Sourcing and Substituting Collateral

When a market participant receives a margin call, the people in charge of funding or collateral management choose whether to pay in cash or which collateral to deliver. They weigh cost and reliability.

Which assets to post, and where to source them

Collateral is cash or bonds exchanged in derivatives trades to cover losses if the counterparty defaults.

Under Japan's margin rules, as of October 2026, variation margin and initial margin are posted in cash or in other assets designated by the Commissioner of the Financial Services Agency¹.

For interest rate swaps at the central counterparty Japan Securities Clearing Corporation (JSCC), initial margin can be deposited in cash in Japanese yen or US dollars. It can also be deposited in substitute securities, which are Japanese government bonds or US Treasury securities². The range of assets that can be posted depends on the counterparty and the contract, so the choice is made within that range, with attention to cost and reliability.

The steps for sourcing collateral are as follows.

1. The required collateral value is set.
2. The range of assets that can be posted, as set by regulation, contracts, and clearing house rules, is confirmed.
3. The means of sourcing and the assets are chosen, such as delivering assets held, reusing collateral received, or transforming collateral.
4. If a non-cash asset is chosen, the required market value is found, which is larger by the haircut.
5. The collateral is posted by the required time.

Ways to source collateral

Three examples of ways to source assets for collateral are listed below.

The FSB recommends that market participants other than banks and clearing houses hold, for calls payable only in cash, cash or a reliable source of funding that can be paid in the currency, at the time, and at the place of the call⁴⁵.

Collateral transformation

Collateral transformation is a trade that temporarily exchanges less liquid assets that a firm holds for high-quality assets that can be used as collateral. This page uses the term in that sense, following the usage in documents of the Bank of England (BoE) and the UK authority, the Prudential Regulation Authority (PRA). It takes forms such as a long-term repo or securities lending, in which the firm borrows high-quality securities and hands over less liquid securities in return. In 2012, a BoE paper observed that clearing mandates and other changes would increase the demand for collateral while narrowing the range of assets seen as safe. The paper said this would give firms a stronger incentive to manage collateral actively, and that such trades might increase⁶.

Terms and scope differ by source. A 2013 PRA supervisory statement describes a collateral upgrade transaction as a trade lasting more than a year. The statement covers trades that exchange assets of materially different quality, including long-term repo and securities lending, and excludes short-term trades of one year or less⁷. The statement lists three concerns. The first is a tendency for assets to remain encumbered as collateral. The second is whether borrowed assets used to meet liquidity regulation or to fund a firm would hold up under stress. The third is that such trades could get in the way of resolution. The statement was replaced by another document in 2019⁸. The FSB, by contrast, uses collateral transformation without defining it, and the remarks of market participants that the FSB cites include one that speaks of turning assets into cash⁹.

In its recommendations for non-bank market participants, the FSB lists, alongside cash on hand, reliable sources of funding and collateral transformation arrangements as ways to prepare for unexpected margin calls⁴. Among the views of market participants was one that stressed the importance of preparing in advance for using collateral transformation services when markets are stressed⁹.

The required amount grows by the haircut

Non-cash collateral is valued at its market value less the haircut. Under Japan's margin rules, non-cash assets are valued at market value less an amount set by multiplying it by a rate that the Commissioner of the Financial Services Agency sets. A further deduction applies if the currency differs¹⁰. The haircut is covered in Funding Variation and Initial Margin.

Let $V$ be the collateral value, $h$ the haircut, and $M$ the market value of the asset posted. The valuation is $M(1-h)$. For this to reach $V$, the market value must be as follows.

$$M = \frac{V}{1-h}$$

Consider a hypothetical example in which the required collateral value is 9.8 billion yen and the haircut on government bonds is 2%. Then $M = 9.8 \div (1 - 0.02) = 10$, so government bonds with a market value of 10 billion yen are needed. The calculation example sets the haircut on cash at 0%, so cash needs 9.8 billion yen.

Which collateral is cheaper

Where cash collateral in several currencies is allowed, it is rational to post the one with the lowest cost. In XVA valuation around 2017, the valuation adjustment for this right to post the cheapest collateral was called CTDVA (Cheapest To Deliver Valuation Adjustment). It was valued by comparing the collateral rates of each currency and building a curve from the cheapest rates¹¹.

