Capital Markets: Derivatives 2024 Comparisons

The regulation of derivatives under Japanese law is divided into two major pieces of legislation, namely, the Financial Instruments and Exchange Act (Act No. 25 of 1948, as amended, “FIEA”) and the Commodities Futures and Exchange Act (Act No. 239 of 1950, as amended, “CFEA”).

The FIEA regulates over-the-counter (OTC) derivatives transactions falling under the definition of OTC Financial Derivatives Transactions, which include OTC derivatives referencing financial instruments such as interest rates, FX, equity, credit, electronic payment instruments or crypto-assets. The concept of OTC Financial Derivatives Transactions is further divided into the following three categories: (i) securities-related OTC Financial Derivatives Transactions (ie, OTC Financial Derivatives Transactions which refer to securities); (ii) non-securities-related OTC Financial Derivatives Transactions (ie, OTC Financial Derivatives Transactions which do not refer to securities) which do not reference crypto-assets etc; and (iii) non-securities-related OTC Financial Derivatives Transactions which refer to crypto-assets etc. As a result of an amendment to the FIEA in 2022, the term “crypto-assets etc” is defined to include not only crypto-assets but also certain electronic payment instruments defined under the Payment Services Act (which essentially means stablecoins). The scope of electronic payment instruments included in the definition of “crypto-assets etc” is to be designated by the Financial Services Agency of Japan (“JFSA”), but such designation has not yet been made.

Separately from the FIEA, the CFEA regulates OTC derivatives transactions falling under the definition of OTC Commodity Derivatives Transactions, which include OTC derivatives transactions referencing commodities such as oil, gas, electricity, precious metals and agricultural products.

OTC derivatives referencing underlying instruments which are related to neither financial instruments nor commodities will not trigger the licensing/registration requirement under the FIEA or the CFEA.

Exchange-traded derivatives referencing financial instruments and commodities are also regulated under the FIEA and CFEA.

As a result of an amendment to the Foreign Exchange and Foreign Trade Act (Act No. 228 of 1949, as amended) which came into force in 1980, Japanese parties are now able to enter into cross-border transactions without having to obtain any prior consents/approvals from the Japanese authorities under this Act. This event has had a significant impact on the development of the derivatives market in Japan.

In 1998, the Act on Close-Out Netting of Specified Financial Transactions Conducted by Financial Institutions (Act No. 108 of 1998, as amended) was enacted, and the validity and enforceability of the close-out netting arrangement concerning certain OTC derivatives has been expressly confirmed by legislation. Further, as a result of amendments to insolvency laws (eg, Article 58 of the Bankruptcy Act), protection of the close-out netting arrangement has been expanded to cover a broader scope of derivatives. The legal certainty brought about by netting legislation has underpinned the growth of the derivatives market in Japan.

The development of the regulatory framework governing derivatives transactions has also influenced the way the derivatives markets have evolved. Before the Securities and Exchange Act was renamed as the Financial Instruments and Exchange Act by the amendments of 2006 (effective as of 2007), derivatives transactions were regulated as follows:

• securities-related derivatives were regulated under the Securities and Exchange Act;
• financial futures and options listed on the financial futures exchange were regulated under the Financial Futures Trading Act (Act No. 77 of 1988, as amended);
• commodities futures and options listed on the commodity futures exchange were regulated under the Commodity Exchange Act (Act No. 239 of 1950, as amended); and
• OTC derivatives referencing interest rates, FX or certain other financial instruments were not directly regulated by any specific legislation.

The Securities and Exchange Act and the Financial Futures Trading Act were merged into the FIEA, and the regulation of OTC Financial Derivatives Transactions was integrated under the FIEA.

Following the global financial crisis in 2008, the G20-initiated OTC derivative regulatory reforms (ie, mandatory clearing, mandatory trade execution, a trade data reporting requirement and a margin requirement for uncleared derivatives) were implemented under the FIEA.

