Trends and Developments
Close-Out Netting of OTC Derivative Transactions Referencing Digital Assets Under the Laws of Japan
The growing prevalence of OTC (over-the-counter) derivative transactions referencing digital assets ("OTC digital asset derivative transactions") has led to extensive discussions about whether – and to what extent – close-out netting arrangements for such transactions would be valid and enforceable in events of insolvency under Japanese law.
Crypto-assets are defined in Article 2, Paragraph 14 of the Payment Services Act (Act No. 59 of 2009, as amended; the "PSA"). However, the legal nature of crypto-assets (such as Bitcoin and Ethereum) and other digital assets is still a fluid concept under Japanese law. Moreover, every digital asset has its own distinct characteristics. Accordingly, product-by-product analysis is required to discuss the validity and enforceability of netting arrangements in respect of OTC digital asset derivative transactions. In this context, this article summarises the fundamental legal framework regarding the validity and enforceability of close-out netting arrangements under Japanese law.
Close-Out Netting Under the Netting Act
Close-out netting arrangements for OTC digital asset derivative transactions are considered valid and enforceable if they meet the requirements outlined in the Act on Close-out Netting of Specified Financial Transactions entered into by Financial Institutions (Act No. 108 of 1998, as amended, referred to as the "Netting Act").
More specifically, close-out netting will be enforceable under the Netting Act if:
- at least one of the parties is a financial institution;
- the parties have entered into specified financial transactions;
- the specified financial transactions are governed by a master agreement;
- the master agreement contains provisions on eligible close-out netting; and
- one of the parties has become subject to a Japanese insolvency event.
In relation to the above, the terms "financial institution,""specified financial transactions," and "master agreement" are especially pertinent. Therefore, we will now examine each of these terms.
Financial institution
The term "financial institution" encompasses the following entities:
- banks;
- broker-dealers;
- insurance companies;
- federation of cooperative banks (shinnyo kinko rengou kai);
- Norinchukin Bank;
- Shoko Chukin Bank;
- Japan Bank for International Cooperation;
- securities financing companies;
- call loan dealers; and
- commodities futures transaction dealers.
A dealer that engages in the business of OTC derivative transactions referencing crypto-assets as a principal, agent, intermediary or broker is generally required to undergo registration as a Type I Financial Instruments Business Operator under the Financial Instruments and Exchange Act (Act No. 25 of 1948, as amended; the "FIEA"). Meanwhile, a dealer that engages in the business of trading crypto-assets as a principal, agent, intermediary or broker, providing custody services for customers' fiat currency in connection with such trading or managing crypto-assets for the benefit of others is generally required to undergo registration as a Crypto-Asset Exchange Services Provider under the PSA. Under the Netting Act, Type I Financial Instruments Business Operators are classified as Financial Institutions, albeit the Crypto-Asset Exchange Services Providers do not.
Specified financial transactions
The term "specified financial transactions" includes the following transactions:
- OTC derivative transactions (as such term is defined under the FIEA);
- financial derivative transactions under Article 10, Paragraph 2, Item 14 of the Banking Act (Act No. 59 of 1981, as amended);
- conditional sale and purchase of securities;
- securities lending;
- sale and purchase of securities with options;
- forward foreign exchange transactions;
- OTC commodity derivative transactions defined under the Commodity Derivatives Transaction Act (Act No. 239 of 1950, as amended); and
- loans for consumption or deposits for consumption of cash or securities as collateral to secure any transactions listed above.
It is important to note that OTC derivative transactions referencing crypto-assets fall within the scope of OTC derivative transactions since, under the Financial Instruments and Exchange Act (FIEA), crypto-assets are categorised as financial instruments. Additionally, the Financial Services Agency of Japan (FSA) can designate any electronic payment instrument (primarily stablecoins as defined in the Payment Services Act (PSA)) as a financial instrument. However, the FSA has not yet exercised this discretion. In view of the foregoing, it is important to determine whether the digital assets referenced by a specific OTC digital asset derivative transaction constitute crypto-assets under the PSA to ascertain whether the Netting Act applies to such OTC digital asset derivative transactions.
