Intragroup Back-to-Back Trades

Staff in trade booking, intragroup credit, and regulatory work use this to check the trade between two entities of a financial group when the entity that trades with the client and the entity that holds the market risk are different companies.

Moving a client trade within the group

Within a financial group, the sales entity that trades with a client and the booking entity that holds the market risk of that trade can be different. The trade that connects the two entities is an intragroup back-to-back trade. "Booking" here is different from the work of entering a trade's execution details into the trading system (trade capture). How to choose the booking entity is covered in Choosing the Booking Entity.

If the sales entity enters into an opposite trade on the same terms with the booking entity, the trades the sales entity holds cancel each other, and the variability of payments and receipts (the market-risk portion) moves to the booking entity.

A position in which the risk of a trade is reduced by an opposite trade with another party is called a back-to-back position. The examination manual of the US Federal Reserve Board (April 2003 edition) uses this term for the seller of a credit derivative¹. An intragroup back-to-back trade is the case in which the other party to the opposite trade is another entity in the same group.

Consider a hypothetical example in which a client company enters into a 3-year interest rate swap with the sales entity, with a notional amount of 10 billion yen. The client company pays a fixed rate of 1% and receives a floating rate. The sales entity enters into an opposite swap with the booking entity, with the same notional amount, term, and fixed rate, but with the fixed-rate payer and receiver reversed. The sales entity pays the booking entity the fixed rate of 1% and receives the floating rate. The fixed-rate payment for one year is 10 billion yen × 1% = 100 million yen.

Figure description

The fixed payment of 100 million yen a year that the client company makes passes through the sales entity to the booking entity unchanged, and the floating payments flow in the opposite direction. Nothing, fixed or floating, remains with the sales entity.

Flow of payments, receipts, and gains and losses

The sales entity's payments and receipts cancel out however the floating rate moves. In the example, compare the payments and receipts for one year when the average floating rate over the year is 1.5% and when it is 0.5%. The floating payments and receipts are 10 billion yen × 1.5% = 150 million yen and 10 billion yen × 0.5% = 50 million yen. The table shows the amounts after netting the fixed and floating payments and receipts. Fees, day counts, and the possibility of a counterparty default are not considered.

When the floating rate is 1.5%, the client company gains and the booking entity loses. When it is 0.5%, the reverse holds: the client company loses and the booking entity gains. The sales entity's net amount is 0 yen in both cases. The net amounts of the three entities add up to 0, and the client company's gain or loss appears at the booking entity as a loss or gain, with only the direction reversed.

The sales entity's net amount is 0 only when the two trades have the same terms, such as notional amount, term, fixed rate, and payment dates. If any of them differs, the difference stays with the sales entity. For example, if the fixed rate the sales entity pays the booking entity is 1.1%, the sales entity bears 10 million yen a year.

How the terms of intragroup trades are set

Some regulations require the terms of an intragroup trade to be set by comparison with the terms of trades outside the group.

Japanese banks are subject to Article 13-2 of the Banking Act. A bank must not enter into a trade with a specified related party, such as a subsidiary or a bank holding company, on terms that harm the bank when compared with the ordinary terms of the bank's trades. Exceptions apply, for example when there is an unavoidable reason and the Prime Minister has given approval². Whether a trade harms the bank is decided by whether its terms are disadvantageous to the bank, compared with the terms on which the bank would trade the same type and amount in similar circumstances with a similar party other than a specified related party. Whether a party is similar is judged by the type of business, size, creditworthiness, and so on³. This provision is the so-called arm's length rule⁴.

The FSA's Comprehensive Guidelines for Supervision of Major Banks, etc. (the supervisory guidelines for major banks) position the arm's length rule as a provision to prevent conflict-of-interest transactions between a bank and companies in its banking group from harming the soundness of the bank's management, among other things. Whether the bank appropriately verifies that its intragroup trades do not violate the provision is a point of focus in the guidelines⁴. This regulation applies on a consolidated basis⁵.

Financial instruments business operators, such as securities companies, are subject to Article 44-3 of the Financial Instruments and Exchange Act. A financial instruments business operator must not trade securities or conduct other transactions, including over-the-counter derivative transactions, with its parent or subsidiary corporation on terms that differ from ordinary terms where this may harm the fairness of the transaction. Exceptions include cases where the operator has received approval from the Prime Minister on the ground that there is no impediment to the public interest or investor protection. Paragraph 2 contains a provision to the same effect for registered financial institutions⁶. Article 13-2 of the Banking Act concerns terms that harm the bank, whereas Article 44-3 concerns terms that may harm the fairness of the transaction.