As a result of an amendment to the CFEA in 2014, derivatives referencing electricity became regulated. In addition, as a result of an amendment to the FIEA in 2019, derivatives referencing crypto-assets became regulated. As described in 1.1 Overview of Derivatives Markets, the amendment to the FIEA in 2022 defined the term “crypto-assets etc” to include not only crypto-assets but also a certain type of electronic payment instrument and as a result derivatives referencing “crypto-assets etc” became regulated as such. Derivatives referencing other types of electronic payment instruments also fall under the scope of derivatives regulated under the FIEA.

As regards the most recent developments in this area, the following amendments to the trade data reporting requirement came into force in April 2024:

• Although reporting dealers were previously allowed to report trade data to either the JFSA (ie, direct reporting) or the designated trade repository (ie, indirect reporting), they are now obligated to submit trade data to the trade repository, unless there is a natural disaster or any other due reason why they cannot report to the trade repository (in such a case, reporting dealers may submit trade data to the JFSA).
• For the purpose of implementing the data requirements specified by CPMI-IOSCO’s CDE Technical Guidance, the use of an LEI (legal entity identifier), a UTI (unique transaction identifier) and improved CDE (critical data elements) is now required.

The risk of rising interest rates in the future is having a major impact on the derivatives market. Specifically, the balance of outstanding JPY interest rate swap transactions cleared by the Japan Securities Clearing Corporation (“JSCC”) has reached record levels.

Futures and options are listed on regulated markets operated by the following four Japanese exchanges:

• Osaka Exchange, Inc. (OSE) (for both financial instruments and commodities derivatives);
• Tokyo Financial Exchange Inc. (TFX) (for financial instruments derivatives);
• Tokyo Commodity Exchange, Inc. (TOCOM) (for commodities derivatives); and
• Osaka Dojima Exchange, Inc. (ODEX) (for commodities derivatives).

No futures or options referencing crypto-assets are currently listed in Japan.

On 11 October 2023, the Tokyo Stock Exchange (TSE) established a carbon credit market for J-Credits. On this carbon credit market, carbon dioxide equivalent quotas and other similar products are traded. Emission allowance derivatives have generally been considered to not relate to either financial instruments or commodities. However, the legal status of carbon credits and how to regulate them is still under discussion, and therefore it is necessary to closely watch the JFSA’s announcements in the future.

It is usual to conclude an ISDA Master Agreement for swap transactions. Voice trading is generally more common than electronic trading.

Swaps referencing financial instruments (including securities) are regulated as OTC Financial Derivatives Transactions under the FIEA, whereas swaps referencing commodities are regulated as OTC Commodity Derivatives Transactions under the CFEA.

Swaps cleared by the JSCC are subject to the JSCC’s clearing rules. Uncleared swaps are subject to margin requirements, as we describe in 4.1.2 Margins.

Although cash-settled forward transactions are regulated as OTC Financial Derivatives Transactions or OTC Commodity Derivatives Transactions (depending on the underlying assets), spot or forward transactions which are settled only physically are considered as sales and purchases of underlying assets, which do not fall under the definition of OTC Financial Derivatives Transactions or OTC Commodity Derivatives Transactions.

OTC Derivatives

(1) Type I FIBO registration requirement under the FIEA

Engaging in the business of acting as a principal, intermediary, broker or agent in OTC Financial Derivatives Transactions falls under the definition of a Type I Financial Instruments Business. Under the FIEA, a person who conducts a Financial Instruments Business must be registered with the JFSA as a Type I Financial Instruments Business Operator (“Type I FIBO”).

(2) Regulation of Foreign Securities Dealer under the FIEA

A Foreign Securities Dealer is defined as an entity which (i) engages in a business involving securities-related transactions in accordance with the law of a foreign jurisdiction, and (ii) is not registered as a Financial Instruments Business Operator (“FIBO”) or licensed as a Financial Institution in Japan. A Foreign Securities Dealer is generally prohibited from acting as a principal, intermediary, broker or agent in securities-related transactions with an end user in Japan, including securities-related OTC Financial Derivatives Transactions.

