In the 19th century, farmers would bring their full season’s crop to the market. But they couldn’t forecast supply and demand, so some crops would go to waste. Conversely, if anyone wanted to buy that crop out of season, they were forced to pay high prices due to scarcity.
To solve this problem, farmers and consumers gathered at central markets and agreed to forward delivery of their crops: the first example of a “futures” contract in action. The humble roots of these first futures contracts are still visible today, in everything from newspaper subscriptions to complex investment products. By definition, futures address the uncertainties of the changing investment market and hedging against risk. These uncertainties make clear reporting and accurate reconciliation even more important for futures. Understanding the reporting and data visibility issues inherent to futures can help in determining whether these non-traditional assets fit into your company’s investment strategy.
A futures contract (future) is a standardized financial contract where a buyer or seller agrees to purchase or sell an underlying asset at a predetermined future date (delivery date) and at a particular price (forward price). Futures include physical commodities and financial instruments, and are considered a derivative because their value is based on their specific underlying asset.
Buyers and sellers work with futures at the futures exchange, which is a centralized marketplace for investors around the world to enter into futures contracts. The futures market is extremely liquid, and the risks of very large losses are balanced by the possibility of extremely large gains.
Futures are traded in a batch manner, which means that a future on 100 underlying assets can be traded as a single unit or contract. An investor opening a futures contract must deposit a minimum amount of money into a margin account (known as an Initial Margin Requirement, or IMR). The IMR is a guarantee from the exchange against any default risk from either party entering into the contract. The margin account increases or decreases daily as market values of the positions change.
A Maintenance Margin Requirement (MMR) with a certain minimum allowed in the margin account is also key to a futures contract. If market values of the positions decrease and the balance goes below the MMR value, then the holder of the account is required to post additional cash or collateral to bring the balance back up to the IMR. After a margin call, brokers must deliver funds immediately, or the brokerage can liquidate the investor’s position and their right to any additional deficit from closing the contract. For hedging investors (who have physical ownership of the underlying asset) or spread traders (who have a balanced position on offsetting contracts) the MMRs are often reduced or waived.
Futures are unique in that the current market value of a future is the difference between the current quoted price and the entry price for that position. Because of the entry price, market value has to be calculated at lot level. This complexity is especially challenging when reporting on futures.
Minimum price movements, or ticks, present another reporting challenge. Tick sizes can vary for specific futures contracts, which can cause confusion when calculating the market value.
The relationship between the margin balance and the futures contracts means that futures reconciliation is also often more complicated than traditional asset reconciliation.
The applicable NAIC guidance for derivatives can be found in SSAP 86. This guidance focuses on the three categorizations of applicable derivative strategies: hedging, income generation, and replication.
The NAIC requires futures to be reported on Schedule DB Part B of an insurers’ filings. Quarterly holdings, annual disposals, and holding reports must be disclosed. The DB reports can be difficult for insurers to automate, given the level of subjectivity and strategy-based decisions that need to be made.
Investors looking to hedge their risk against market swings or speculate on price changes often look to futures as a potentially valuable addition to their portfolios. While futures can generate high yields and hedge against risk of market fluctuations, they also have potential for very serious losses.
Investors evaluating futures for their portfolio need to consider their own tolerance for loss, especially because any changes to market value flow through the holding gain and loss amounts and impact the income statement directly.
Clearwater’s ability to automate reconciliation and general ledger accounting, along with the user-friendly Clearwater interface, gives investors in-depth data visibility and reporting flexibility. Clearwater’s automated reconciliation eases scalability concerns with incorporating futures’ complex reporting and regulatory needs.
Clearwater follows the fair value accounting guidance1 for derivatives, where all changes in market value flow through the income statement. As such, all changes in market value for futures flow through the holding gain/loss amounts (similar to a security designated as trading under FAS1152) and impact the income statement directly.
Clearwater also takes an unrealized gain/loss approach in reporting the market value of futures contracts. Factoring in the contract size in this approach makes for more accurate reporting on the leveraged portfolio return.
For more information on how Clearwater can help you integrate and simplify your investment accounting, reporting, and analytics for non-traditional asset classes, contact us or visit our complex accounting and reporting center for more resources.