US member banks are subject to Regulation W, which implements sections 23A and 23B of the Federal Reserve Act. Derivative transactions with an affiliate that is not a depository institution are subject to the market terms requirement of section 23B⁷. The trade must be on terms substantially the same as, or at least as favorable to the bank as, those of comparable transactions with a non-affiliate at the time. If there is no comparable transaction, the terms must be those that would be offered in good faith to a non-affiliate⁸.

Collateral on intragroup trades

Whether collateral is exchanged on intragroup trades is treated differently by each regulation.

The Cabinet Office Order on Financial Instruments Business, etc. requires Japanese financial instruments business operators, etc. to apply variation margin and initial margin measures to non-cleared over-the-counter derivative transactions. These provisions do not apply to trades whose counterparty is the operator's parent company, etc., subsidiary company, etc., or a subsidiary company, etc. of its parent company, etc. as defined there¹⁰. Under these provisions, intragroup trades are excluded from the margin measures.

The CFTC's rules in the US provide for exempting intragroup swaps from the clearing requirement, and the exchange of variation margin is relevant to the conditions for electing the exemption. The conditions include documenting the terms of the trade in writing (with swap dealers and certain other entities also meeting separate documentation requirements) and the trade being subject to a centralized risk management program. In addition, when an entity in the group enters into a swap of a type subject to the clearing requirement with a party outside the group, there is a condition to comply with the clearing requirement or with an exception or exemption from it. This condition is deemed met if the group has an entity located in certain countries or regions, including Japan, and the group exchanges variation margin in full on intragroup swaps daily¹¹.

Risks specific to intragroup trades

Even in an intragroup trade, counterparty risk (counterparty credit risk) arises between the sales entity and the booking entity. In the example, if the floating rate rises and the market value on the client company's side becomes positive, the sales entity owes the client company a payment and stands to receive the same amount from the booking entity. If the booking entity cannot perform, the sales entity has to cover the payment to the client company itself. If the market value becomes negative, the direction reverses: the sales entity stands to receive from the client company and owes a payment to the booking entity. An intragroup trade does not remove counterparty risk.

When several sales entities trade with the same booking entity, trades concentrate at the booking entity. The FSA's supervisory guidelines state that a financial group with multiple business types may face the spread of risk within the group and risk concentration in the group, in addition to organizational complexity and conflicts of interest¹². This point concerns banking groups in general and is not limited to derivative trades.

Notes

1. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual", Section 4350.1, "Credit Derivatives" (April 2003), page 9 (PDF page 640). ↩

2. "銀行法" (Banking Act, in Japanese; English translation: Japanese Law Translation), Article 13-2, paragraph 1. Specified related parties are subsidiaries of the bank, major shareholders of the bank, bank holding companies of which the bank is a subsidiary, subsidiaries of such a bank holding company (excluding the bank), bank agents for which the bank is the principal bank, and any other person having a special relationship with the bank as specified by Cabinet Order. ↩

3. "銀行法施行規則" (Ordinance for Enforcement of the Banking Act, in Japanese), Article 14-10, paragraph 1 (trades under Article 13-2, item 1 of the Act). ↩

4. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.), V-2, "Arm's Length Rule" (printed page 373, PDF page 389), the opening and (1) (in Japanese). The term "so-called arm's length rule" also appears in III-6-3-2 of the guidelines (PDF page 332). ↩ ↩²

5. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.), V-1(3), "Outline of consolidated supervision" (printed pages 372–373, PDF pages 388–389) (in Japanese). ↩

6. "金融商品取引法" (Financial Instruments and Exchange Act, in Japanese; English translation: Japanese Law Translation), Article 44-3, paragraph 1, item 1 and paragraph 2, item 1. ↩

7. 12 CFR Part 223 (Regulation W), § 223.33(a) and (b). Derivative transaction is defined in § 223.3(l). ↩ ↩²

8. 12 CFR Part 223 (Regulation W), § 223.51(a) and (b). ↩

9. "銀行法施行規則" (Ordinance for Enforcement of the Banking Act, in Japanese), Article 14-8, paragraph 1, item 3, and Article 14-9, paragraph 1. ↩

10. "金融商品取引業等に関する内閣府令" (Cabinet Office Order on Financial Instruments Business, etc., in Japanese), Article 123, paragraph 1, item 21-10 (variation margin) and item 21-11 (initial margin), paragraph 12, item 3, and paragraph 13, item 3. ↩

11. 17 CFR 50.52(b)(2), (b)(3), (b)(4)(i), and (b)(4)(ii). The requirements for swap dealers and certain other entities are in 17 CFR 23.504 and 23.600, which the section cites. ↩

12. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.), I-1(4), "Risk management of financial groups including multiple business types" (printed page 8, PDF page 24) (in Japanese). ↩

13. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual", Section 3000.1 (January 2009), page 24 (PDF page 251), the "Derivative Transactions with Affiliates" part. ↩