Use this flow to follow a single OTC derivative trade, from the sales staff who propose it to a client to the operations staff who handle settlement at maturity.

What the client business is for

The client business exists so that a financial institution enters into OTC derivative trades only when the client understands them and they fit the client's purpose, and then manages those trades until maturity. Depending on the market, an OTC derivative can cause a client a large loss or a large cost to terminate it. For that reason, a bank sets internal rules for explaining the key points of a trade in light of the client's knowledge, experience, financial situation, and purpose of the trade. It then builds arrangements for running its business in line with those rules. The Financial Services Agency (FSA) sets out its view in the "Comprehensive Guidelines for Supervision of Major Banks, etc." These guidelines state that the Banking Act and the Ordinance for Enforcement of the Banking Act require banks to have these arrangements1. For credit transactions, including derivative trades, the same supervisory guidelines also list points of focus for supervisors when they examine a bank's internal controls2.

Consider a hypothetical example in which Company E, a non-financial company, asks a bank about an FX forward for the USD 1 million of import payments it owes in one year. As a hedge against a weaker yen, Company E wants to buy USD 1 million in one year. Why non-financial companies use derivatives is covered in How Corporates Use Derivatives.

The flow from before the trade to maturity

The flow splits into the steps up to the trade and the steps from the trade to maturity. Figure 1 uses Company E's FX forward to show who does what, and in what order. How departments are divided and named, and which department handles which step, differ from one institution to another. The division in the figure is one example.

Company ESales staffCredit reviewBack officeCancelMaturityAsks abouta hedgeIdentifiesthe client'sneedsCarries outKYCReviewscredit, setscredit limitProposes andexplains inwritingCheckssuitabilityPlacesthe orderExecutesthe tradeExchangestheconfirmationReports themarket valueAsks forearlyterminationSettlesat maturity
Figure 1Workflow for an OTC derivative trade with a client (the division among departments is one example)
Figure description

Before the trade, the sales representative finds out what Company E needs and carries out the KYC procedures, the credit review department reviews credit and sets a credit limit, and the sales representative proposes a trade and checks that it suits Company E. Only then does Company E place the order and the sales representative execute the trade. After the trade, the back office exchanges a trade confirmation and the sales representative reports the market value. The path then splits: if Company E asks to cancel, the trade ends in early termination; otherwise, the back office settles it at maturity.

The following nine pages cover each step.

  1. Understanding Client Needs
  2. KYC and Credit Review
  3. Proposals and Explanations
  4. Delivery of documents: Product Explanations and Pre-Contract Disclosures
  5. Suitability Checks
  6. Trade Execution
  7. Confirmation: Trade Confirmations
  8. Mark-to-Market Reporting to Clients
  9. Early termination or settlement at maturity: Early Termination

Steps up to the trade

In the steps up to the trade, the bank confirms what Company E wants the trade for, reviews whether it can trade with Company E, and makes sure Company E understands the terms and risks of the trade. When the purpose is a hedge, as with Company E, the bank checks whether the trade is an effective hedge that fits Company E's purchases, sales, and pricing, and explains the result to Company E3.

KYC confirms what kind of company the counterparty is. The legal procedure is verification at the time of transaction, which the Act on Prevention of Transfer of Criminal Proceeds requires of banks and others. For a corporate client, the bank confirms its name and head office address, the purpose of the transaction, the nature of its business, the person who effectively controls its business, and other matters4. In the credit review, the bank assesses Company E's creditworthiness and sets a credit limit for trades with Company E. With derivatives, exposure to a counterparty grows as the market moves. The bank manages exposure counterparty by counterparty5.

In the proposal and explanation step, the bank explains the terms and risks of the trade using a document with examples. The explanation covers the loss if the market moves sharply (the loss under the worst-case scenario) and the amount to be paid or received if the trade is terminated early (the termination payment). The bank confirms with Company E that it received the explanation and keeps a record of this6.

When a trade falls under the definition of an OTC derivatives transaction in the Financial Instruments and Exchange Act, that Act's rules also apply. The Act requires financial instruments business operators, etc. to provide the client with information about the trade before the contract is concluded7. The document used for this is the pre-contract document8. The Act also sets the suitability principle, which prohibits solicitation that is inappropriate in light of the client's knowledge, experience, financial situation, and purpose of concluding the contract. The FSA's supervisory guidelines for major banks ask banks to make sure their derivative trades do not breach this rule9. So the suitability check matters from the start of the proposal, not only just before the trade. As a rule, these two provisions of the Act do not apply when the client is a professional investor (such as a qualified institutional investor, the national government, or the Bank of Japan)10.

Steps from the trade to maturity

Once Company E places the order and the bank agrees on the terms, the trade is executed. The terms of the executed trade, such as the trade date, counterparty, amount, and price, are recorded in the institution's systems11. Each party sends a confirmation setting out the terms, and the parties check the terms with each other before settlement12. The 1998 examination manual of the US Federal Reserve Board said that the back office (operations and settlement) sends and manages confirmations, and that it is good practice to ask clients such as non-financial companies to return a signed copy12. The same manual said that which department records the terms of an executed trade, and how, differs depending on the institution's trading systems11.

When the trade falls under the definition of an OTC derivatives transaction in the Financial Instruments and Exchange Act and the client is not a professional investor, the financial instruments business operator, etc. provides the client with information without delay once the contract is concluded. The document used for this is the trade report (the document delivered at the conclusion of a contract)13.

Follow-up until maturity is also part of the explanation arrangements listed in the FSA's supervisory guidelines for major banks. The bank checks whether the hedge is still working effectively in light of Company E's business conditions and its actual imports. If Company E asks, the bank tells it the market value of the trade and the termination payment at that point, so that Company E can use them for its financial statements or for deciding whether to terminate14.

