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Clearing organisations required for OTC

A draft of the Act partially amending the Financial Instruments and Exchange Act, Etc (the 2010 Amendment) was submitted to the National Diet on March 9 2010 and was promulgated on May 19 2010. The 2010 Amendment consists of provisions to improve the stability and transparency of settlement of over-the-counter (OTC) derivative transactions including (i) systems for infrastructure development relating to clearing, (ii) a requirement to use a clearing organisation, and (iii) establishment of a system for the conservation and reporting of trading data. Provisions relating to (i) above will become effective within one year from May 19 2010 while provisions relating to (ii) and (iii) above will become effective within two and a half years from May 19 2010.

In Japan, clearing organisations are typically not used for the settlement and clearing in respect of interest swap transactions regardless of the monetary size of such transactions. However, if a financial institution which deals with a high volume of derivative transactions becomes insolvent and has not utilised clearing organisations for the settlement and clearing of its derivative transactions, many parties will need to look for other counterparties for their desired hedges. Further, the insolvency of such financial institution would cause concern among market players about the possibility of a chain reaction bankruptcy and keep these players from entering into new derivative transactions. Therefore, the 2010 Amendment Act has obliged financial instruments business operators and registered financial institutions (both as defined in the Financial Instruments and Exchange Act (Act No. 25 of 1948) (the FIEA)) to use a clearing organisation when they enter into certain kinds of OTC derivative transactions. By using a clearing organisation, only such clearing organisation needs to find new counterparties in the event of the bankruptcy of a financial instruments business operator or registered financial institution.

There are two types of OTC derivative transactions which require the usage of a clearing organisation. Type I must be cleared through a domestic financial instruments clearing organisation (as defined in the FIEA, a Fico) and Type II must be cleared either (i) through a domestic Fico, (ii) by a domestic Fico, a foreign financial instruments clearing organisation (as defined in the FIEA, a FFICO) or an entity established under the laws and regulations of a foreign state which engages in the same kind of business as the financial instruments obligation assumption service (as defined in the FIEA) linked with a domestic Fico or (iii) through a FFICO. Although the detailed specifications for such two types of transactions will not be clear until publication of the cabinet office ordinance, according to materials provided by the Financial Service Agency of Japan (the FSA), the FSA plans to designate (i) credit default swap transactions referring to an index of iTraxx Japan for Type I and (ii) plain vanilla yen interest rate swap transactions for Type II.

Nobuharu Sakai

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