A financial institution tells the client about mid-term cancellation and termination payments in its explanation before the trade. After the trade, the institution also gives the client the market value and the termination payment amount on request, so that the client can use them for its financial closing and for deciding whether to cancel.

When early termination happens

Early termination can happen at the client's request or because of an event set out in the contract, such as a default. Early termination at the client's request is also called mid-term cancellation. Some trades cannot, in principle, be cancelled mid-term. For those, the financial institution explains this before the trade1.

When a client cancels a trade mid-term for its own reasons, a termination payment may be required2. A trade entered into for hedging can stop being needed even when the derivatives trade itself shows no loss. It can also stop working until maturity, for example when the client's business shrinks3. With an interest rate swap used to fix the rate on a loan, repaying the loan early leaves only the swap in place. The supervisory guidelines for major banks and for small, medium-sized and regional institutions list, as a point of focus for banks, rechecking after the trade whether the hedge still works for the client's actual needs4.

Early termination caused by an event set out in the contract can happen even if the client does not want it. In a trade with a bank, an event under the bank transaction agreement or similar documents can cause the client to lose the benefit of time (the right not to repay before the due date). The client may then also lose the benefit of time under the derivatives trade and become obliged to pay a termination payment. The bank also explains this before the trade5.

How the termination payment is determined

The starting point of a termination payment is the market value of the trade. Market value is the present value of the payments for the remaining term, revalued at current rates and prices. During the life of a trade, it can be positive or negative. The market value for one party is the market value for the other party with the sign reversed6. A trade can be ended early when one party pays the other its market value7. How market value is calculated is covered in Valuing an Interest Rate Swap.

The amount actually paid to end a trade is not necessarily the same as its market value, because market value is calculated without transaction costs7. Likewise, the amount in a market value report does not necessarily become the termination amount as it is.

What is added to market value has been discussed in court cases on early termination caused by a default. A 2013 Tokyo High Court judgment concerned the settlement amount for trades terminated early after a bankruptcy filing by the counterparty's credit support provider. It took the approach of calculating the loss by estimating "a replacement price that adds the replacement cost to the mark-to-market value" (our translation). A 2018 report by a financial law study group of the Japanese Bankers Association (JBA) commented on this judgment. The report names two main differences between the present value of the future payments (the market price) and this replacement price. One is the cost of the counterparty's credit borne by a financial institution that enters into the same trade anew. The other is the difference in terms between entering into a trade and cancelling it, which corresponds to the bid-ask spread8.

Consider a hypothetical example in which Company S enters into a loan and an interest rate swap. Company S borrowed 1 billion yen at a floating rate and entered into an interest rate swap in which it pays a fixed rate of 1% and receives a floating rate. With the loan and the swap together, the rate Company S pays is fixed (Figure 1)9. With 3 years left, Company S decides to repay the loan and cancels the swap mid-term. In this example, the costs added to the market value are 2 million yen, and they work in the direction of increasing what Company S pays and reducing what it receives.

Lender1 bn yenCompany SBorrowerSwap partyTo cancelFloating int.Fixed 1%Floating
Figure 1Company S's loan and interest rate swap
Figure description

Company S pays floating-rate interest to its lender, pays a fixed rate of 1% to its swap counterparty, and receives a floating rate from that counterparty. In this example, the trade being cancelled mid-term is the interest rate swap, not the loan.

Amount for Company S (million yen; negative means Company S pays) If market rates fall If market rates rise
Market value of the swap −20 +15
Costs added to the market value −2 −2
Termination payment −22 +13

When market rates fall, the commitment to keep paying a fixed 1% works against Company S, and the market value becomes negative. Company S pays 22 million yen, the market value plus the costs, to end the trade. When rates rise, the market value becomes positive, and Company S receives 13 million yen after the costs are deducted. If the loan were still outstanding, the higher net swap payments after a fall in rates would be offset by the lower interest on the loan. In a mid-term cancellation, only the swap side is settled, in a lump sum covering the remaining term.

What to explain before the trade

Mid-term cancellation and termination payments are explained before the trade, for example by handing the client a written document. The points of focus for this explanation are in three sets of FSA supervisory guidelines. The Comprehensive Guidelines for Supervision of Major Banks, etc. and the Comprehensive Guidelines for Supervision of Small and Medium-Sized and Regional Financial Institutions cover cases where a bank's lending business includes derivatives trades (including when the bank enters into derivatives trades alone). The Comprehensive Guidelines for Supervision of Financial Instruments Business Operators, etc. cover OTC derivatives such as currency options and interest rate swaps10. The items to explain are almost the same across the three sets of guidelines1.

