3. If a clearing house / exchange has a right to change the rules applicable to settlement processes, does this prevent offsetting from being applied?
The amendment to IAS 32 states that the right of set-off “must not be contingent on a future event” (AG38B) and explains in BC84 that "a right of set-off that could disappear or that would no longer be enforceable after a future event that could take place in the normal course of business or in the event of a default, or in the event of insolvency or bankruptcy, such as a ratings downgrade, would not meet the currently legally enforceable criterion…".
Therefore, if a clearing house / exchange has a right that is judged to be substantive and which allows it to change the rules in such a way that the right of set-off could disappear or no longer be enforceable, offsetting should not be applied.
This issue was initially raised in respect of Regulation 34 of the LCH.Clearnet Limited (‘LCH Limited’) rulebook, which allows LCH Limited to unilaterally vary its rules, effective for existing open contracts, such that the legal right to set off could be withdrawn. For this specific situation, it was concluded that Regulation 34 was not a substantive right that could be used to remove the right of offsetting, due to factors including:
- LCH Limited confirming that they did not currently envisage making any changes to the rulebook with the intention of removing a member’s legally enforceable right of set-off;
- oversight by multiple global regulators and the likelihood of their intervention in the event of any such change being proposed, given the impact on systemic credit risk;
- the adverse commercial consequences to LCH Limited of such a change, given the importance of offsetting to their clients; and
- the significant operational changes required by LCH Limited and all its members to settlement processes in the event of any such change.
So, Regulation 34 does not prevent offsetting from being applied to contracts, such as those transacted on the SwapClear or RepoClear platforms, with LCH Limited. For other clearing houses or exchanges with similar powers, the individual facts and circumstances will need to be separately assessed. However, the factors set out above are likely to be relevant in judging whether the powers are substantive and therefore prevent offsetting.
4. Where daily cash settlements contractually have to be made on a net basis for all derivatives with a particular counterparty, is it possible to offset an uncollateralised derivative asset and an uncollateralised derivative liability held with that counterparty?
Yes, but only if the two derivatives have matching terms so that all their cash flows will occur on exactly the same dates in all situations. If this is the case, under the daily net settlement process all future cash flows will be required to be settled net, so that the entity has a legal right to offset the derivative asset (that is, all the contracted cash flows) against the liability.
However, in a typical situation the two derivatives are unlikely to have matching terms, and so their cash flows will not all occur on exactly the same dates in all situations. In this case, the entity does not have a legally enforceable right to set off the derivative asset (that is, all the contracted cash flows) against the liability. This can be illustrated by a simple example, where the derivative asset and liability both have one remaining cash flow, which occurs in one month’s time for the asset and in two months’ time for the liability: the entity does not have the legally enforceable right to set off the recognised derivative asset against the liability, because the cash flows will occur on different dates and will not be net settled under the net settlement process.
5. Can cash collateral posted in respect of a portfolio of derivatives be offset against the balance sheet derivative positions?
As a simple example, an entity might have entered into a single derivative with a bank or clearing house. To reduce credit risk, the two entities might have agreed to post cash collateral periodically with each other equal to the fair value of the derivative. The posting of the collateral does not result in legal settlement of the outstanding balance. However, the terms of the collateral agreement are that the collateral will be used to settle the derivative as and when payments are due (as well as on a default or bankruptcy of either party) and both entities intend to settle this way.
If this is the case, the entity will have a legally enforceable right to set off the derivative and the collateral, and will intend to settle net. If market prices do not change, no further cash flows will arise. Any changes in the collateral balance post balance sheet date arise as a result of future events and are not relevant to the balance sheet date assessment. The offsetting requirements in IAS 32 are therefore met, and the collateral should be offset against the balance sheet derivative position. If, on the other hand, the cash collateral is not used to settle the derivative’s remaining cash flows, the offsetting requirements in IAS 32 are not met.
More typically, an entity will have a portfolio of derivatives with a bank or clearing house, rather than just a single derivative. If the net cash collateral required to be posted for the whole portfolio is the aggregate of the individual amounts of cash collateral for each derivative in the portfolio (each individual amount again being equal to the fair value of the derivative), the above analysis for a single derivative should be applied. This is done by firstly dividing the net cash collateral payable or receivable balance into the individual amounts relating to each derivative in the portfolio. For each individual derivative, the derivative balance is then offset against the associated collateral balance in the same way as described in the simple example above. In practice, in the absence of factors such as time delays between derivative fair value movements and cash collateral movements, this should result in the entire derivative portfolio being offset against the cash collateral balance.
In practice, bilateral OTC trades between a bank and an SME may not be subject to cash collateral netting in the ordinary course of business, with collateral payments made separately from derivative payments. As a result, further cash flows will arise, even if market prices do not move, and so offsetting is not permitted. Even where cash collateral netting is applied in the ordinary course of business, if this is just a matter of practice but the contracts between the bank and SME do not give them the contractually enforceable right to do this, the parties are still not permitted to offset.
6. What impact does the ability to post non-cash collateral (for example, securities) have on offsetting a derivative against collateral?
