Therefore, because of the inherent checks and balances in business functions, there would be no danger of undervaluing positions. The ISDA goes a step further in its supports of GAAP valuations and asserts that there is no practical alternative to the use of GAAP financial reporting values for over-the-counter (OTC) derivatives contracts to comply with Sec. 475. The comments go on to say that:
“To ISDA’s knowledge, all dealers now use the adjusted mid-market method for both financial reporting under GAAP and complying with Sec. 475. There is thus no difference between the mark-to-market methodologies used by dealers for these two purposes. The same method, the adjusted middle-market methods is used for both.”
According to the ISDA, no difference exists between marking to market (to mid-market) for both financial reporting under GAAP and complying with Sec. 475.
3.2 Description of GAAP mark-to-market in practice
Industry members attempted to clarify and illustrate actual accounting practices to support the appropriateness of the use of GAAP for mark-to-market valuations.
The ISDA asserted that all dealers use the adjusted mid-market method to value their OTC derivatives contracts under GAAP, and goes on to explain the basic theory and approach of the adjusted middle-market method. Mid-market valuation values and derivatives portfolio at the middle of the current market (the average of bid and offer prices), less specific adjustments. Once mid-market values have been determined, future cash flows are generated based on implied forward curves and prices. There cash flows are then discounted back using a zero-coupon curve, which is generated from the mid-market value of the portfolio. The net present value of the cash flow represents the mid-market value of the portfolio. Once the mid-market value of the portfolio is determined, dealers make adjustments to these mid-market values in order to determine the actual value of their OTC derivatives under GAAP. Possible adjustments to these values include mid-market and model adjustments, as well as portfolio adjustments. Portfolio adjustments include adjustments for market risk and credit adjustments, as well as administrative and other portfolio adjustments.
The ISDA points out that dealers use different names and categories when making these adjustments, but they are all intended to determine fair market value accurately. All adjustments reflect factors that participants in derivatives markets must take into account in determining fair market value.
“There differences in nomenclature and technique are all compatible with GAAP and should be irrelevant under a safe harbour based on book-tax conformity, particularly where, as is proposed here, the safe harbour will require non-tax business uses. […], that requirement, together will competitive pressures, will ensure dealers have incentives to determine and report values accurately.”
The SIA also discusses the adjusted mid-market method for valuing derivatives, “as it is currently employed by all derivatives dealers of which we are aware”. OTC derivatives are valued using pricing models that determine the present value of estimated future gross cash flows. The values produced by these pricing models are intended to reflect the price for a derivative that is at mid-point between the prevailing bid and ask prices. There mid-market valuations effectively value the anticipated future gross from a position. It is then necessary to make additional adjustments to the mid-market values in order to arrive at the adjusted mid-market value of a dealer’s portfolio of OTC derivatives.