What to explain Guidelines for major banks and for small, medium-sized and regional institutions Guidelines for financial instruments business operators
If the trade cannot, in principle, be cancelled mid-term, that fact Yes Yes
If mid-term cancellation gives rise to a termination payment, that fact and what it involves Yes Yes
The estimated termination payment assuming a worst-case scenario, and the possibility of exceeding it Yes Yes
Confirming the termination payment the client can tolerate, and the possibility of exceeding that amount even outside the worst-case scenario Yes Yes
That a termination payment obligation may arise if an event causing the loss of the benefit of time occurs Yes Not listed

"Worst-case scenario" is a term from the supervisory guidelines, and the scenario is based on reasonable assumptions such as data from past periods of stress11. The estimate is a guide to how large the termination payment could become at most. If conditions differ from the assumptions, the payment can exceed the estimate. For that reason, if the estimate could be exceeded, that possibility is also part of the explanation1.

The procedure for confirming with the client that it received the explanation, and keeping a written record, is covered in Product Explanations and Pre-Contract Disclosures12.

In selling structured notes, the issue is a mid-term sale rather than a mid-term cancellation. The FSA's supervisory guidelines for financial instruments business operators state that, for structured notes, "mid-term cancellation" is to be read as "mid-term sale" and "termination payment" as "the estimated loss from a mid-term sale" (our translation)13.

From the trade to termination

The steps involved in a mid-term cancellation run in the following order. Figure 2 shows the same steps split between the financial institution and the client.

  1. Before the trade, the financial institution explains the mid-term cancellation and termination payment items in writing and confirms with the client that it received the explanation112.
  2. After the trade, if the client asks, the financial institution provides the market value and the termination payment amount at that time, either regularly or as needed. The client uses this for its financial closing and for deciding whether to cancel4.
  3. The client requests a mid-term cancellation, one party pays the other the termination payment, and the trade ends7.
Financial institutionClientExplains inwriting beforethe tradeConfirms theclient receivedthe explanationOn request, givesmarket value andamount payableUses it foraccounts and thecancellation decisionRequestsmid-termcancellation
Figure 2Steps from the trade to mid-term cancellation, for the financial institution and the client
Figure description

The financial institution's lane covers the explanation and confirmation before the trade, and providing the market value and termination payment amount after it. The client's lane covers using that information for its financial closing and its decision on cancellation, and requesting the mid-term cancellation.

Common problems and how to prevent them

Termination payments and the explanation given before the trade have been points of contention in mid-term cancellations. From July to September 2011, as the strong yen continued, complaints about FX derivatives with banks received by the JBA's consultation office rose sharply. Some of these complaints said that the bank had not explained the risk in the worst case. Others expressed dissatisfaction that the only option offered was, for example, a loan to fund the termination payment. Of the new disputes filed with the JBA's mediation committee in the same three months, 67.3% concerned derivatives business14.

Among these complaints, the lack of an explanation of the worst case is addressed by the procedure of showing the estimated termination payment under a worst-case scenario before the trade and comparing it with the amount the client can tolerate1.

The procedures for explaining mid-term cancellation and providing information follow the points of focus in the FSA's three sets of supervisory guidelines. The FSA's supervisory guidelines for major banks, based on Article 12-2, paragraph 2 of the Banking Act and Article 13-7 of the Ordinance for Enforcement of the Banking Act, list internal rules and systems for giving explanations by means such as delivering documents15. The guidelines for major banks and for small, medium-sized and regional institutions also list, for explaining derivatives trades, the need to take care not to breach Article 13-3 of the Banking Act or the items of Articles 38 and 40 of the Financial Instruments and Exchange Act16.

How trades are settled when they end early is set by the parties' contract. In the contract in the 2013 court case mentioned above, the parties had chosen a method that calculates the amount of loss reasonably17. When trades end early because of a default or similar event, the rules on close-out netting also apply: the values of multiple trades with the same counterparty are offset against each other to produce a single claim or obligation.

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-3-3-1-2(2)①イ, item b (pages 217–218); "中小・地域金融機関向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Small and Medium-Sized and Regional Financial Institutions) (October 2026), II-3-2-1-2(2)①イ, item b (page 86); "金融商品取引業者等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Financial Instruments Business Operators, etc.) (October 2026), IV-3-3-2(6)② (page 165) (all in Japanese). ↩ ↩2 ↩3 ↩4 ↩5

  2. Financial Services Agency, "デリバティブ商品を契約するときのポイント" (Points to check when entering into a derivatives contract) (pamphlet; no publication date given), front side, "説明事項（主な例）" (Items to be explained (main examples)) (in Japanese). ↩

  3. "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.), III-3-3-1-2(2)①イ, item c, note 2 (page 218); "金融商品取引業者等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Financial Instruments Business Operators, etc.), IV-3-3-2(6)③, note 2 (page 166) (both in Japanese). ↩