Master agreement
The term "master agreement" is broadly defined in Article 2, Paragraph 5 of the Netting Act as "an agreement intended to govern two or more Specified Financial Transactions to be entered into on a continuing basis between a Financial Institution and a counterparty, stipulating the terms of such transactions and other basic matters relating thereto."
The ultimate master agreement, which governs two or more master agreements, is generally understood to be the master agreement (as defined under the Netting Act).
The ISDA master agreement is a prime example of a "master agreement." However, it is important to analyse whether other master agreements designed specifically for OTC digital asset derivative transactions also meet the definition of a master agreement, as in some instances, they may need to be revised to ensure compliance with the Netting Act.
Close-Out Netting Under the Bankruptcy Act
An OTC digital asset derivative transaction that does not fall within the ambit of the Netting Act may nevertheless fall within the ambit of close-out netting under Article 58 of the Bankruptcy Act (Act No. 75 of 2004, as amended), which provides as follows.
(1) If an agreement involving transactions in instruments that have quotations on organised exchanges or other markets cannot fulfil its objectives unless it is settled at a specific time and date, and if the scheduled settlement time and date occur after the start of bankruptcy proceedings, then the contract is considered terminated upon the initiation of those bankruptcy proceedings.
(2) In the case mentioned in paragraph (1) above, the amount of damages arising from the termination of the agreement should be the difference between the market quotation prevailing at the relevant place and time and the contract price.
(3) [Omitted.]
(4) In connection with the matters mentioned in paragraphs (1) and (2) above, if the relevant exchange or market has different provisions, then paragraphs (1) and (2) should be interpreted in line with and in accordance with the rules of that exchange or market, as applicable.
(5) If a master agreement for repeated transactions, as outlined in paragraph (1) above, specifies that all transactions should be settled by netting the damages described in paragraph (2) above, then the amount of damages one party owes to the other should be determined according to that provision.
With respect to paragraph (1) above, it is necessary to determine whether the digital assets referenced by an OTC digital asset derivative transaction have "quotations on organised exchanges or other markets." Furthermore, in order to ensure that "the contract is deemed to be terminated upon the commencement of the bankruptcy proceeding," as is the case with other derivative transactions, it may be advisable to insert an automatic early termination provision in the contract.
Article 58 of the Bankruptcy Act will apply mutatis mutandis to a party with respect to which a civil rehabilitation or corporate reorganisation proceeding is commenced (Article 51 of the Civil Rehabilitation Act (Act No. 225 of 1999, as amended), Article 63 of the Corporate Reorganization Act (Act No. 154 of 2002, as amended) and Article 41, Paragraph 3 and Article 206, Paragraph 3 of the Act on Special Measures for the Reorganization Proceedings of Financial Institutions (Act No. 95 of 1996, as amended), respectively).
Close-Out Netting by Way of Set-Off
Even if an OTC digital asset derivative transaction does not fall within the ambit of the Netting Act or Article 58 of the Bankruptcy Act, the non-defaulting party in such a transaction may still be able to exercise its statutory or contractual set-off rights. In this regard, the contractual set-off rights would be enforceable if the requirements of Article 505, Paragraph 1 of the Civil Code (Act No. 89 of 1896, as amended), which are set forth as follows, are met:
- all the receivables and payables to be set-off are held by parties bound to each other;
- the parties are bound by obligations the nature of which are of the same kind; and
- the obligations of both parties under the agreement are due and payable.
To evaluate whether an OTC digital asset derivative transaction complies with all the requirements of Article 505, Paragraph 1, each case must be assessed individually, taking into consideration the specific type and nature of these transactions.
Conclusion
Although there is currently no standard practice in Japan regarding close-out netting arrangements for OTC digital asset derivative transactions, it is hoped that with the increasing prevalence of such transactions and the corresponding need to analyse them, standardised practice for such close-out netting will soon emerge.
Originally published by Chambers and Partners
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