Non-cash collateral received (rather than posted) by an entity will not be recognised on- balance sheet, because it will fail derecognition in the transferor and so provides the entity with no accounting entry against which to offset on-balance sheet derivative positions. Therefore, consider a simple scenario where a firm has one trade that is an asset of 50 and another trade that is a liability of 50; if the liability matures first, cash of 50 will be paid by the firm to settle the liability, and securities of 50 will be received as collateral for the remaining asset trade of
50. As a result, the firm does not have the legally enforceable right to set off the recognised amounts (that is, the asset trade of 50 and the liability trade of 50), and so the requirements for offsetting are not met.
7. What impact does the existence of a physical settlement option have on offsetting a derivative against cash collateral?
In some situations, it is possible that a contract will be settled not by cash being paid but by the delivery of a physical asset. An example is an exchange-traded, cash-collateralised Credit Default Swap (CDS). Ordinarily, the cash collateral paid by an entity to the exchange is used to net settle the CDS liability when a credit event has occurred. However, on a credit event the exchange could settle the contract by retaining the cash collateral already paid by the entity and physically delivering to the entity the defaulted bond that is the reference asset underlying the CDS in return for the entity delivering additional cash equal to the difference between the bond principal and the cash collateral already paid. Exchange-traded commodity contracts are another example of contracts that can feature a physical settlement option.
By virtue of IAS 32.AG38B, the right of set-off must not be contingent on a future event and it must be enforceable in the normal course of business in the event of default and in the event of insolvency or bankruptcy. If the option to physically settle the contract can be imposed by the exchange and cannot be avoided by the entity, and the bond and cash are not settled simultaneously in accordance with IAS 32.AG38F, the entity’s ability to set off the cash collateral paid against the CDS liability is contingent on the decision of the exchange and is not legally enforceable in all circumstances, and so fails the requirements of IAS 32.AG38B. If the physical settlement option is solely at the discretion of the entity and not the exchange, this would not by itself prevent the entity from applying offsetting.
In some cases, it might be possible to demonstrate that the return of cash collateral, the delivery of the physical asset and the payment of any other monies required (for example, the exercise price) are settled simultaneously in accordance with IAS 32.AG38F and that offsetting should still be applied. However, this is likely to require very detailed analysis of the different scenarios that could arise and the payment mechanisms that would be used for each.
8. What impact might a ‘one way’ collateral posting arrangement have on applying offsetting?
Under a so-called ‘one way’ collateral arrangement between a firm and an exchange, cash margin is typically only required to be paid if a firm is in a net liability position. If the exchange is in a net liability position, it is not required to pay cash margin to the firm. Consider a simple scenario where a firm has one trade that is an asset of 50, another trade that is a liability of 30, and nil cash margin (because the exchange is in a net liability position); if the liability matures first, the firm will be required to pay 30 to the exchange to settle it. As the firm’s remaining position will be the asset of 50, under the ‘one way’ arrangement the exchange will remain in a net liability position, and so no margin payment will be made to the firm. On this analysis, the liability would not have been offset against the asset – if this had been the case, only a net payment of 20 would have been required. The requirement for an entity to have a legally enforceable right of offset is not therefore met, and so the positions should not be offset.
9. Do financial assets and liabilities that are subject to a legally enforceable arrangement for simultaneous settlement qualify for offsetting?
IAS 32.42(a) requires that offsetting be applied when, and only when, an entity currently has “a legally enforceable right to set off the recognised amounts”, including in the normal course of business. However, the settlement arrangements for a clearing house / exchange and its members might involve a member having:
- both the right and the obligation to settle transactions in the normal course of business through a gross settlement system that meets the characteristics set out in IAS 32.AG38F (that is, the outcome is in effect equivalent to net settlement);
- the right to actually set off and settle net in the event of the counterparty’s default/insolvency/bankruptcy; and
- an obligation to actually set off and settle net in the event of its own default/insolvency/bankruptcy, if the counterparty so elects.
In such a case, the entity does not have a legal right to actual net settlement that is enforceable in the normal course of business.
In our view, the requirement of IAS 32.42(a) to have a legally enforceable right to set off is still met in this scenario. This is supported by IAS 32.45 which explicitly states that: “A right of set- off is a debtor's legal right, by contract or otherwise, to settle or otherwise eliminate all or a portion of an amount due to a creditor by applying against that amount an amount due from the creditor”. In this scenario, the gross amounts are ‘eliminated’ during the settlement process, and it is irrelevant that such elimination is carried out by exchanging the gross amounts using a clearing system. In this situation, IAS 32.AG38F indicates the types of gross settlement process that have an outcome that is equivalent to net settlement in the normal course of business.
10. Can repos and reverse repos with different bond CUSIPs/ISINs be offset?
When offsetting a sale and repurchase agreement (repo) and a reverse repo under IAS 32, the asset and liability being offset are typically the cash payable on the repo and the cash receivable on the reverse repo, and not the bonds themselves, given that they might not even be on- balance sheet (see question #7). Therefore, offsetting can be applied, provided the terms of the cash payable and receivable meet the IAS 32 offsetting criteria, irrespective of whether the bonds underlying the repo and reverse repo are identical and have the same CUSIP/ISIN.
However, in practice the bonds and cash payments will typically all need to be settled through the same settlement institution (for example, a central securities depository (CSD), such as EuroClear or ClearStream) in order to settle the cash legs on a net basis or to realise them simultaneously in accordance with IAS 32.AG38F. This does therefore mean that the type of bond, and hence the CSD through which it settles, will restrict to some extent the repos and reverse repos that qualify for offset.