The Credit Support Annex (CSA)

When a requested collateral amount does not match your firm's own calculation, you go back to the terms of the CSA. You do the same when you check how much exposure the threshold and the minimum transfer amount leave uncovered by collateral.

Attaching an agreement on collateral to the master agreement

Collateral exchange for bilateral OTC derivatives is generally based on a credit support annex (CSA) attached to a master agreement such as the ISDA Master Agreement¹. The FSA's supervisory guidelines also give the ISDA Master Agreement and the CSA as examples of the contract for variation margin². The structure of the documents, including the master agreement and the schedule, is covered in The ISDA Master Agreement and Schedule.

The amount of collateral is found by adding up the market values of the trades with each counterparty, not trade by trade³. The CSA sets who delivers which collateral, in what amount, and when, against this total.

Two ways to deliver collateral

Collateral is delivered in one of two ways. Either ownership of the collateral passes to the receiving party, or a security interest is created and the collateral is placed in the possession or under the control of the receiving party (the UK regulations' definitions are given below).

Japan's margin rules require both variation margin and initial margin to be posted by loan, by deposit, or by a similar method⁴⁵. According to a 2021 commentary (Oxford Business Law Blog), collateral for OTC derivatives in Japan was generally structured using a loan combined with set-off, rather than as a security interest such as a pledge⁶.

With this structure, if the receiving party fails, the posting party cannot recover the part of the collateral that exceeds the secured obligation. The commentary links this point to a judgment of the Tokyo High Court dated October 27, 2010⁶.

The close-out netting act also deals with the security interest structure. The act was amended in May 2019, and the amendment came into force in May 2020, so that close-out netting is also protected where a security interest was created in rehabilitation proceedings⁷⁸.

The UK's 2003 regulations define two kinds of collateral arrangement⁹. In a title transfer arrangement, the party posting collateral transfers legal and beneficial ownership of it to the receiving party, and once the secured obligation has been performed, the receiving party transfers ownership of equivalent collateral back. In a security arrangement, the party posting collateral creates a pledge, mortgage, charge, or similar security interest, and the collateral is held in the possession or under the control of the receiving party.

Some comments on the US final rule on margin asked the regulators to permit title transfer and charge-back arrangements for initial margin. The regulators declined, on the ground that these do not ensure enough safety, and required initial margin to be held separately with an independent third-party custodian¹⁰.

A law firm's commentary from April 2016 notes that the initial margin documents come in an English law form and a New York law form, and that both set out security interest arrangements¹¹.

Terms agreed in a CSA

Japan's margin rules apply to OTC derivatives trades entered into by financial instruments business operators and others, other than trades whose obligations are assumed by a clearing house and similar trades (the Cabinet Office Order calls them "non-centrally cleared OTC derivatives trades")⁴. Below, these are called "trades in scope".

The main CSA terms, and how they are treated for trades in scope, are as follows. For trades in scope, some terms have a cap or a prohibition.

On interest, in an example of practice around 2010, the overnight rate of the currency of the cash collateral was normally used¹⁷. The reuse of collateral is treated differently for variation margin and initial margin. Japan's margin rules do not prohibit pledging or lending the variation margin received¹⁸. Initial margin is covered in a later section. For variation margin with financial end users, the US final rule allows the parties to agree that the receiving party may rehypothecate non-cash collateral and the like¹⁹.

How the threshold and the minimum transfer amount change what is exchanged

For variation margin on trades in scope of the margin rules the threshold is zero. Consider a hypothetical example in which a financial institution and its counterparty agree on a threshold of JPY 500 million for each side, a minimum transfer amount of JPY 100 million, and cash-only collateral with no haircut. This shows how a contract with a threshold works. The market value $V$ is the total of the trades from the financial institution's point of view, and when it is positive the financial institution is the receiving party. Let $X$ be the collateral the financial institution is holding (negative if it has posted collateral), and $\Delta$ the amount newly exchanged today.

$$\Delta = \max(V - T_C, 0) - \max(-V - T_B, 0) - X$$

$T_C$ is the counterparty's threshold and $T_B$ is the financial institution's own threshold. Collateral is exchanged only when the size of $\Delta$ exceeds the minimum transfer amount $M$²⁰.

