TIME for an April Fool joke? If only….

It’s Easter Monday. Europe is closed. The US wishes it were.  Along comes this scary headline…which is even scarier because it’s from a column in TIME written by a contributor: Why Derivatives May Be the Biggest Risk for the Global Economy.

We furiously click through the link to get to the entire article. We read through it, drawing nary a breath. We see claims (with absolutely no attribution or substantiation) that the OTC derivatives market is bigger than the BIS says it is. Which means the risks are even greater than many had supposed.

We are puzzled.

And then we come to the piece de resistance, the giveaway:

“…in theory, at least, the total losses could add up to more money than there is in the entire world.”

A moment of clarity descends upon us. We “get” it.

It’s April 1. The column is an April Fool’s Day prank.

It has to be…because the story simply makes no sense. The venerable TIME would never run a column that confuses its facts so badly. It mixes up notional amounts outstanding with the level of OTC derivatives risk outstanding (which is properly measured by market value). If you do a $100 million interest rate swap, you agree to exchange payments based on the $100 million notional amount. You don’t actually exchange the $100 million.

We know people sometimes find OTC derivatives confusing, but we had imagined that by now just about everyone gets this point (or at least everyone with the yank to write a column in TIME). Notional does not measure risk. In fact, the amount at risk in OTC derivatives typically averages about 4% of the notional outstanding. And it’s less after you factor in collateralization and netting (about 0.2% of notional).

Unfortunately, the misguided notions on notional are not all that’s wrong with the column. It also fails to recognize the significant growth in central clearing, the progress made in increasing regulatory transparency, the continuing efforts in collateral management – all of which help to reduce risk.

We’re glad April Fool’s Day only comes once a year.

Nothing to Hide

John and Sally like to trade with each other. They have conducted five derivatives trades. In three of the trades, John owes Sally $1 per trade. In the other two, Sally owes John $1 per trade. How much do John and Sally owe each other?

A. John owes Sally $3.
B. Sally owes John $2.
C. John owes Sally $1.

The correct answer – in jurisdictions in which the counterparties have signed ISDA Master Agreements and in which netting is legally enforceable – is C. And C is what firms that follow the US GAAP rules report on their financial statements (the “FASB approach”). Under IFRS rules, they would report A and B.

As the example makes clear, netting is a simple concept. Yet it remains subject to misunderstanding, as this recent article indicates.

Readers will recall we wrote on a similar topic not that long ago, so we won’t repeat our basic argument on the accounting treatment of netting here. But we do think it is important to point out a few additional facts.

First, as we stated in a paper on netting in 2010:

“the effect of the netting agreement is to treat all transactions done under it between two parties as a single legal whole with a single net value.”

This point is worth repeating because all transactions under an ISDA netting agreement will net to a single amount upon a counterparty event of default.

Another point worth repeating relates to the legal strength of the netting agreement. ISDA currently has 55 legal opinions on the enforceability of the Master Agreements netting provisions. And the close-out netting provisions of the ISDA Master Agreement have never, to our knowledge, been found to be unenforceable in instances in which ISDA has published an opinion confirming such enforceability.

In other words, netting is the law, netting works and netting accurately reflects the risks between counterparties. That’s why we believe the current FASB approach – which provides financial statement users with the net amount of exposure – is more accurate and transparent.

One final point: the first quarter of 2013 is the first period in which derivative market participants will provide expanded derivative disclosures. US GAAP filers already provide detailed derivative netting disclosures; and will provide further derivative netting information that would be achieved upon a counterparty event of default that cannot be recognized on the balance sheet today. IFRS filers will be required to provide detailed disclosures for the first time. So it will be interesting to see in the IFRS financial statements how much netting currently is being done and is already incorporated in them.

We’re sure there will be yet another round of comparisons between the two accounting approaches in the weeks to come. And that’s a good thing – it’s yet another opportunity to explain what netting is, how it works, and why ISDA has spent so much time and energy on it.

The Net-Net on Netting… and Risk

We’re the first to admit it: accounting isn’t easy… and that includes derivatives accounting. But it’s not exactly rocket science, either.

So we always feel mixed emotions (equal parts sympathy and dismay) when an article tries to cover an important derivatives accounting issue. A case in point: the recent Bloomberg story, US Banks Bigger Than GDP as Accounting Rift Masks Risk. The article is basically a criticism of the current US accounting treatment of OTC derivatives. We published a paper on this not long ago.

The US Financial Accounting Standards Board (FASB) permits the netting of exposures between counterparties on financial statements. This treatment mirrors the fact that in a number of jurisdictions, “netting IS DA law” (as we like to say around here). This means that netting is legally enforceable – a fact of law – and recognized as such by courts, regulators and market participants.

As a result, the accounting, legal and regulatory views on netting for US-based companies are aligned. So the outlier in this situation is actually the International Accounting Standards Board’s rules. These rules ignore the legal and regulatory consensus on netting and require firms to report their gross positions.

One result of all of this is that non-US firm balance sheets are larger than US firms’. We believe this ballooning of the balance sheet is artificial by virtue of the inclusion of both gross derivative assets and gross derivatives liabilities. The net amount is a better reflection of risk. For this reason, financial statements based on the FASB rules are more transparent.

Another result of the differences in approach is that firms deal with investors who are familiar with one, the other, or both sets of accounting rules. So firms also publish in their annual financial statements information that would be required if they followed the other set of accounting rules. In other words, firms that reflect net exposures in their balance sheets disclose the gross numbers in the footnotes.

That concludes the sympathy part of the emotional equation. Now on to the dismay part.

Despite what the Bloomberg story’s headline claims, risk is not being masked by the FASB rules. What’s being masked (in the story, at least) is the role of netting in reducing risk. In addition, in commenting on the size of derivatives exposure, the article could have made it clear that it was referring to notional amounts outstanding, which are not an accurate reflection of risk. As the BIS has published (and as can be seen in our
most recent Market Analysis
), the gross market value of outstanding OTC derivatives (at June 30, 2012) was about 4% of notional. After factoring in the impact of netting, credit exposure was 0.6% of notional. Collateralization reduces that credit risk even further.

So, net-net, netting does not mask anything. It actually presents the true face of risk.