Cleared vs Bilateral Trades

The sales desks that set the terms of a derivatives trade, and the teams that manage margin and credit risk after the trade, first check whether the trade will go through a central counterparty.

What changes depending on who your counterparty is

The differences between cleared and bilateral trades come from who your counterparty is, and from what follows from that: credit risk, margin, netting, and what happens when a party defaults.

The differences between exchange-traded derivatives, which are bought and sold on an exchange, and OTC derivatives, which are traded outside an exchange, are covered in Exchange-Traded vs OTC Derivatives.

Counterparty credit risk in bilateral trades

A bilateral trade is a trade in which the parties act as each other's direct counterparties through to settlement. In a bilateral trade, if the other party defaults, you may not receive money you are owed. Consider a hypothetical example in which Bank P and Bank Q enter into an interest rate swap with a notional amount of 10 billion yen. Bank P pays a floating rate, and Bank Q pays a fixed rate of 1% a year. Interest is paid once a year. If, on a payment date, Bank P pays its floating-rate interest but Bank Q does not pay its fixed-rate interest of 100 million yen, Bank P fails to receive that 100 million yen.

You bear credit risk to as many parties as you trade with, and settlement work arises separately for each counterparty. If you trade with 10 firms, you bear credit risk to each of the 10¹.

Trades with a central counterparty in between

In a cleared trade, a central counterparty steps in between the parties, becoming the buyer to the seller and the seller to the buyer, and guarantees settlement of the trade². The parties that a central counterparty deals with directly are clearing members. If Bank P and Bank Q in the earlier example are both clearing members, the swap is replaced by two trades. One is between Bank P and the central counterparty. The other is between the central counterparty and Bank Q. Bank P pays the floating rate to the central counterparty and receives the fixed rate, and Bank Q pays the fixed rate to the central counterparty and receives the floating rate.

Figure description

These are the payments after a central counterparty (CCP) steps in and replaces the interest rate swap between Bank P and Bank Q (notional amount 10 billion yen) with two trades. Bank P pays floating-rate interest to the central counterparty and receives fixed-rate interest at 1% a year from it. Bank Q pays fixed-rate interest at 1% a year to the central counterparty and receives floating-rate interest from it. There are no direct payments between Bank P and Bank Q.

After the replacement, the original trade no longer exists, and the central counterparty takes on the obligations that the original parties owed each other³. For interest rate swaps, the term "assumption of obligations" describes a central counterparty taking on the parties' obligations⁴. Because it settles trades as the counterparty to multiple clearing members, a clearing house is also called a central counterparty (CCP)⁵.

After the assumption of obligations, Bank P's counterparty is the central counterparty, not Bank Q. Because a single creditworthy institution takes on the obligations and guarantees settlement, the parties can trade without worrying about the credit risk of the original counterparty¹. In exchange, the central counterparty takes on credit risk to its clearing members. For this reason, a central counterparty usually requires margin from its clearing members, and it may also have arrangements for clearing members to share losses².

JSCC clears interest rate swaps between its interest rate swap clearing members⁶. A firm that is not a clearing member can also have its trades cleared if a clearing member acts as an intermediary. In this arrangement, a clearing member takes an instruction from a customer. It has the central counterparty assume the obligations, and the gains and losses belong to the customer. The Financial Instruments and Exchange Act calls this "brokerage for clearing of securities, etc.," and trades cleared this way are called customer trades⁷.

JSCC clears exchange-traded transactions, OTC derivatives trades in credit default swaps (CDS) and interest rate swaps, and OTC trades in Japanese government bonds⁸. In Japan, the Financial Instruments and Exchange Act requires financial instruments business operators and others to have a central counterparty assume the obligations under certain OTC derivatives trades⁹. Which trades and firms are covered is explained in Mandatory Clearing.

Initial margin and variation margin

A central counterparty exchanges two kinds of margin with its clearing members. The first is initial margin, which covers losses that could arise if a clearing member defaults and the market value moves sharply before its trades are closed out. The second is variation margin, which settles gains and losses that have actually arisen from changes in market value, between clearing members and the central counterparty¹⁰.