Figure 1 first shows how the threshold changes the collateral level that is needed. It ignores the minimum transfer amount and the collateral already held, and shows, for each market value, the level when only the excess over the threshold is covered by collateral. The level on the vertical axis is the same quantity as the "Excess over threshold" column of the table below.

Figure description

The horizontal axis is the market value from the financial institution's side, and the vertical axis is the collateral level that covers the excess over the threshold: positive is collateral the financial institution receives, and negative is collateral it posts. From a market value of −JPY 500 million to JPY 500 million, the level is 0 and no collateral is needed. Above JPY 500 million, the level of collateral received rises by the amount of the excess, reaching JPY 500 million at JPY 1 billion. Below −JPY 500 million, the level falls by the amount below the threshold, reaching −JPY 500 million at −JPY 1 billion. The vertical lines at −JPY 500 million and JPY 500 million are the financial institution's own threshold and the counterparty's threshold. Within the thresholds, collateral stays at 0: if the market value is positive, the financial institution holds exposure not covered by collateral, and if it is negative, the counterparty does.

The excess-over-threshold column is the amount to be covered by collateral, by the counterparty if positive and by the financial institution if negative. On Day 1, the market value is within the threshold, so the financial institution holds JPY 400 million of exposure with no collateral. On Day 3, the difference between the collateral required and the collateral held is JPY 50 million, at or below the minimum transfer amount, so nothing is exchanged. On Day 5, even though the market value is still positive at JPY 300 million, it is within the threshold, so the financial institution returns all the collateral it received. When the market value moves in the financial institution's favor, the counterparty posts collateral, and when it moves against the financial institution, the financial institution posts it. On Day 6, the financial institution posts only JPY 300 million, the part above its own threshold of JPY 500 million.

The direction and size of the exchanges over the 6 days, from the financial institution's side, are shown in Figure 2.

Figure description

An upward arrow is collateral the financial institution receives, and a downward arrow is collateral it posts or returns (on Day 5, all of the collateral it holds). The length of each arrow is a rough guide to the size of the amount, and there are no arrows on the days with no exchange (Day 1 and Day 3).

Contracts that comply with the margin rules

Japan's supervisory guidelines list, as a point of focus in a financial instruments business operator's control framework, entering into an appropriate contract with the counterparty for variation margin (the examples are an ISDA Master Agreement and a CSA). For initial margin, they also list entering into a contract on the management of initial margin (such as a contract establishing a trust) in addition to these².

Firms in scope of the rules are required to calculate variation margin every day. In the December 2015 public comment procedure on the draft Cabinet Office Order, a comment set out the following understanding: the daily calculation also has to be stated expressly as daily in the CSA, and it is not permitted to make it weekly on a condition. The FSA confirmed that this understanding is correct²¹.

The receiving party must manage initial margin by establishing a trust or a similar method, so that it can be used without delay if the counterparty fails to perform, and so that it is returned to the counterparty if a close-out netting event occurs for the receiving party itself. Initial margin received must not be pledged or lent. Cash initial margin may, however, be invested in a safe manner incidental to its management²². The US final rule likewise requires initial margin to be held by a custodian unaffiliated with either party, and requires the custody agreement to prohibit the custodian from rehypothecating or the like. Cash may be held in a general deposit account of the custodian under certain conditions²³.

There are cases where a firm wants to include trades that are not in scope in the calculation under the same contract. Japan's Cabinet Office Order provides that, if the parties include them on a continuing basis, trades such as OTC commodity derivatives trades, forward foreign exchange trades, and trades under a master agreement with a close-out netting provision may be included in the calculation²⁴.

The US final rule requires a written agreement on collateral arrangements with a counterparty in scope. The agreement must give a contractual right to exchange margin in the amount and form the rule prescribes, and must set out how the market value is determined when variation margin is calculated and the procedures for resolving valuation disputes²⁵.

