Cross-Border Derivatives Reporting System Becomes Operational

Questions and Answers

1. Question: Why is Treasury collecting this data?

Answer.

Global derivatives markets have grown substantially in recent years, and international cross-border derivatives contracts are a significant part of that market. The TIC form D collects information needed for the inclusion of derivatives transactions and positions in reports on cross-border transactions and holdings such as the U.S. Balance of Payments and the U.S. International Investment Position.

2. Question: What is a derivative?

Answer:

A derivative contract is a financial contract whose value is derived from the values of one or more underlying assets, reference rates, or indices of asset values or reference rates. Derivative contracts include interest rate derivative contracts, exchange rate derivative contracts, equity derivative contracts, commodity derivative contracts, and credit derivatives.

To be more technical, the TIC form D collects data on derivatives contracts that meet the FASB Statement No. 133 (FAS 133) definition. FAS 133 defines a derivative as a financial instrument or other contract with all three of the following characteristics:

a. It has (1) one or more underlyings (i.e., specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variable) and (2) one or more notional amounts (i.e., number of currency units, shares, bushels, pounds, or other units specified in the contract) or payment provisions or both. Those terms determine the amount of the settlement, and, in some cases, whether or not a settlement is required;

b. It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have similar response to changes in market factors; and

c. Its terms require or permit net settlement, it can be readily settled net by a means outside the contract, or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

3. Question: Why aren’t the derivatives data collected on existing TIC forms?

Answer:

Because of some important aspects of derivative contracts, a new reporting form was designed instead of trying to use existing TIC reporting forms.

There is an issue with collecting derivatives positions data on other TIC forms because, for some derivatives, it is not clear if the contract is a claim or a liability. For example, over the lives of derivatives such as interest rate swaps, the fair market value may be positive at times and negative at other times, possibly switching signs several times within a quarter. So these instruments are neither strictly claims, with consistently positive fair values and payments to U.S. resident counterparties to the contract, nor strictly liabilities, with consistently negative fair values and payments from the U.S. resident counterparty.

4. Question: Who reports derivatives data on the TIC Form D?

Answer.

All U.S.-resident banks, securities dealers, and other firms with worldwide holding of derivatives in their own and in their customers’ accounts exceeding $100 billion in notional value are required to file the data quarterly.

5. Question: How are the derivatives data reported by country – by the location of the transaction as is done with the S-data on transactions in long-term securities, or by the location of the holder as is done in the annual surveys of securities holdings?

Answer:

The gross fair (market) values and net settlement payments on derivatives are reported by country based on the residence of the direct foreign counterparty. Positions of foreign customers on U.S. exchanges are reported opposite the country in which the foreign counterparty resides. In the case of U.S. residents’ futures contracts on foreign exchanges, the country of the exchange is reported as the country of the foreign counterparty.

6. Question: What do some of the terms mean in the website tables on derivatives?

Answer.

(a) Fair (market) Value. Fair value is generally defined as the amount for which a derivative contract could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. If a quoted market price is available for a contract, the fair value is calculated as the number of trading units of the contract multiplied by the market price. If a quoted market price is not available, the institution’s best estimate of fair value based on the quoted market price of a similar contract or on valuation techniques such as discounted cash flows is reported (see FASB Statement No. 133, Appendix F, paragraph 540 for additional information about estimating fair (market) value.)

The fair value is different from a derivative’s “notional” amount, which is the number of currency units, shares, bushels, pounds, or other units specified in a derivative instrument and used to compute the payouts from the contract.

For example, consider a foreign exchange (FX) forward contract that specifies future delivery of $100 million to a foreigner at an exchange rate of 2.1 foreign currency units (fcu) per dollar. For this contract the notional value of the contract is $100 million, and if the market exchange rate on the delivery date is 2.0 fcu/$ then the fair value is $5 million. A review of the settlement may help explain the fair value. The foreigner sends fcu 210 million, under the contract terms, and the U.S. party converts it into $105 million, of which $100 million is placed in the foreigner’s account and $5 million is retained as net settlement of the forward contract. Continuing further with this example, the U.S. balance of payments accounts would record a $105 million increase in FX holdings, a $100 million increase in bank liabilities to foreigners, and a positive $5 million inflow on the derivatives account.

(b) Over-the-Counter (OTC) and Exchange-Traded contracts. The terms of OTC contracts such as forwards are negotiated on a contract-by-contract basis between the two parties to the contract. Contracts such as futures that trade on organized exchanges have standardized contract dates, contract terms, and quantities.

(c) Forwards and futures. Forwards are OTC contracts that represent agreements for delayed delivery of financial instruments or commodities in which the buyer agrees to purchase and the seller agrees to deliver, at a specified future date, a specified commodity or instrument at a specified price or yield. Futures contracts are similar to forwards, except that they trade on exchanges and are subject to daily settlement of profits and losses (variation margin).

(d) Options. Contracts that convey either a right or an obligation to buy or sell a financial instrument at a specified price by a specified future date. Options may trade on an organized exchange or in OTC markets.

-- Bought Options: The buyer of an option contract has, for compensation (such as a fee or premium), acquired the right (or option) to sell (put) or purchase (call) the specified amount of the underlying or its cash equivalent at a stated price on a specified future date.

-- Written Options: The seller (writer) of the contract has, for compensation, become obligated to purchase or sell the specified amount of the underlying or its cash equivalent at a stated price on a specified future date at the option of the buyer of the contract.

(e) Swaps. Contracts in which two parties agree to exchange assets or their cash equivalent, or periodic interest payments in the case of interest-rate swaps, based on a specified notional amount for a specified period.

(f) U.S. Net Settlements with Foreign Residents. Net Settlements include all cash receipts and payments made during the quarter for the acquisition, sale, or final closeout of derivatives, including all settlement payments under the terms of derivatives contracts such as the periodic settlement under a swap agreement and the daily settlement of an exchange-traded contract. In calculating Net Settlements, U.S. receipts of cash from foreign persons are positive amounts (+), and U.S. payments of cash to foreign persons are negative amounts (-). Items excluded from Net Settlements are: (a) commissions and fees (they are regarded as transactions in financial services rather than as transactions in derivatives); (b) collateral including initial and maintenance margins, whether or not in the form of cash; and (c) purchases of underlying commodities, securities, or other non-cash assets. (e.g. the purchase/sale by foreigners of a long-term security is reported on TIC Form S).

The following are some examples of net settlements:

Example 1. A U.S. resident purchases call options on equities listed on a foreign exchange for a $5 million premium. The options appreciate in value to $12 million and are then exercised for the underlying equities. The cash premium payment should be reported as a negative $5 million in U.S. Net Settlements, because it was a U.S. payment to foreigners. The increase in value of the options to $12 million is not reported in U.S. Net Settlements because there was no cash settlement. The underlying purchase of foreign equities is recorded on other TIC reports.

Example 2: Two commodity forward contracts (one on copper and one on oil) are entered into by a U.S. entity reporter and settled during the current reporting quarter. The copper contract had a negative market value of $20 million to the U.S. reporter when it was cash settled. The $20 million payment is reported as a negative value in U.S. Net Settlements, because it represents a cash payment to extinguish the forward contract. The oil contract had a positive market value of $20 million to the U.S. reporter at the time it was settled via physical delivery of oil in lieu of cash. There would be no entry in U.S. Net Settlements, because a commodity, not cash, was exchanged.

Department of Treasury

April 27, 2007