Consider a hypothetical example in which Bank P and Bank Q each deposit 300 million yen of initial margin with the central counterparty. Market interest rates then move, and the market value of the trade becomes plus 200 million yen from Bank P's point of view and minus 200 million yen from Bank Q's. The central counterparty then receives 200 million yen of variation margin from Bank Q, whose value has fallen, and pays 200 million yen to Bank P, whose value has risen¹¹. The central counterparty receives and pays the same 200 million yen, so it makes no gain or loss itself.

Figure description

This example shows Bank P and Bank Q exchanging margin with the central counterparty (CCP). MTM is the market value of the trade (mark-to-market), IM stands for initial margin, and VM stands for variation margin. Bank P and Bank Q each deposit 300 million yen of initial margin with the central counterparty. When the market value of the trade becomes plus 200 million yen for Bank P and minus 200 million yen for Bank Q, Bank Q pays 200 million yen of variation margin to the central counterparty, and the central counterparty pays 200 million yen to Bank P. Both banks deposit initial margin, while variation margin moves through the central counterparty from the side whose value fell to the side whose value rose.

When variation margin is exchanged at least daily, gains and losses do not build up, and the losses that could arise when a clearing member defaults also become smaller¹². For exchange-traded derivatives, CDS, interest rate swaps, and OTC trades in Japanese government bonds, JSCC revalues unsettled trades at current prices at least once a day (mark-to-market) and exchanges variation margin with clearing members¹³.

The amount of initial margin is based on an estimate of how long it takes to close out the trades and how much the market value could move in that time¹⁰. For interest rate swaps, JSCC calculates initial margin from past changes in market data, and sets the holding period (the time it takes to close out the trades) at 5 days, or 7 days for customer trades¹⁴.

In bilateral trades, the parties may also exchange margin with each other, and in Japan regulation requires this for certain trades. The Cabinet Office Order on Financial Instruments Business, etc. lists situations in which the way a firm runs its business may cause problems. One of them is a financial instruments business operator or similar firm that is not exchanging variation margin and initial margin on OTC derivatives trades not cleared through a central counterparty¹⁵. The rules cover only some trades (for example, some trades are exempt from initial margin).

The effect of netting

Because a central counterparty is the counterparty to every clearing member, trades with different counterparties can be netted against each other as trades with the central counterparty. Netting means offsetting obligations to reduce the amount of payments and deliveries needed for settlement, and it can also reduce losses when a clearing member defaults¹⁶. Consider a hypothetical example in which the following three payments are due among Bank P, Bank Q, and Bank R on a given day.

In bilateral trades, there are three payments, one for each pair, totaling 2,400 million yen. If all three trades are cleared by the same central counterparty, each bank pays or receives only its net amount with the central counterparty.

Bank P pays 400 million yen to the central counterparty, and the central counterparty pays 200 million yen each to Bank Q and Bank R, so the total amount moved falls to 800 million yen. The central counterparty nets obligations before settlement so that deliveries are made efficiently¹⁷.

Netting also reduces losses when a party defaults. Consider a hypothetical example in which Bank P has an interest rate swap with Bank Q and an opposite interest rate swap with Bank R. From Bank P's point of view, the market value is plus 500 million yen on the trade with Bank Q and minus 500 million yen on the trade with Bank R, which adds up to 0. If these are bilateral trades and Bank P defaults, Bank R's trade with Bank P is worth plus 500 million yen to Bank R, and Bank R may not receive that 500 million yen. Bank P's two trades add up to a market value of 0, but they cannot be netted because the counterparties are different.

Japan's law on close-out netting by financial institutions provides as follows. Suppose a financial institution or similar firm has agreed close-out netting with a counterparty in a master agreement. If a petition is filed to start bankruptcy or similar proceedings for the counterparty, the values of all trades under that agreement are added up, and the net amount becomes one claim or one obligation¹⁸. This close-out netting covers trades between the parties to the master agreement, so it cannot combine the trade between Bank P and Bank Q with the trade between Bank P and Bank R.