(3) Commodity Derivatives Business Operator licensing requirement under the CFEA

A person is considered to engage in the business of OTC Commodity Derivatives Transactions if such person acts as a principal, intermediary, broker or agent in such transactions as a business. Under the CFEA, depending on the type of commodities, a person who engages in such business must be licensed by the Ministry of Economy, Trade and Industry (“METI”) and/or the Ministry of Agriculture, Forestry and Fishery (“MAFF”) as a Commodity Derivatives Business Operator.

Exchange-Traded Derivatives

Type I or Type II FIBO registration requirement under the FIEA

A person who engages in the business of exchange-traded derivatives (“ETDs”) in Japan must be registered (i) as a Type I FIBO if the underlying instruments of such ETDs are certain highly liquid securities (eg, government bonds, municipal bonds, corporate bonds, corporate shares, share option certificates, units in investment trusts, commercial papers, mortgage securities, depositary receipts and negotiable deposit certificates) or if such ETDs are commodities futures listed on a financial instruments exchange licensed in Japan or (ii) as a Type II FIBO if such ETDs do not fall under the scope of (i) above.

Regulation of Foreign Securities Dealer under the FIEA

A Foreign Securities Dealer is generally prohibited from acting as a principal, intermediary, broker or agent in securities-related transactions with an end user in Japan, including securities-related ETDs.

In addition, a Foreign Securities Dealer is permitted to trade ETDs listed on a financial instruments exchange licensed in Japan without being registered as an FIBO if it has obtained permission from the JFSA.

Commodity Derivatives Business Operator licensing requirement under the CFEA

Under the CFEA, a person who engages in the business of acting as an intermediary, broker or agent in commodities ETDs listed on a commodities exchange licensed in Japan or on a commodities exchange outside Japan must be licensed as a Commodity Derivatives Business Operator. As distinct from OTC Commodity Derivatives Transactions discussed in (3) above regarding OTC derivatives, entering into commodities ETDs as a principal does not trigger this licensing requirement.

The JFSA published the aggregated notional amounts of OTC derivatives reported to it as of March 2023. According to such published material, the underlying financial instruments of OTC derivatives predominantly traded in Japan are as follows in descending order on the basis of the aggregate notional amounts:

• interest rates (96.7%):
• FX (2.0%);
• credit (0.8%); and
• equity (0.5%).

In addition, commodity, electricity, earthquake and weather derivatives have been traded in Japan. As new asset classes, OTC crypto-asset derivatives have recently been emerging in Japan.

OTC derivatives referencing new asset classes may be caught by the prohibition of gambling under the Criminal Code (Act No. 45 of 1907, as amended). Gambling means any provision or receipt of money or other economic value on a contingency basis. This definition is sufficiently broad to include virtually all derivatives transactions, including OTC Financial Derivatives Transactions and OTC Commodity Derivatives Transactions. Gambling is a criminal offence unless it is authorised by law or there is a legitimate reason. For a detailed description of the situations where OTC derivatives transactions are authorised by law, please see below.

(i) FIEA Provisions

Any off-market act aimed at providing and/or receiving a monetary difference based on quotations or indices of stock exchanges or financial futures exchanges in Japan is illegal, unless it is an OTC Financial Derivatives Transaction to which an FIBO or Registered Financial Institution is a party, or an FIBO or Registered Financial Institution acts as an intermediary, broker or agent.

(ii) CFEA Provisions

The CFEA prohibits any off-market act aimed at providing and/or receiving a monetary difference based on quotations of domestic commodities exchanges, unless a licensed Commodity Derivatives Business Operator or a Specified OTC Commodity Derivatives Transactions Dealer that has made a notification to the MAFF or the METI is a party thereto. If a licensed Commodity Derivatives Business Operator or a notified Specified OTC Commodity Derivatives Transactions Dealer is a party, dealing in the relevant OTC Commodity Derivatives Transaction will be considered as legal for the purpose of the Criminal Code.

