A sales representative at a financial institution can use this page to put together the documents and the explanation when proposing a derivative to a client. On the client side, staff considering a trade read it to check what the explanation should cover, and staff who maintain internal rules read it when they review those rules.

Why proposals and explanations are needed

Proposals and explanations exist so that the client can understand what a derivative contains and what its risks are, and then decide for itself whether to trade. The financial institution selling the product and the client differ in how much they know about the product and in the information they have. This gap is called information asymmetry. With this gap in mind, Principle 5 of the Financial Services Agency's (FSA's) "Principles for Customer-Oriented Business Conduct" asks financial business operators to present important information in a form the client can understand1.

For banks, the FSA's "Comprehensive Guidelines for Supervision of Major Banks, etc." (the FSA's supervisory guidelines for major banks) set out points of focus for checking a bank's arrangements for explanations. These points apply both when a derivative is combined with a loan and when a derivative is traded on its own. Drawing on Article 12-2, paragraph 2 of the Banking Act and Article 13-7 of the Ordinance for Enforcement of the Banking Act, the guidelines ask banks to set methods of explanation in internal rules and similar documents. The methods are to be suited to the client's knowledge, experience, financial situation, and purpose of the trade. The guidelines also ask banks to build arrangements for carrying out their business in line with those internal rules2. Each bank sets the steps and forms for the explanation in its internal rules and similar documents, and the guidelines give their points of focus as examples3.

In the past, banks and the FSA received complaints about FX derivatives sold to small and medium-sized enterprises. The typical contract for an importer produced a gain if the yen weakened and a loss if the yen strengthened4.

What goes into the proposal and the explanatory documents

The proposal and the explanatory documents describe, with concrete examples, how the trade works, when it produces a loss, and what happens if the client wants to exit early. The first item among the points of focus in the FSA's supervisory guidelines for major banks is explaining the product by giving the client a document that sets out its contents and risks clearly, with examples. When an example differs from the actual trade, the bank also says that it differs5. Which document must contain what, and how the named documents (the product explanation and the pre-contract document) differ, are covered in Product Explanations and Pre-Contract Disclosures.

Item Contents Basis
How the product works What is paid and received, and when; which market price determines the profit or loss Supervisory guidelines for major banks, Principle 5
Effectiveness as a hedge Whether, given the client's sales and purchases, the trade works as a hedge until the end of the contract Supervisory guidelines for major banks
Risks How market moves lead to a loss, and which moves would have a serious effect on the client's business or finances Supervisory guidelines for major banks
Loss under the worst-case scenario The estimated maximum loss, and the fact that the loss grows further if conditions turn out worse than assumed Supervisory guidelines for major banks
Fees and other costs The amount or calculation method of each type of cost the client bears Principle 4 (for information provided before the contract, Article 81 of the Cabinet Office Order on Financial Instruments Business, etc.)
Early termination and termination payments Whether the client can exit early, the fact that doing so triggers a termination payment, and an estimate of it Supervisory guidelines for major banks
Reason for the choice Why this product is proposed (why it is considered to fit the client's needs and wishes) Principle 5

For a trade whose purpose is hedging, the bank checks, in light of the client's business, whether the trade will remain an effective hedge until the end of the contract, and explains the result6. How to check this is covered in Understanding Client Needs.

For trades for which the Financial Instruments and Exchange Act requires information to be provided before the contract (including OTC derivative trades), the information provided includes the costs the client pays. These costs are shown by type, whatever they are called (fees, remuneration, or other names), together with their total. What is shown is the amount, the maximum amount, or the calculation method. If none of these can be shown, the firm states that and gives the reason7.

If the trade cannot be ended early, the bank explains that. If ending it early triggers a termination payment, the bank explains an estimate of the payment (an amount calculated assuming the worst-case scenario)8.

The worst-case scenario and the loss the client can tolerate

The worst-case scenario is the case in which the underlying market price, interest rate, or similar variable moves in the direction most unfavorable to the client, assumed on reasonable grounds such as data from past periods of stress. The sales representative explains the estimated maximum loss under the worst-case scenario, including the possibility that the loss could grow further if conditions differ from the assumptions5.

Consider a hypothetical example in which fees are ignored. Company H is a corporate client that will pay USD 1 million for imports in one year. A sales representative proposes an FX forward under which Company H buys USD 1 million in one year at 140 yen per dollar. The profit or loss on the forward depends on the spot exchange rate in one year. In the proposal, the worst-case scenario is set at 100 yen per dollar in one year.