Contractual arrangements when the collateral amounts do not match

When the amounts calculated by the two sides differ, Japan's Cabinet Office Order provides that, for variation margin, the amount to be exchanged is the amount calculated by the method the parties have agreed in advance²⁶. In the December 2015 public comment procedure, two methods used in practice were raised, following the dispute resolution provisions of the CSA: using the average of the two sides' calculated amounts, and using the undisputed amount. The undisputed amount is the smaller of the two calculated amounts, and it is 0 if the directions of the exchange differ. The FSA confirmed its understanding that these fall under "a method agreed in advance"²⁷.

Consider a hypothetical example in which the financial institution asks the counterparty to post JPY 1.2 billion and the counterparty calculates JPY 800 million. Under a contract that uses the average, JPY 1 billion is exchanged first, and under one that uses the undisputed amount, JPY 800 million. When the financial institution asks the counterparty to post JPY 300 million and the counterparty calculates JPY 200 million in the opposite direction, the directions differ, so the undisputed amount is 0.

The supervisory guidelines list, for financial instruments business operators, drawing up measures in advance for margin disputes, responding appropriately, and recording and retaining the content of disputes²⁸. The FSB likewise recommends that non-bank market participants have clear dispute mechanisms in place and a system to track and manage outstanding collateral disputes²⁹. When a counterparty fails, a certain period passes between the last collateral exchange and the completion of processing of the trades, because of disputes and other causes³⁰. The steps to resolution are covered in Handling Margin Calls.

Notes

1. Yuichi Saito, "金融規制の複合的影響を考慮したXVA" (XVA Considering the Combined Effects of Financial Regulations, in Japanese; Bank of Japan Institute for Monetary and Economic Studies, Monetary and Economic Studies, April 2017), Chapter 3 (1), the opening paragraph and the subsections "イ．信用極度額" (credit limit), "ロ．最低受渡担保額" (minimum transfer amount), "ハ．評価頻度" (valuation frequency), and "ニ．適格担保" (eligible collateral) (pages 117–118). The paper writes the threshold as "信用極度額" (credit limit) and the minimum transfer amount as "最低受渡担保額". ↩ ↩² ↩³ ↩⁴ ↩⁵

2. 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-2-4 (4) ① (a) (contracts for variation margin) and ② (a) (contracts for initial margin, and the contract on the management of initial margin) (pages 124–125) (in Japanese). ↩ ↩²

3. "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 (a) (each day, for each counterparty, calculate the total market value of non-centrally cleared OTC derivatives trades and the total market value of variation margin). ↩ ↩²

4. "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 (defining "預託等" as posting by loan, deposit, or a similar method), and item 21-11 (initial margin; uses "預託等" in the same sense). ↩ ↩²

5. Anderson Mori & Tomotsune, "JFSA published final rules of margin requirements for OTC derivatives" (April 2016), section 3, "Margin requirements" (page 2). ↩

6. Hiroyuki Watanabe, "Close-Out Netting and Collateral for OTC Derivatives Transactions – A Japanese and International Finance Law Perspective" (Oxford Business Law Blog, March 9, 2021), the first paragraph after the opening summary. ↩ ↩²

7. Same, the fourth paragraph after the opening summary (the paragraph beginning "Until recently"; the May 2019 amendment and the May 2020 entry into force). ↩

8. "金融機関等が行う特定金融取引の一括清算に関する法律" (Act on Close-Out Netting of Specified Financial Transactions Entered into by Financial Institutions, etc., in Japanese), Article 4, paragraph 1 (vesting when an application for the commencement of rehabilitation proceedings has been filed), paragraph 3 (deduction of the valuation amount), and paragraph 4 (where the agreement provides for the secured party to dispose of the collateral). ↩

9. The Financial Collateral Arrangements (No.2) Regulations 2003, regulation 3 (the definitions of "title transfer financial collateral arrangement" and "security financial collateral arrangement"). Both are limited to arrangements where the parties are not natural persons. ↩

10. US final rule "Margin and Capital Requirements for Covered Swap Entities" (Federal Register, November 30, 2015, 80 FR 74840), the explanatory paragraph on § __.7 (page 74875). ↩

11. Anderson Mori & Tomotsune, "JFSA published final rules of margin requirements for OTC derivatives" (April 2016), footnote 8 (page 4; the FSA's response to a comment, No. 58). ↩