  4. "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.), III-3-3-1-2(2)①イ, item h (pages 219–220); "中小・地域金融機関向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Small and Medium-Sized and Regional Financial Institutions), II-3-2-1-2(2)①イ, item h (pages 87–88); "金融商品取引業者等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Financial Instruments Business Operators, etc.), IV-3-3-2(6)⑥ (page 166) (all in Japanese). Rechecking hedge effectiveness is in the first paragraph of item h. Providing the market value and termination payment amount after the trade is in the second paragraph of item h and in ⑥. ↩ ↩2

  5. "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.), III-3-3-1-2(2)①イ, item b, third point (page 218); "中小・地域金融機関向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Small and Medium-Sized and Regional Financial Institutions), II-3-2-1-2(2)①イ, item b, third point (page 86) (both in Japanese). IV-3-3-2(6)② of the guidelines for financial instruments business operators does not include this point. ↩

  6. Society of Actuaries, "Interest Rate Swaps" (May 2017), Section 6, "Market Value," page 15. The note defines market value as the present value of the future payments discounted at the spot rates at that time, states that it can be positive or negative during the life of the swap, and states that the market value for one counterparty is the negative of the market value for the other. ↩

  7. The same source, Section 6, "Market Value," page 15, text and footnote 8. The text describes market value as "ignoring transaction costs." Footnote 8 gives one counterparty paying the other the market value as one way to close a swap. ↩ ↩2 ↩3

  8. 全国銀行協会 金融法務研究会 (financial law study group of the Japanese Bankers Association), "デリバティブ取引に係る諸問題と金融規制の在り方" (Issues in derivatives transactions and the approach to financial regulation) (March 2018), Chapter 2 (神田秀樹), "６　店頭デリバティブ取引におけるネッティング後の損害の額の算定（東京高判平成25年4月17日判例時報2250号14頁）" (6. Calculating the amount of loss after netting in OTC derivatives transactions (Tokyo High Court judgment of April 17, 2013)), "（３）コメント" (3. Comment), pages 36–37 (in Japanese). ↩

  9. Society of Actuaries, "Interest Rate Swaps" (May 2017), Section 1, page 3. The note states that an interest rate swap can remove the uncertainty of a floating-rate loan. ↩

  10. "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.), III-3-3-1-2(2)①イ (page 217); "中小・地域金融機関向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Small and Medium-Sized and Regional Financial Institutions), II-3-2-1-2(2)①イ (page 85); "金融商品取引業者等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Financial Instruments Business Operators, etc.), the introductory text of IV-3-3-2(6) (page 164) (all in Japanese). ↩

  11. "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.), III-3-3-1-2(2)①イ, item a (page 217); "金融商品取引業者等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Financial Instruments Business Operators, etc.), IV-3-3-2(6)①イ (page 165) (both in Japanese). ↩

  12. "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.), III-3-3-1-2(2)①イ, item d (page 219); "中小・地域金融機関向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Small and Medium-Sized and Regional Financial Institutions), II-3-2-1-2(2)①イ, item d (page 87); "金融商品取引業者等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Financial Instruments Business Operators, etc.), IV-3-3-2(6)④ (page 166) (all in Japanese). ↩ ↩2

  13. "金融商品取引業者等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Financial Instruments Business Operators, etc.), the note to IV-3-3-2(6)② (page 165) (in Japanese). ↩

  14. Japanese Bankers Association, "全国銀行協会紛争解決等業務の実施状況（平成23年度第2四半期）" (Status of the JBA's dispute resolution operations, second quarter of fiscal 2011) (covering July to September 2011), "⑻デリバティブ業務" (8. Derivatives business) (page 8), and the number of new filings in the quarter by type of business under "Ⅲ．あっせん委員会における紛争解決手続の状況" (III. Status of dispute resolution procedures at the mediation committee) (page 9) (in Japanese). ↩

  15. "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.), III-3-3-1-1(1) (page 215) (in Japanese). ↩

  16. "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.), the introductory text of III-3-3-1-2(2)①イ (page 217); "中小・地域金融機関向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Small and Medium-Sized and Regional Financial Institutions), the introductory text of II-3-2-1-2(2)①イ (page 85) (both in Japanese). ↩

  17. 全国銀行協会 金融法務研究会 (financial law study group of the Japanese Bankers Association), "デリバティブ取引に係る諸問題と金融規制の在り方" (Issues in derivatives transactions and the approach to financial regulation) (March 2018), Chapter 2 (神田秀樹), section 6, "（３）コメント" (3. Comment), page 36 (in Japanese). According to the report, the contract in that case had chosen a method called "loss" for settling early termination, under which the settlement amount was the loss reasonably estimated by the party to which no early termination event applied. ↩