Variation Margin changes for Cleared Derivatives

The Chicago Mercantile Exchange (CME) and the London Clearing House (LCH) have changed the rules such that variation margin is now legally characterized as settlements as opposed to collateral.

The CME rule changes were effective 1/3/17 which will impact calendar year clients in Q1. The LCH changed its rules in 2016, but counterparties can opt for the change and if they opt in when the change is effective. These swaps are now considered settled-to-market (STM) rather than collateralized-to-market (CTM) contracts.

Why the change?

The change stems from the financial crisis of 2008. Lawmakers and regulators worldwide have taken steps to increase liquidity and reduce counterparty credit risk in the OTC derivatives market. Dodd Frank domestically and the European Market Infrastructure Regulation abroad, require central clearing for certain OTC derivatives. The two parties to a centrally cleared derivative exchange daily payments reflective of the daily change in value of the derivative – variation margin. Historically, these payments have been treated and accounted for as collateral and interest was paid by the party receiving the payments. Collateral is treated separately from derivatives for accounting purposes so posters recorded a receivable and the party receiving the collateral recorded a deposit liability. Interest income and expense was accrued by both parties and recorded in the P&L.

What is the impact?

The International Swaps and Derivatives Association (ISDA) has taken the lead on how to apply these rules changes. They reached out to the SEC and the SEC staff has stated that they do not object to the following conclusions:

• Variation payments deemed to be legal settlements would be considered as a single unit of account with the derivative for accounting and presentation purposes
• Hedge accounting relationships can continue uninterrupted by the legal characterization change.

Variation Margin Impact – The initial thought is that the amount exchanged will not change as a result of the rule changes.

Balance Sheet Impact – The variation margin will no longer be characterized as a receivable or deposit liability. Instead, they will be included as part of the derivative mark to market (MTM) which will bring the MTM to zero or near zero. Under the old rules, the entity had the choice of netting the collateral against the derivative and after the re-characterization, not netting will no longer be a choice.

Income Statement Impact – The interest on the variation margin may need to be presented in the P&L in the same line item as the derivative changes for non-designated derivatives. In addition, if unrealized and realized gains and losses are tracked separately, the change in MTM will now be classified as realized rather than unrealized. You should consult with your tax specialist about possible tax consequences.

Hedge Accounting Impact – Many practioners were worried that the change in the variation margin legal characterization from a separate unit of account to the same unit of account as the derivative would qualify as a change to the critical term of the derivative necessitating a dedesignation/redesignation. The SEC staff has indicated that this will not be necessary. The SEC also noted that the change in legal characterization would not disqualify a derivative from using the shortcut method (applicable to interest rate swaps only) in and of itself.

Disclosure Impact – The SEC indicated that derivative disclosures under ASC 815 would continue to apply. Since the fair value when you include the variation margin would be zero or near zero on a gross basis per instrument, the offsetting tables will show zero in the first column. The ASC 820-10 table that shows the level (1,2 or 3) of the derivative will be impacted as will the 815-10 table that shows the assets on the left and the liabilities on the right and where the amounts are booked.
Subsequent Event Impact – One of the big four accounting firms is recommending that the re-characterization is disclosed as a Type II subsequent event at year-end.

Next Steps – Accounting firms and the SEC are encouraging companies to conduct a thorough legal analysis in reaching appropriate accounting conclusions resulting from the characterization change. In addition, other Central Clearing Parties are in different stages of implementing similar rule changes so companies are encouraged to continue to monitor the situation of their clearing houses.