(iii) Other Acts

The Banking Act (Act No. 59 of 1981, as amended) and other legislation regulating Financial Institutions licensed in Japan provide that certain types of OTC derivatives transactions are included in the legitimate business of such Financial Institutions. OTC derivatives transactions that are entered into by such Financial Institutions pursuant to those statutes should also be considered as not being contrary to the Criminal Code.

If an OTC Financial Derivatives Transaction, an OTC Commodity Derivatives Transaction or any other derivatives transaction is not authorised by law and there is no legitimate reason for it, there is a theoretical risk that it could be deemed as a form of gambling.

Exemptions for Transactions With Eligible Investors

1. OTC derivatives

Exemptions from the registration requirement under the FIEA or the licensing requirement under the CFEA are available, in cases where counterparties to OTC derivatives are limited to certain eligible investors. The scope of such eligible investors is different depending on the types of underlying assets (ie, securities, crypto-assets, other financial instruments and commodities) to which the relevant OTC derivatives refer.

(1) Exemption from the Type I FIBO registration requirement under the FIEA

As an exemption from the Type I FIBO registration requirement, the FIEA provides that for non-securities-related OTC Financial Derivatives Transactions that are not Specified OTC Financial Derivatives Transactions (as defined in 3.1.3 Mandatory Trading) and do not refer to crypto-assets etc, a person will not be considered to be conducting a Financial Instruments Business by acting as a principal, intermediary, broker or agent in such transactions where the counterparties thereto are limited to the following entities (“Eligible Financial Derivatives Investors”):

(i) Type I FIBOs;

(ii) Registered Financial Institutions;

(iii) qualified institutional investors (QIIs);

(iv) stock corporations (kabushiki kaisha) with a paid-up capital of JPY1 billion or more; and

(v) overseas persons equivalent to (i) to (iv) above.

In addition, a person conducting the business of OTC Financial Derivatives Transactions referencing crypto-assets etc solely outside Japan pursuant to the laws of the foreign jurisdiction will not be deemed to be conducting a Financial Instruments Business by entering into such transactions from outside Japan where the counterparties are limited to the following entities:

(i) the government of Japan or the Bank of Japan;

(ii) FIBOs and Financial Institutions that engage in OTC Financial Derivatives Transactions referencing crypto-assets etc in the course of business;

(iii) Financial Institutions, trust companies or foreign trust companies (only if they conduct OTC Financial Derivatives Transactions referencing crypto-assets etc for the purpose of investments or on the account of trustors under trust agreements); and

(iv) FIBOs that engage in investment management business (only if such entities conduct any act related to investment management business).

(2) Exemption from the regulation of Foreign Securities Dealer under the FIEA

As mentioned in 2.4 Listed v Over-the-Counter, a Foreign Securities Dealer is generally prohibited from acting as a principal, intermediary, broker or agent in securities-related OTC Financial Derivatives Transactions with an end user located in Japan. This general prohibition does not apply where the securities-related OTC Financial Derivatives Transactions are effected from outside of Japan:

(i) with FIBOs conducting securities-related businesses, government organisations, the Bank of Japan, FIBOs engaging in an investment management business and acting on behalf of their clients in the course of such business, banks, trust banks, insurance companies, co-operative banks, federations of co-operative banks, labour credit associations, federations of labour credit associations, The Norinchukin Bank, The Shoko Chukin Bank, credit associations, federations of credit associations (for their own investment purposes or for the account of a settlor (entrustor) pursuant to a trust agreement);

(ii) with an Eligible Financial Derivatives Investor in Japan pursuant to an order of such investor without any solicitation on the part of the Foreign Securities Dealer; or

(iii) with an Eligible Financial Derivatives Investor in Japan through a Type I FIBO acting as intermediary, broker or agent without any solicitation on the part of the Foreign Securities Dealer.