12. Anderson Mori & Tomotsune, "JFSA published final rules of margin requirements for OTC derivatives" (April 2016), footnote 6 (page 3; the initial margin threshold, JPY 7 billion across the consolidated group). See also the Financial Services Agency's "コメントの概要及びコメントに対する金融庁の考え方" (Summary of comments and the FSA's responses, in Japanese), No. 62 (page 10). ↩

13. US final rule "Margin and Capital Requirements for Covered Swap Entities" (80 FR 74840), the definition of "Initial margin threshold amount" in § __.2 (page 74901; USD 50 million). ↩

14. "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 (b) and item 21-11 (b) (the amount determined in advance below which no call is required; JPY 70 million or less for variation margin and initial margin combined). ↩ ↩²

15. US final rule "Margin and Capital Requirements for Covered Swap Entities" (80 FR 74840), § __.5(b) (page 74903). ↩

16. "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 10 (assets that may be used as margin) and paragraph 11 (substitute value; item 1 is cash, item 2 is assets in the same currency, and item 3 is assets in a different currency). ↩

17. Masaaki Fujii, Yasufumi Shimada, and Akihiko Takahashi, "A Note on Construction of Multiple Swap Curves with and without Collateral" (first version June 2009, revised January 2010), section 3.1 (page 9). ↩

18. Financial Services Agency, "コメントの概要及びコメントに対する金融庁の考え方" (Summary of comments and the FSA's responses, in Japanese; December 11, 2015), No. 105 (page 15). ↩

19. US final rule "Margin and Capital Requirements for Covered Swap Entities" (80 FR 74840), the explanatory paragraph on § __.6(b) (page 74874; for variation margin with financial end users, if the parties agree, non-cash collateral may be rehypothecated and the like). ↩

20. Yuichi Saito, "金融規制の複合的影響を考慮したXVA" (in Japanese; Monetary and Economic Studies, April 2017), Chapter 3 (2), equation (3) (page 118) and equations (4) and (5) (page 119). The paper's $V(t_k)$, $X(t_{k-1})$, $T_C$, $T_B$, $MTA$, $MTA_C$, and $MTA_B$ are written here as $V$, $X$, $T_C$, $T_B$, and $M$. ↩ ↩² ↩³

21. Financial Services Agency, "コメントの概要及びコメントに対する金融庁の考え方" (in Japanese; December 11, 2015), No. 80 (page 12). ↩

22. "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 21-11 (d) (management by establishing a trust or a similar method) and (e) (not to be pledged or lent; excluding investment of cash initial margin in a safe manner incidental to its management). ↩

23. US final rule "Margin and Capital Requirements for Covered Swap Entities" (80 FR 74840), § __.7(b) (custody of initial margin) and (c) (the custody agreement; the prohibition on rehypothecation and the like, and the exception for cash in a general deposit account) (page 74905). ↩

24. "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 9 (item 1 lists the trades that may be included for variation margin, and item 2 those for initial margin). ↩

25. US final rule "Margin and Capital Requirements for Covered Swap Entities" (80 FR 74840), § __.10 (pages 74908–74909). ↩

26. "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 (c) (where the amount of variation margin differs from the amount calculated by the counterparty, receive the amount calculated by the method the parties agreed in advance). ↩

27. Financial Services Agency, "コメントの概要及びコメントに対する金融庁の考え方" (in Japanese; December 11, 2015), No. 116 (page 17). The FSA answered "ご理解のとおりです" (that is correct) to the description of practice in the comment. ↩

28. 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-2-4 (4) ③ (b) (common to initial margin and variation margin; disputes over margin; page 125) (in Japanese). ↩

29. Financial Stability Board, "Liquidity Preparedness for Margin and Collateral Calls: Final report" (December 10, 2024), section 3.3, Recommendation 6 (page 18). That the recommendation is addressed to non-bank market participants is in section 1 (page 3). ↩

30. Yuichi Saito, "金融規制の複合的影響を考慮したXVA" (in Japanese; Monetary and Economic Studies, April 2017), Chapter 3 (1), "ハ．評価頻度" (valuation frequency) (page 117). ↩