded but a market price can be determined using broker pricing quotes.)

To qualify as net settlement by a market mechanism:

1. the mechanism must allow one party to realize the net gain or loss through a net payment,

2. the party must be fully relieved of its right and obligations under the original contract,

3. liquidation of the net position does not require significant transaction costs.

Let's look at these individually:

1. The mechanism must allow one party to realize the net gain or loss through a net payment

   1. This is alluding to a formal exchange process like the NYSE.

2. The party must be fully relieved of its right and obligations.

   1. Entering into an offsetting contract does not necessarily relieve a counterparty of its rights and obligations under the contract. It might just offset the gain or loss of the original contract with the proceeds of the second contract. The company needs to verify that the original contract is actually cancelled through a clearing house or some other mechanism before it can state that it has been relieved of all its rights and responsibilities under the contract.

3. Liquidation of the net position does not require significant transaction cost.

   1. Under this characteristic a counterparty has to determine the costs of liquidating the contract, such as significant negotiation of the contract, the accessibility to potential counterparties, and binding prices being available.

Additionally, the counterparty needs to assess any assignment clauses that precludes a party from being relieved of all rights and obligations under the contract.

There are a lot of other examples in FASB 815 for market mechanism characteristics starting at 815-10-15-113 of the codification. (go to FASB.org to look it up)

That's enough for today. Next week we will look into net settlement through readily convertible to cash.

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