Net settlement under the terms of the contract is met if neither party is required to deliver an asset that is associated with the underlying and that has a principal amount, stated amount, face
value, number of shares, or other denomination that is equal to the notional amount (or the notional amount plus a premium or minus a discount). Net settlement may be made in cash or by delivery of any other asset, whether or not that asset is readily convertible to cash.
Net settlement through a market mechanism is achieved if one of the parties to a contract is required to deliver
an asset of the type described in ASC 815-10-15-100, but there is an established market mechanism that facilitates net settlement outside the contract. Many derivatives are traded on exchanges. Other qualifying market mechanisms include, among others, over-the-counter arrangements, and private transactions where there are multiple market participants will and able to enter into a transaction at market prices. Evaluation of the this criteria should be made at inception of the contract and throughout its life. If a market mechanism for net settlement disappears after the initial assessment, and there is no other means for achieving net settlement, then the net settlement criteria is not met and the instrument no longer meets the definition of a derivative.
Net settlement through delivery of a derivative contract or asset that is readily convertible to cash is met if the “readily convertible to cash” criteria in the glossary to ASC 815 are met. The characteristics include: (1) interchangeable (fungible) units, and (2) quoted prices that are available in an active market, which can rapidly absorb the quantity held by an entity without significantly affecting the price. These characteristics often make thinly traded commodities and stocks unable to meet the criteria, even if the owner might be able to borrow using the assets as collateral. One way to evaluate this criteria is to estimate the amount of cash that would be received in a net settlement arrangement versus the amount of cash that would be received by converting the asset or derivative received to cash. If the difference is significant, say more than 10%, then the asset or derivative is probably not readily convertible to cash under this definition.