According to X-1-2 of the JFSA’s “Comprehensive Guidelines for Supervision of Financial Instruments Business Operators, etc.”, the posting by a Foreign Securities Dealer of advertisements regarding activities concerning securities-related businesses on its websites will, in principle, be deemed to constitute a solicitation. However, it may not be deemed to constitute a solicitation aimed at investors in Japan if reasonable measures (as illustrated below) are taken to prevent such advertisement from resulting in activities concerning securities-related business with investors in Japan as their transaction counterparties:

• Disclaimer: A disclaimer to the effect that the advertised service is not targeted at investors in Japan must be indicated.
• Measures to prevent transactions: Measures to prevent transactions with investors in Japan regarding activities concerning securities-related businesses must be put in place.

(3) Exemption from the Commodity Derivatives Business Operator licensing requirement under the CFEA

As an exemption from the licensing requirement as a Commodity Derivatives Business Operator, the CFEA provides that for OTC Commodity Derivatives Transactions, a person will not be considered to be engaging in the business of OTC Commodity Derivatives Transactions by acting as a principal, intermediary, broker or agent in such transactions where the counterparties to such transactions are limited to the following entities (“Eligible Commodity Derivatives Investors”):

(i) Commodity Derivatives Business Operators;

(ii) Commodity Investment Advisors;

(iii) qualified institutional investors (QIIs);

(iv) Type I FIBOs;

(v) Registered Financial Institutions;

(vi) stock corporations with a paid-up capital of JPY1 billion or more;

(vii) overseas persons equivalent to (i) to (vi) above;

(viii) special purpose companies (tokutei mokuteki kaisha) established under the Act on the Securitisation of Assets (Act No. 105 of 1998, as amended) (a) whose specified share capital is JPY1 billion or more or (b) whose specified share capital of JPY30 million or more and whose asset-backed securities are held by eligible investors only; and

(ix) subsidiaries of any of the foregoing entities.

OTC Commodity Derivatives Transactions with Eligible Commodity Derivatives Investors are referred to as “Excluded OTC Commodity Derivatives Transactions”. Under Article 349 of the CFEA, a person who engages in the business of Excluded OTC Commodity Derivatives Transactions is required to file a prior notification as a Specified OTC Commodity Derivatives Transaction Dealer if the underlying assets of such transactions are related to commodities or commodity indices which are designated by the relevant authority (currently, commodities and commodity indices referred to by exchange-traded commodities derivatives listed on commodities exchanges licensed in Japan are designated).

2. Exchange-traded derivatives

(1) Exemption from the FIBO registration requirement under the FIEA

The exemption from the registration requirement under the FIEA in cases where the counterparties are limited to certain sophisticated investors (see 1(1) above) is not available for ETDs listed on a financial instruments exchange licensed in Japan.

(2) Exemption from the regulation of Foreign Securities Dealer under the FIEA

A Foreign Securities Dealer is permitted to trade ETDs listed on a financial instruments exchange licensed in Japan without being registered as an FIBO, if it has obtained permission from the JFSA.

In the case of securities-related ETDs listed on a foreign financial instruments exchange, a Foreign Securities Dealer is permitted to engage in such ETDs for Japanese customers under the regulatory framework for a Foreign Securities Dealer as described in 1(2) above. Further, in the case of non-securities-related ETDs listed on a foreign financial instruments exchange, a foreign dealer is permitted to engage in such ETDs for Japanese customers under a regulatory framework similar to the regulatory framework for a Foreign Securities Dealer as described in 1(2) above.

(3) Exemption from the Commodity Derivatives Business Operator licensing requirement under the CFEA

As distinct from OTC Commodity Derivatives Transactions discussed in 1(3) above, entering into commodity ETDs as a principal does not trigger this licensing requirement. Further, a person who engages in the business of commodity ETDs listed on a foreign commodity exchange by acting as an intermediary, broker or agent in such foreign commodity ETDs need not be licensed as a Commodity Derivatives Business Operator, if customers or counterparties in Japan are limited to Eligible Commodity Derivatives Investors.

