JPMORGAN CHASE WHALE TRADES: A CASE HISTORY OF DERIVATIVES RISKS AND ABUSES

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bid-ask spread and midpoint price for derivatives of interest. 614 Some financial firms employ
independent price reporting services to identify, for a fee, the bid-ask spread and midpoint prices
of specified derivatives for use in their financial reporting. 615
Still other firms use their own
personnel to identify the daily bid-ask spread and midpoint prices for their derivatives.
Although GAAP essentially provides a safe harbor for midpoint prices, it does not
compel firms to use them. For example, if a trade were to occur late in the day at a price near the
extreme end of the daily price range (bid-ask spread), GAAP would allow a market participant to
use that price (versus the mid-price) if it were to determine that the end-of-day price was “most
representative of fair value in the circumstances.” 616
Because GAAP requires derivative values to be recorded each business day in accordance
with market values, derivatives are often characterized as “mark-to-market.” The values or
prices assigned to the derivatives each day are often referred to as the daily “marks.” Under
GAAP, the value of every derivative must be recorded or “mark-to-market” each day in a
company’s books, even if the derivative was not actually purchased, sold, or otherwise actively
traded. The daily gain or loss is typically reported internally by each business line within a firm
and rolled up into a firmwide daily profit and loss statement.
Because derivative values often fluctuate, parties to a derivative agreement often agree to
post cash collateral on an ongoing basis to cover the cost of settling the derivatives contract. The
amount of cash collateral that has to be posted typically changes periodically to reflect the fair
value of the derivative. If a dispute arises over the value of the derivative and the amount of
collateral to be posted, the parties typically negotiate a resolution of the “collateral dispute.”
As part of establishing the fair value of derivatives, pricing adjustments are also
sometimes made when the derivatives are, for example, traded in less liquid markets, 617 or are
part of a large holding whose size might affect the price. 618
Parties with derivative portfolios
may also establish a reserve, known as a fair value adjustment, based on such considerations as
the illiquidity of the market, the creditworthiness of its derivative counterparties, the extent to
614
See, e.g., Markit Group, Ltd., a global financial information services company that administers multiple credit
index products, and publishes the daily bid-ask spread and midpoint price for them on its website at
www.markit.com. Markit Credit Indices: A Primer (October 2012), at 7, 12; see also
http://www.markit.com/en/products/data/indices/credit-and-loan-indices/cdx/cdx-prices-iframe.page.
615
JPMorgan Chase’s Investment Bank, for example, took this approach.
616
Accounting Standards Codification Topic 820-10-35-24B, Fair Value Measurements and Disclosures (ASC
820).
617
See Accounting Standards Codification Topic 820-10-35-54D, Fair Value Measurements and Disclosures (ASC
820) (“If a reporting entity concludes that there has been a significant decrease in the volume or level of activity for
the asset or liability in relation to normal market activity for the asset or liability (or similar assets or liabilities),
further analysis of the transactions or quoted prices is needed.”).
618
See, e.g., 1/16/2013 “Report of JPMorgan Chase & Co. Management Task Force Regarding 2012 CIO Losses,”
http://files.shareholder.com/downloads/ONE/2288197031x0x628656/4cb574a0-0bf5-4728-9582-
625e4519b5ab/Task_Force_Report.pdf (hereinafter “2013 JPMorgan Chase Task Force Report”), at 49, footnote 60
(“By convention, the exit price is estimated for normal trading size, and CIO was not required to estimate the prices
it would have received if it attempted to sell its entire (large) position at once.”). See also 5/10/2012 JPMorgan
Chase Controllers special assessment of CIO’s marks, January to April 2012, at 5, JPM-CIO 0003637-654, at 641
(“GAAP continues to permit size-based adjustments for derivatives portfolios if an election is made to do so.”).