Types of collateral also differ in ways other than cost. In Japan, government bonds were commonly used as collateral. Posting them could reduce items such as the cost of the counterparty's credit risk (the credit cost). Unlike cash variation margin, however, they could not be used to offset exposure under the leverage ratio, so that benefit was not available¹². Widening the choice of collateral makes the right to choose harder to value and hedge, and around the same time there was also a move to limit eligible collateral¹¹.

Calculation example: Cash versus a bond

Consider a hypothetical example in which Company P needs 9.8 billion yen of collateral value and will provide it in either cash or government bonds. The assumptions are as follows. In the table, "planned" is the cost if the firm had planned to use the bond in a repo trade. "Not planned" is the cost if it had no other planned use for the bond.

• The haircut is 2% on the government bond and 0% on cash.
• Company P's unsecured borrowing rate is 1.0% a year.
• The rate when it lends the bond in a repo trade to borrow cash (the repo rate) is 0.3% a year, and it can borrow the full market value of the bond.
• Cash posted as collateral earns interest at 0.4% a year.

The cost of borrowing cash unsecured and posting it is the borrowing rate less the interest earned: $9{,}800 \times (1.0\% - 0.4\%) = 58.8$ million yen. If the firm posts the bond, it can no longer use that bond in a repo trade. If it had used the bond in a repo trade, it could have borrowed 10 billion yen in cash at 0.3% a year. That would cut its unsecured borrowing by 10 billion yen at 1.0% a year. By posting the bond, it gives up the 0.7% difference, a cost of $10{,}000 \times (1.0\% - 0.3\%) = 70.0$ million yen. If there was no other planned use for the bond, there is nothing to give up, so this cost is 0.

If the firm planned to use the bond in a repo trade, posting cash is cheaper by 11.2 million yen. If it did not, posting the bond is cheaper by 58.8 million yen. Which is cheaper reverses depending on how the asset would otherwise be used. In an actual trade, the repo haircut, fees, administrative costs, and day-to-day changes in rates would also matter. This comparison is not a formula from a source; it holds only within the assumptions above.

Deposits and returns at the clearing house

As of October 2026, at JSCC, deposits and returns of initial margin, intraday margin, and clearing fund contributions are netted together with receipts and payments of variation margin. The deadline for depositing initial margin and the deadline for clearing participants to pay variation margin are both 11:00. The deadline for applying for a return is also 11:00. The required amount and the market value of substitute securities are calculated every business day, and any shortfall must be posted by each deposit deadline². Government bonds are transferred between accounts under the Bank of Japan's book-entry transfer system for government bonds, and US Treasury securities are transferred between accounts at local custodians using FED-WIRE².

The value of collateral can also change along the way. JSCC can change the substitute price of substitute securities on short notice, for example when markets move sharply¹³. If the substitute price falls, the same government bond is worth less as collateral, and the shortfall against the required amount must be posted.

Consider a hypothetical example in which the required amount is 9.8 billion yen and the government bonds already posted are worth exactly 9.8 billion yen as collateral. If the substitute price falls and the same bonds are worth 9.5 billion yen, then $9.8 - 9.5 = 0.3$, so there is a shortfall of 0.3 billion yen. That 0.3 billion yen must be posted by each deposit deadline. This simplified example shows only that the amount to be posted rises by as much as the valuation falls; it does not show how substitute prices are actually set.

In bilateral trades, the types of collateral that may be posted, and the haircut for each type, are set in advance in the CSA¹⁴. The same recommendation also covers reviewing the agreements with counterparties to see whether non-cash collateral could be made easier to use, to the extent that it is economically rational and commercially practicable⁴.

When sourcing becomes difficult under stress

When markets are stressed, converting assets into cash becomes harder. In the views of market participants, holding highly liquid assets was not itself the problem. The problem was that converting them into cash to pay margin could become difficult. Because the repo market, in which cash is borrowed against bonds and other assets, can stop, they said holding cash is also necessary⁹.

On collateral, the FSB's recommendations call for the following. They apply, however, to market participants other than banks and clearing houses⁵.

• Confirm, through testing and similar means, that the collateral set aside for margin is not pledged in other trades and can be used by the required time³.
• For calls payable only in cash, hold cash, or a reliable source of funding, that can be paid in the currency, at the time, and at the place of delivery of the call⁴.
• For calls payable in non-cash assets, hold enough collateral spread across issuers and asset types, and allow for appropriate haircuts as well⁴¹⁵.
• Place collateral in advance in the place (the entity) where it will be used⁴.