Non-derivative Products Including Spot Transactions

Regarding the definitions of the terms “OTC Financial Derivatives Transactions” and “OTC Commodity Derivatives Transactions”, the following types of transactions are considered neither as OTC Financial Derivatives Transactions nor as OTC Commodity Derivatives Transactions:

• forward foreign exchange transactions (ie, physically-settled FX spot transactions, FX forward transactions and physically-settled FX swap transactions); and
• derivatives transactions whose underlying asset is neither financial instruments nor commodities (eg, certain emissions allowances or freight).

In addition, physically-settled securities forward transactions are generally not regulated as OTC Financial Derivatives Transactions but are regulated as sales and purchases of securities under the FIEA.

Physically-settled FX spot/forward transactions are generally entered into as sale and purchase transactions of currencies. However, since foreign exchange margin transactions are rolled over, such FX transactions are regulated as OTC Financial Derivatives Transactions. Therefore, under the FIEA, a person who provides such FX transactions must be registered with the JFSA as a Type I FIBO. For more information about the regulation applicable to a provider of FX transactions (eg, for retail investors), please see 3.1.6 Business Conduct.

Derivatives are regulated at the level of national laws, although certain supervisory functions are delegated by the national regulators (ie, the JFSA, METI and MAFF) to the Local Finance Bureau; the Regional Bureau of Economy, Trade and Industry; and the Regional Agricultural Administration Offices.

The following self-regulatory organisations operate in Japan:

• Japan Securities Dealers Association (JSDA) for Type I FIBOs and Registered Financial Institutions regulated under the FIEA;
• Financial Futures Association of Japan (FFAJ) for FX and interest rate derivatives (including OTC binary option derivatives) regulated under the FIEA;
• Japan Commodity Futures Industry Association (JCFIA) for commodity derivatives regulated under the CFEA; and
• Japan Virtual and Crypto assets Exchange Association (JVCEA) for crypto-asset derivatives regulated under the FIEA.

These self-regulatory organisations are subject to the national-level oversight by the JFSA, the METI and/or the MAFF (as applicable).

For Designated Cleared Transactions to which the JSCC as a CCP offers clearing services, the JSCC establishes a form of Clearing Brokerage Agreement which must be entered into between the clearing broker and its customer as part of the JSCC’s clearing rule. The clearing broker and the customer may execute a side letter (or any other supplemental instrument) to the extent it does not conflict with the Clearing Brokerage Agreement.

In addition, the ISDA/FIA Cleared Derivatives Execution Agreement is widely used for cleared derivatives by market participants in Japan.

In order to recognise the effect of the close-out netting arrangement for the purpose of calculation of the regulatory capital of Japanese banks, it is in practice required to obtain a legal opinion. More specifically, the relevant Japanese FSA’s Basel Q&A requires Japanese banks to confirm the existence of a reasonable written legal opinion, according to which the competent judicial court and authority would likely determine that the bank’s exposure will be limited to the amount which is netted pursuant to the applicable netting agreement in light of the related laws upon occurrence of any legal dispute. In addition, Japanese banks may consider obtaining a legal opinion on the validity and enforceability of the collateral arrangement for the purpose of taking into account the credit risk mitigation effect of the collateral arrangement when calculating the regulatory capital.

Under the FIEA, a person who conducts a Financial Instruments Business must be registered with the JFSA as an FIBO. Breach of such registration requirement could result in criminal penalties (ie, imprisonment and/or fine). In practice, it is common that the JFSA posts to its website the names of unregistered business operators and a summary of their unregistered business, as well as individually giving written warnings to such business operators. Especially, while a foreign business operator’s act of soliciting Japanese investors from outside Japan in principle constitutes a Financial Instruments Business (unless any relevant exemption applies), a number of such warnings have been made to such unregistered foreign business operators. Approximately 20 operators’ names have been posted on the JFSA’s website as unregistered operators over the latest 12 months. The trend towards enforcement is expected to continue as the JFSA’s examination priority. The METI and the MAFF have also made similar warnings in the past.