Spot rate in one year Profit or loss on the forward (compared with buying at spot) Total payment (imports and forward combined)
170 yen per dollar Gain of 30 million yen 140 million yen
140 yen per dollar 0 yen 140 million yen
120 yen per dollar Loss of 20 million yen 140 million yen
100 yen per dollar (worst-case scenario) Loss of 40 million yen 140 million yen
90 yen per dollar Loss of 50 million yen 140 million yen

The profit or loss on the forward is (spot rate − 140 yen) × USD 1 million. If the yen weakens to 170, Company H buys the dollars 30 million yen more cheaply than at spot. At 100, the worst-case scenario, it pays 40 million yen more than at spot, and this is the estimated maximum loss. If the yen strengthens beyond the assumption to 90, the loss grows to 50 million yen. As long as Company H pays for the imports as planned, its payment is 140 million yen whatever the rate.

The sales representative also checks how large a loss Company H can tolerate. If Company H can tolerate 20 million yen, the tolerable amount is exceeded once the yen strengthens past 120, even before it reaches 100, the worst-case scenario. When there is a rate at which the tolerable amount is exceeded like this, the sales representative explains it so that Company H understands5. For securities firms and similar businesses trading OTC derivatives, the FSA's "Comprehensive Guidelines for Supervision of Financial Instruments Business Operators, etc." (the FSA's supervisory guidelines for financial instruments business operators) also list, as a point of focus, explaining at what market levels the loss would exceed the tolerable amount9.

The loss on the forward becomes Company H's own loss when the imports being hedged disappear. If the business shrinks and the USD 1 million payment is no longer needed, the forward to buy dollars at 140 yen still remains. If the rate in one year is 100, Company H has to sell the dollars it bought at 140 at the spot rate of 100, and the 40 million yen loss stays with Company H. At 170, the same sale produces a gain of 30 million yen. The sales representative explains which market levels would have a serious effect on Company H's business or finances5.

The explanation process

The order below is one example that lines up the points of focus in the supervisory guidelines and the requirements of the law. It does not fix which department is responsible or how many documents are used. Each bank sets its methods of explanation in internal rules and similar documents3.

ClientSales rep.FirmListens to needs,checks the productsuits the clientPrepares proposaland explanatorydocumentsProvides requiredinfo by the timeof contractGives documents,explains, checksloss it can bearHears theexplanation anddecides to tradeConfirms receiptof the explanationand keeps a record
Figure 1Flow from the proposal to confirming that the client received the explanation
Figure description

The figure shows steps 1 to 4 and 6 below, plus the client's decision to trade. "Sales rep." is the sales representative, and "Firm" is the financial institution. The sales representative listens to the client and prepares the documents, the firm provides the information required by law by the time of the contract at the latest, and the sales representative then hands over the documents and explains them. In step 4, the sales representative checks the loss the client can tolerate and also the termination payment the client can tolerate. After the explanation, the client's decision to trade and the sales representative's confirmation and written record of the explanation sit side by side, and the figure does not fix which comes first. Step 5, explaining that declining will not affect the client's loans, applies only to banks, so it is not in the figure.

  1. The sales representative finds out the client's needs and checks whether the product suits the client (the suitability check).
  2. The sales representative prepares a proposal and a document explaining the product's contents and risks, early termination, and termination payments (the FSA's supervisory guidelines for major banks).
  3. The financial institution provides the client, by the time the contract is concluded, with the information set out in Article 37-3 of the Financial Instruments and Exchange Act. It does so either by giving a document (the pre-contract document) or by electromagnetic means10. If the client is a professional investor, this requirement does not apply11.
  4. The sales representative gives the document from step 2 and explains it, and checks the loss the client can tolerate and the termination payment the client can tolerate (the FSA's supervisory guidelines for major banks).
  5. Because a client may worry that declining a derivative will affect its loans, the bank explains, where needed, that declining will not affect its loans. The bank also confirms with the client that the client received this explanation (the FSA's supervisory guidelines for major banks)12.
  6. The sales representative confirms with the client that the client received the explanation, and keeps a written record (the FSA's supervisory guidelines for major banks). At securities firms and similar businesses, for trades that could have a large effect on the client's business, the firm also checks the client's internal decision-making (the FSA's supervisory guidelines for financial instruments business operators).