Related regulation and contracts

As of October 2026, the range of assets usable as collateral is set by margin regulation, the CSA for bilateral trades, and the rules of the clearing house. In Japan, the margin regulation is the Cabinet Office Order on Financial Instruments Business, etc. The provisions of the Cabinet Office Order cited here are part of the margin rules for uncleared OTC derivatives. The scope and thresholds of the rules are covered in Margin Requirements for Uncleared Derivatives.

What this page does not cover

The definition, contractual rights, and procedures of substitution, and the practice of borrowing cash or bonds through unsecured borrowing, repo, or securities lending to use as collateral, are not covered on this page.

Notes

1. Cabinet Office Order on Financial Instruments Business, etc. (金融商品取引業等に関する内閣府令), Article 123, paragraph 10 (in Japanese). It provides that variation margin and initial margin are to be covered by money or other assets designated by the Commissioner of the Financial Services Agency. ↩

2. Japan Securities Clearing Corporation, "金利スワップ担保・決済" (Interest rate swap collateral and settlement), the section "当初証拠金、日中証拠金及び清算基金の差入れ及び返戻並びに変動証拠金の決済方法" (Posting and return of initial margin, intraday margin, and clearing fund contributions, and settlement of variation margin) (in Japanese). It explains the assets that can be deposited, netting, deadlines, the daily calculation, and the transfer of government bonds and US Treasury securities. ↩ ↩² ↩³

3. Financial Stability Board, "Liquidity Preparedness for Margin and Collateral Calls: Final report" (December 10, 2024), Recommendation 6 (pages 18–19). ↩ ↩² ↩³

4. Financial Stability Board, "Liquidity Preparedness for Margin and Collateral Calls: Final report" (December 10, 2024), Recommendation 7 (page 19). ↩ ↩² ↩³ ↩⁴ ↩⁵ ↩⁶

5. Financial Stability Board, "Liquidity Preparedness for Margin and Collateral Calls: Final report" (December 10, 2024), Section 2.1 (page 9). Commercial banks and financial market infrastructures such as clearing houses are outside the scope of the recommendations. ↩ ↩²

6. "OTC derivatives reform and collateral demand impact" (Bank of England, Financial Stability Paper No. 18, October 2012), page 14. ↩

7. Bank of England (PRA), "Collateral upgrade transactions and asset encumbrance" (Supervisory Statement LSS2/13, April 2013), Annex 1, A2 (page 3). It defines the trades covered and those excluded. ↩

8. Bank of England (PRA), "Collateral upgrade transactions and asset encumbrance" (LSS2/13, April 2013), Executive summary (page 1). A note at the start of the document says it was replaced by another document on September 24, 2019. ↩

9. Financial Stability Board, "Liquidity Preparedness for Margin and Collateral Calls: Final report" (December 10, 2024), Section 1, the description of the FSB's outreach (page 6). ↩ ↩² ↩³

10. Cabinet Office Order on Financial Instruments Business, etc., Article 123, paragraphs 10 and 11 (in Japanese). It sets how non-cash assets are valued and a further rate for a different currency. The formula $M = V/(1-h)$ solves for $M$ with the valuation $M(1-h)$ set equal to $V$. ↩

11. 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 regulation), Kinyu Kenkyu, Institute for Monetary and Economic Studies, Bank of Japan (April 2017), the end of Section 2 on CTDVA and footnote 4 (page 113) (in Japanese). ↩ ↩²

12. 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 regulation), Kinyu Kenkyu, Institute for Monetary and Economic Studies, Bank of Japan (April 2017), Section 3 (1), footnote 11 (page 118) (in Japanese). ↩

13. Japan Securities Clearing Corporation, "金利スワップ取引清算業務に関する業務方法書" (Business rules on clearing of interest rate swap transactions), Article 7 (substitute securities) (in Japanese). ↩

14. 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 regulation), Kinyu Kenkyu, Institute for Monetary and Economic Studies, Bank of Japan (April 2017), Section 3 (1), "ニ. 適格担保" (d. Eligible collateral) (page 118) (in Japanese). ↩

15. Financial Stability Board, "Liquidity Preparedness for Margin and Collateral Calls: Final report" (December 10, 2024), Recommendation 7, footnote 40 (page 19). It refers to Recommendation 2 of the 2024 consultative report of the Basel Committee on Banking Supervision and the International Organization of Securities Commissions. ↩

16. Financial Stability Board, "Liquidity Preparedness for Margin and Collateral Calls: Final report" (December 10, 2024), Recommendation 8 (page 20). ↩