If both trades are cleared by the central counterparty, Bank P's counterparty is the central counterparty in both, and the net market value between Bank P and the central counterparty is 0. So if Bank P defaults in the same way, the central counterparty's loss in market value with Bank P is 0 after netting.

If Bank Q defaults, Bank P does not lose the plus 500 million yen on its trade with Bank Q. That is not because of netting but because Bank P's counterparty has become the central counterparty. However, the central counterparty covers the loss from Bank Q's default in a set order, so Bank P may still bear part of the loss through its contribution to the default fund or in other ways.

What happens when a counterparty defaults

When a clearing member defaults, JSCC stops taking on new trades, closes out the defaulted member's trades, and determines the loss. For interest rate swaps, it promptly hedges the defaulted member's trades so that the loss does not grow, and then closes them out through an auction in which non-defaulting members take part. For customer trades, JSCC can transfer the trades and the collateral to another clearing member. Settlement stays on the normal schedule even when a clearing member defaults¹⁹.

Losses from the close-out are covered by resources used in a set order. One of these resources is the default fund (in JSCC's terms, the clearing fund), which clearing members deposit in advance and which is used for losses when a clearing member defaults. In JSCC's interest rate swap clearing, the order is as follows²⁰.

1. The initial margin and clearing fund contribution deposited by the defaulted clearing member
2. JSCC's own contribution
3. The clearing fund contributions of non-defaulting clearing members, and an additional contribution from JSCC

Consider a hypothetical example in which Bank Q had deposited 300 million yen of initial margin and 100 million yen of clearing fund contribution, and closing out its trades resulted in a loss of 500 million yen. In this case, Bank Q's 400 million yen is used first, and the remaining 100 million yen is covered by JSCC's own contribution, the second item. JSCC bears losses itself before the other clearing members do. This is to keep an incentive for the central counterparty to manage risk properly²⁰.

If the first three items are not enough, JSCC also has ways to ask for contributions afterward, such as requiring clearing members to pay a special clearing charge²⁰. As a result, in cleared trades you may bear part of a loss even when a clearing member that is not your counterparty defaults.

When a counterparty defaults in a bilateral trade, the claim netted under close-out netting is dealt with in the counterparty's bankruptcy or similar proceedings. For example, if Bank Q defaults and Bank P is on the receiving side, Bank P's claim becomes a claim in Bank Q's bankruptcy or similar proceedings²¹. The Cabinet Office Order also requires that initial margin received under the margin rules be managed so that it can be used promptly if the counterparty fails to perform its obligations²².

Notes

1. Japan Securities Clearing Corporation, "金利スワップ 債務負担" (Interest rate swaps: assumption of obligations, in Japanese), "債務負担の具体例" (Examples of assumption of obligations). An English version is available: "IRS Clearing", "Example of Clearing". ↩ ↩²

2. Committee on Payment and Settlement Systems of the BIS and Technical Committee of the International Organization of Securities Commissions, "金融市場インフラのための原則" (Principles for financial market infrastructures, provisional Japanese translation; April 2012), paragraph 1.13 (pages 11–12), and the text of Principle 6 (page 68; credit exposures to participants) (in Japanese). The English original is CPSS-IOSCO, "Principles for financial market infrastructures" (April 2012), which uses the same paragraph numbers. ↩ ↩²

3. "金融市場インフラのための原則" (Principles for financial market infrastructures, provisional Japanese translation), paragraph 3.1.8 (page 31) and footnote 12 to paragraph 1.13 (page 12) (in Japanese). The document calls this replacement novation. ↩

4. Japan Securities Clearing Corporation, "金利スワップ 債務負担" (in Japanese). Article 2, paragraph 28 of the "金融商品取引法" (Financial Instruments and Exchange Act, in Japanese; English translation: Japanese Law Translation) defines "financial instruments obligation assumption services," the business of a central counterparty, as "taking over, novating, or in any other way bearing, on a regular basis, the obligations" arising from subject transactions (official English translation). ↩