Records of the explanation and checks before and after the trade

The written acknowledgment of explanation is used in step 6 to confirm that the client received the explanation. The FSA's supervisory guidelines for major banks call it a "confirmation document, etc." (our translation). It is different from the trade confirmation, which the parties send each other after the trade to set out its terms13.

For securities firms and similar businesses, the FSA's supervisory guidelines for financial instruments business operators list, as a point of focus, arrangements for confirming the client's intention to enter into an OTC derivative contract. In doing so, the firm pays attention to whether the client's decision-making procedure matches the contents and size of the contract and the client's business and management structure. For a trade that could significantly shape the client's future business, the firm checks whether the contract was approved by the client's board of directors or a similar body14.

After the trade, the bank checks the effectiveness of the hedge again in light of the client's business conditions and actual needs, and on the client's request informs it of the market value and the termination payment amount15.

The Principles for Customer-Oriented Business Conduct

The Principles for Customer-Oriented Business Conduct are principles for how financial business operators run their business. The FSA formulated them in March 2017 and revised them on September 26, 202416. Rather than setting detailed rules, they set out principles so that each financial business operator can achieve customer-oriented business in substance in a way that fits its own circumstances (a principles-based approach). A financial business operator that adopts the principles prepares and publishes a policy and regularly publishes the status of its efforts. If it does not implement a principle, it explains why or what it does instead17.

The four principles most relevant to proposals and explanations are these.

Principle What it says Use in proposals and explanations
Principle 2 Conduct business sincerely and fairly toward clients, and pursue the client's best interest The basis for making a proposal
Principle 4 Show fees and other costs, whatever they are called, including what they are paid for The fee section of the proposal
Principle 5 Present important information clearly, such as benefits and risks, trade terms, the reason for the choice, and the nature of conflicts of interest The contents of the proposal and the explanatory documents
Principle 6 Understand the client's assets, trading experience, knowledge, purpose, and needs, and propose suitable products Understanding needs, suitability checks

The notes to Principles 5 and 6 make the way of presenting information more concrete. For complex or high-risk products, the firm uses materials that make it easy to compare the product with others of the same type, explains carefully starting from the basic structure (such as the relationship between risk and return), and highlights important information1. In a proposal, the firm presents the product while comparing it with the contents (including fees) of similar or alternative products18.

The client's best interest is also set out in law. Article 2, paragraph 1 of the Act on the Provision of Financial Services and the Improvement of the Usage Environment (Financial Services Provision Act) covers those who carry out business designated by Cabinet Order, such as financial instruments business and banking. They must conduct their business sincerely and fairly while taking into account the client's best interest19.

The main laws and regulations behind the steps of proposals and explanations are listed below. The first, Article 4 of the Financial Services Provision Act, and the third, Article 37-3, paragraph 2 of the Financial Instruments and Exchange Act, set out a duty to explain important matters to the client. This duty is called the duty to explain.

  • Article 4 of the Financial Services Provision Act requires important matters to be explained before financial instruments, including OTC derivative trades, are sold. The matters explained include the risk that changes in market prices or similar factors cause a loss below the principal or a loss exceeding the initial principal, the indicators that cause that risk, and the important parts of how the trade works. The explanation uses the method and depth needed for the client to understand it, in light of the client's knowledge, experience, financial situation, and purpose of the contract20.
  • Article 5 of the Financial Services Provision Act prohibits, before a sale, giving a conclusive judgment on uncertain matters or saying things that may mislead the client into thinking something is certain21. The FSA's supervisory guidelines for major banks also list, as a point of focus, arrangements to prevent conclusive judgments and misleading presentations or explanations22.
  • Article 37-3, paragraph 2 of the Financial Instruments and Exchange Act applies when information is provided before a contract. The matters provided (except some, such as the risk of loss) must be explained using the method and depth needed for the client to understand them. This is judged in light of the client's knowledge, experience, financial situation, and purpose23. If the client is a professional investor, this requirement does not apply11.
  • To avoid violating Article 13-3 of the Banking Act and Articles 38 (prohibited acts) and 40 (suitability principle) of the Financial Instruments and Exchange Act, the FSA's supervisory guidelines for major banks list, as a point of focus, explaining the product's contents and risks as they apply to the product. The explanation is based on the client's knowledge, experience, financial situation, and purpose of the trade224.