A trade ends either with settlement on the agreed terms at maturity or with termination before maturity. For some trades, terminating before maturity means a termination payment must be paid or received6.

Departments and their roles

The sales representative is Company E's point of contact, and departments inside the institution share the other steps. The sales representative is the person in the front office (sales and trading) who deals with clients. The FSA's supervisory guidelines for major banks ask banks to set out in internal rules the roles and authority of the managers of the market division (front office), the operations division (back office), and the risk management division (middle office)15. One way to organize credit review is to separate the division that promotes business from the division that reviews credit16.

The front-office trader quotes prices to the sales representative, executes the trade, and records its terms. The middle office (risk management and similar) measures and manages market risk, including the executed trades. Which department handles which step depends on how the institution is organized.

Points to watch in explanations and confirmations

Before the trade, the bank watches for any worry or misunderstanding the client may still have. After the trade, it watches for any mismatch in the terms of the trade.

A client that borrows from the bank may worry that declining a derivative will affect its loans, and where needed the bank explains in a way that clears up that worry17.

After the trade, the terms in the confirmation may not match the institution's own records, so the bank checks for mismatches by reconciling the confirmation.

Laws and supervisory guidelines involved

The work in this chapter is based on the laws and supervisory guidelines below. The rows for Articles 37-3, 37-4, and 40 of the Financial Instruments and Exchange Act are rules for trades that fall under the definition of an OTC derivatives transaction in that Act, and as a rule they do not apply when the client is a professional investor (Article 45).

Step What is required Basis
KYC Verification at the time of transaction (confirming the client's identifying information, the purpose of the transaction, the nature of its business, and other matters) Act on Prevention of Transfer of Criminal Proceeds, Article 4
Proposal and explanation Explaining in writing the loss under the worst-case scenario, the termination payment, and other matters FSA's supervisory guidelines for major banks, III-3-3-1-2(2)
Delivery of documents Providing information before the contract is concluded (pre-contract document) Financial Instruments and Exchange Act, Article 37-3
Suitability check No inappropriate solicitation in light of knowledge, experience, financial situation, and purpose Financial Instruments and Exchange Act, Article 40
After the trade Providing information when the contract is concluded (trade report, or document delivered at the conclusion of a contract) Financial Instruments and Exchange Act, Article 37-4
Reporting the market value Providing the market value and the termination payment on request FSA's supervisory guidelines for major banks, III-3-3-1-2(2)

Notes

  1. 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.) (October 2026), III-3-3-1-1(1) (page 215) (in Japanese). The guidelines cite Article 12-2, paragraph 2 of the Banking Act and Article 13-7 of the Ordinance for Enforcement of the Banking Act. ↩

  2. 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.) (October 2026), III-3-3-1-1(2) (page 215) (in Japanese). ↩

  3. 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.) (October 2026), III-3-3-1-2(2)①イ, first point of item c and Note 1 (page 218) (in Japanese). ↩

  4. "犯罪による収益の移転防止に関する法律" (Act on Prevention of Transfer of Criminal Proceeds, in Japanese), Article 4, paragraph 1, items 1 to 4. Banks are specified business operators under Article 2, paragraph 2, item 1. ↩

  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.) (October 2026), III-2-3-2-1-2(10)① and ② (page 110) (in Japanese). ↩

  6. 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.) (October 2026), III-3-3-1-2(2)①イ, items a, b, and d (pages 217–219) (in Japanese). The guidelines call termination at the client's request "中途解約" (cancellation before maturity). ↩ ↩2

  7. "金融商品取引法" (Financial Instruments and Exchange Act, in Japanese; English translation: Japanese Law Translation), Article 37-3, paragraph 1. Financial instruments business operators, etc. are defined in Article 34. The items to be provided are listed in the items of that paragraph; the method of provision, the details of some items, and some of the cases in which provision is not needed are set by Cabinet Office Order. For clients who are professional investors, see Article 45, item 2. ↩

  8. "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 79, paragraph 1, item 1(a). ↩

  9. "金融商品取引法" (Financial Instruments and Exchange Act, in Japanese; English translation: Japanese Law Translation), Article 40, item 1. For what is asked of banks' derivative trades, see 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.) (October 2026), III-3-3-1-2(2)①イ (page 217) (in Japanese). ↩

  10. "金融商品取引法" (Financial Instruments and Exchange Act, in Japanese; English translation: Japanese Law Translation), Article 45, items 1 and 2 (under the proviso to the Article, they apply in the cases set by Cabinet Office Order). Professional investors are defined in Article 2, paragraph 31. ↩

  11. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 2050.1 "Operations and Systems Risk (Front-Office Operations)" (February 1998), "Transaction Flow," pages 2–3. ↩ ↩2

  12. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 2060.1 "Operations and Systems Risk (Back-Office Operations)" (February 1998), "Confirmations," page 3. ↩ ↩2

  13. "金融商品取引法" (Financial Instruments and Exchange Act, in Japanese; English translation: Japanese Law Translation), Article 37-4, paragraph 1. The name "契約締結時等交付書面" (document delivered at the conclusion of a contract) is in Article 98-2, paragraph 1, item 1(a) of the "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). As a rule, the provision does not apply when the client is a professional investor, under Article 45, item 2 of the Act. ↩

  14. 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.) (October 2026), III-3-3-1-2(2)①イ, item h (pages 219–220) (in Japanese). ↩

  15. 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.) (October 2026), III-2-3-3-2(1)② (page 123) and ⑦ (page 124) (in Japanese). ↩

  16. 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.) (October 2026), III-2-3-2-1-2(2) (page 108) (in Japanese). ↩

  17. 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.) (October 2026), III-3-3-1-2(2)①イ, item g (page 219) (in Japanese). ↩