5. Japan Securities Clearing Corporation, "JSCCとは" (About JSCC, in Japanese), "「清算機関」の機能" (The functions of a clearing house). ↩

6. Japan Securities Clearing Corporation, "清算対象取引（金利スワップ）" (Transactions eligible for clearing: interest rate swaps, in Japanese), "2．取引相手方の要件" (Requirements for counterparties). An English version is available: "Clearing Products", "2．Requirements of Counter Party to the Transaction". ↩

7. "金融商品取引法" (Financial Instruments and Exchange Act, in Japanese; English translation: Japanese Law Translation), Article 2, paragraph 27 (brokerage for clearing of securities, etc.), and Japan Securities Clearing Corporation, "清算対象取引（金利スワップ）" (in Japanese), "2．取引相手方の要件" (Requirements for counterparties; including trades through brokerage for clearing of securities, etc.). ↩

8. Japan Securities Clearing Corporation, "JSCCとは" (About JSCC, in Japanese), "沿革" (History). ↩

9. "金融商品取引法" (Financial Instruments and Exchange Act, in Japanese; English translation: Japanese Law Translation), Article 156-62. ↩

10. "金融市場インフラのための原則" (Principles for financial market infrastructures, provisional Japanese translation), explanation of Principle 6, paragraph 3.6.1 (page 69) (in Japanese). ↩ ↩²

11. "金融市場インフラのための原則" (Principles for financial market infrastructures, provisional Japanese translation), paragraph 3.6.11 (pages 74–75) (in Japanese). ↩

12. "金融市場インフラのための原則" (Principles for financial market infrastructures, provisional Japanese translation), paragraph 3.4.16 (page 57) and key consideration 4 of Principle 6 (page 68) (in Japanese). ↩

13. Japan Securities Clearing Corporation, "リスク管理 証拠金" (Risk management: margin, in Japanese; shown as of December 18, 2024). An English version is available: "Margin" (as of December 18, 2024). ↩

14. Japan Securities Clearing Corporation, "金利スワップ 証拠金" (Interest rate swaps: margin, in Japanese), "①当初証拠金所要額" (Initial margin requirement). An English version is available: "Margin" (interest rate swaps), "Initial Margin". ↩

15. "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), the heading of Article 123 ("situations of business operation that may be contrary to the public interest or impair the protection of investors," our translation) and the opening words of paragraph 1, item 21-10 (non-centrally cleared OTC derivatives trades and variation margin), and item 21-11 (initial margin). Trades exempt from initial margin are set out in paragraph 13 of the same article. ↩

16. "金融市場インフラのための原則" (Principles for financial market infrastructures, provisional Japanese translation), paragraph 3.1.7 (page 31) (in Japanese). ↩

17. Japan Securities Clearing Corporation, "JSCCとは" (About JSCC, in Japanese), "「清算機関」の機能" (The functions of a clearing house) and "JSCCの役割" (The role of JSCC). ↩

18. "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 Conducted by Financial Institutions, etc., in Japanese), Article 2, paragraph 2 (financial institutions, etc.), paragraph 4 (close-out netting events), paragraph 5 (master agreement), and paragraph 6 (close-out netting). ↩

19. Japan Securities Clearing Corporation, "リスク管理 参加者破綻処理" (Risk management: participant default management, in Japanese; shown as of February 13, 2018). An English version is available: "Default Management" (as of February 13, 2018). ↩

20. Japan Securities Clearing Corporation, "リスク管理 損失補償" (Risk management: loss compensation, in Japanese; shown as of February 26, 2026), the text and the column "金利スワップ取引清算資格" (interest rate swap clearing qualification) in the chart "各清算業務における損失補償財源の構成及び使用順序" (Composition and order of use of loss compensation resources for each clearing business). An English version is available: "Loss Compensation" (as of February 26, 2026). ↩ ↩² ↩³

21. "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 Conducted by Financial Institutions, etc., in Japanese), Article 3. ↩

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). ↩