Notes

  1. Financial Services Agency, "顧客本位の業務運営に関する原則" (Principles for Customer-Oriented Business Conduct) (September 26, 2024), page 5, Principle 5 and Notes 1, 4, and 5 (in Japanese). ↩ ↩2

  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(1) and (2) (page 215) and III-3-3-1-2(2)①イ (page 217) (in Japanese). The articles of the Banking Act and the Ordinance for Enforcement of the Banking Act are those cited in the guidelines. ↩ ↩2

  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.), III-3-3-1-1(2) (page 215) and III-3-3-1-2(1)② (page 216) (in Japanese). ↩ ↩2

  4. Financial Services Agency, "中小企業向け為替デリバティブ取引状況（米ドル/円）に関する調査の結果について（速報値）" (Results of the survey on the status of FX derivative trades (US dollar/yen) with small and medium-sized enterprises, preliminary figures), "２．" (number of complaints received by banks), "（参考）" (Reference; number of complaints received by the FSA and the Japanese Bankers Association), and "（注）" (Note; the typical contract of an importer) (in Japanese). ↩

  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.), III-3-3-1-2(2)①イ, item a (page 217) (in Japanese). ↩ ↩2 ↩3 ↩4

  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.), III-3-3-1-2(2)①イ, item c and Notes 1 to 3 (pages 218–219) (in Japanese). ↩

  7. "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 81, paragraph 1 (the matters concerning fees and other costs under Article 37-3, paragraph 1, item 4 of the Financial Instruments and Exchange Act). ↩

  8. 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.), III-3-3-1-2(2)①イ, item b (pages 217–218) (in Japanese). ↩

  9. Financial Services Agency, "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)①ロ (page 165) (in Japanese). ↩

  10. "金融商品取引法" (Financial Instruments and Exchange Act, in Japanese; English translation: Japanese Law Translation), Article 37-3, paragraph 1 (headed "契約締結前の情報の提供等," provision of information before conclusion of a contract, etc.; our translation), and "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) and item 2. ↩

  11. "金融商品取引法" (Financial Instruments and Exchange Act, in Japanese; English translation: Japanese Law Translation), Article 45, item 2 (provisions that do not apply when the counterparty is a professional investor, except in the cases set by Cabinet Office Order under the proviso). ↩ ↩2

  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.), III-3-3-1-2(2)①イ, item g and Notes 1 and 2 (page 219) (in Japanese). ↩

  13. 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.), III-3-3-1-2(2)①イ, item d (page 219) (in Japanese). ↩ ↩2

  14. Financial Services Agency, "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)⑦ (page 166) (in Japanese). ↩ ↩2

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

  16. Financial Services Agency, "顧客本位の業務運営に関する原則" (Principles for Customer-Oriented Business Conduct), cover and page 2 (in Japanese). ↩

  17. Financial Services Agency, "顧客本位の業務運営に関する原則" (Principles for Customer-Oriented Business Conduct), pages 2–3, "本原則の採用するアプローチ" (The approach adopted by these principles) (in Japanese). ↩

  18. Financial Services Agency, "顧客本位の業務運営に関する原則" (Principles for Customer-Oriented Business Conduct), page 6, Principle 6, Note 1 (in Japanese). ↩

  19. "金融サービスの提供及び利用環境の整備等に関する法律" (Act on the Provision of Financial Services and the Improvement of the Usage Environment, in Japanese), Article 2, paragraph 1 and paragraph 2, items 2 and 3. ↩

  20. "金融サービスの提供及び利用環境の整備等に関する法律" (Act on the Provision of Financial Services and the Improvement of the Usage Environment, in Japanese), Article 4, paragraphs 1 and 2, and Article 3, paragraph 1, item 9 (OTC derivative trades). ↩

  21. "金融サービスの提供及び利用環境の整備等に関する法律" (Act on the Provision of Financial Services and the Improvement of the Usage Environment, in Japanese), Article 5. ↩

  22. 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.), III-3-3-1-2(2)①イ, item e (page 219) (in Japanese). ↩

  23. "金融商品取引法" (Financial Instruments and Exchange Act, in Japanese; English translation: Japanese Law Translation), Article 37-3, paragraph 2. ↩

  24. "金融商品取引法" (Financial Instruments and Exchange Act, in Japanese; English translation: Japanese Law Translation), Articles 38 and 40. ↩