Issues Involving Close-out Netting and Collateral for OTC Derivatives Transactions – A Japanese and International Finance Law Perspective
30 Pages Posted: 13 Nov 2020 Last revised: 4 Mar 2021
Date Written: September 10, 2020
This paper looks into recent issues involving close-out netting and collateralization for over-the-counter (OTC) derivatives transactions from the point of Japanese and international financial law.
In Japan, collateralization of OTC derivatives transactions is generally structured using the loan and set-off method, rather than as a security interest (pledge). The problem with this loan and set-off scheme is that the collateral provider is not entitled to restore the portion of the collateral that exceeds the amount of secured obligation when the collateral receiver becomes insolvent (Tokyo High Court judgement dated 27 October 2010). Japan might be able to address this problem by creating a new legislation on financial collateral in line with the EU Directive on Financial Collateral Arrangements. Another option could be the use of a trust scheme, enabling the asset receiver to use or dispose of the deposited asset while managing it separately from its own assets, including the ‘trusts for customer's deposits for securities transactions’ under the Financial Instruments and Exchange Act of Japan (FIEA) primarily designed for retail customers. However, due to various practical hurdles, parties to OTC derivatives transactions are often unwilling to use the trust scheme for collateral management (eg, because the amount of required collateral changes from time to time depending on the market value of the underlying assets). At present, the most effective way to minimize the counterparty risk of derivative transactions is centralized clearing at the clearing house. Most categories of OTC derivative transactions are eligible for such centralized clearing.
For non-cleared OTC derivatives, a solution would be to accumulate collateral (margin) in just proportion at the start of the transaction and to frequently evaluate and adjust the amount of collateral (margin) required as the market value of the derivative transaction fluctuates. This method complicates the procedure but enables a very stable operation. Indeed, international regulations have moved in this direction. Japan also implemented the margin requirements for non-cleared OTC derivatives that required posting or collection of the amount equivalent to market value fluctuations as variable margin, and initial margins to be made by way of either loans, or deposits, for consumption.
In March 2016, the Financial Services Agency of Japan revised the Cabinet Office Ordinance and introduced the new margin requirements to prohibit securities firms and registered financial institutions from conducting certain non-cleared OTC derivative transactions without taking prescribed measures such as depositing margins. With regard to margin for non-centrally cleared derivative transactions, these requirements were agreed upon twice, in September 2013 and March 2015, by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO). The final framework (BCBS/ IOSCO agreement) has been incorporated into Japanese law.
Until recently, the Netting Act in Japan did not encompass the validity and enforceability of close-out netting arrangements with respect to collateral assets posted through the creation of pledges or other security interests. This is because collateral transactions eligible for protection under the Netting Act were limited to loans or deposits for consumption (i.e. title transfer collateral arrangements). In May 2019, the Netting Act was amended to protect the validity and enforceability of close-out netting arrangements under corporate reorganization proceedings, where security interest has been created over eligible financial assets in connection with an eligible financial transaction. These amendments came into force in May 2020.It is expected that the Netting Act, as amended, will result in a significant reduction in regulatory compliance costs, benefiting Japanese derivatives market participants who are required to give and receive initial margins after September 1, 2020..
By the way, in the United States, after the Lehman Shock, some experts have suggested theories denying the enforceability of close-out netting and the favored treatment of derivatives transactions under the insolvency proceedings. Although these theories provide an important perspective for re-examining the significance of close-out netting clauses and collateral systems, they are not completely convincing. The problems that these proposals are predicated on may be countered by other regulatory mechanisms, and there is a significant degree of divergence between the purposes and mechanisms of the regulations proposed. In addition, these theories might carry a significant risk, as they seek to address some abusive cases by denying the framework that effectively mitigates counterparty risks and systemic risks of derivatives transactions.
Consequently, as was done in Japan and the US, granting government agencies the authority to temporarily stay the close-out netting of OTC derivatives transactions for a short period of time would be an effective mechanism for securing the orderly resolution of failed financial institutions. For the types of derivative transactions to be temporarily suspended from close-out netting, considering the current general rule of Japanese clearing houses under which the position of the failed participant is transferred to other clearing participants, and because transaction categories representing 70-80% of the nominal principal of OTC derivatives transactions are centrally cleared at the clearing house, it would be appropriate to extend the restriction on triggering the early termination (close-out netting) clause to listed derivative transactions and OTC derivative transactions settled at the clearing houses as well, besides privately negotiated derivatives transactions.
〔This paper is a major revision in English of my article published in Japanese in August 2013 (Financial Law Journal, No. 1976, pp 6–17), and is based on subsequent law revisions and trends.〕
Keywords: Japanese Law, Securities law, Civil Code, Trust Law, International Finance Law, Close-out Netting, OTC Derivatives Transactions, Margin Requirements, ISDA Master Agreement, CSA, Credit Support Annex, financial collateral, CDS
JEL Classification: G20, G28, G32, G33, G38, K22
Suggested Citation: Suggested Citation