Given its sizable Chinese and Taiwanese corporate client base, it is no surprise HSBC has one of the biggest renminbi-linked structured product books on the street. So when the People's Bank of China unexpectedly devalued the Chinese currency by 1.9% against the US dollar on August 11, causing the US dollar/renminbi exchange rate to rise by 4% in two days, there was an expectation the UK bank would be one of the hardest hit.
"It was a volatile day. It was much larger than what anybody expected," says Ashwath Venkataraman, global head of foreign exchange and precious metal options at HSBC in London. "Everybody thought the announcement would come in terms of widening a trading band or maybe a gradual decision, but it was actually a reasonably large one-off move."
But while some banks rushed to rehedge their risks quickly at any cost, locking in losses in the process, HSBC's risk managers gave the front office more time and temporary limit extensions to cover the key risks first, limiting losses in the process.
The product, known as a target redemption forward (Tarf), has been wildly popular among Chinese and Taiwanese corporates in recent years, as it allows them to sell their US dollars and buy renminbi at a better fixed rate than they could otherwise. As long as the US dollar/renminbi spot rate is below a set strike rate, the corporate can book profits every month. The product, which typically has a two-year maturity, knocks out once the corporate has collected a pre-defined level of profit.
If spot is above the strike rate, however, the corporate has to continue selling at the worse rate. Leveraged structures, which were popular with some clients, knock-in a sold call if the high strike is crossed, forcing the buyer to sell twice the amount of currency at the worse rate.
But while HSBC tends to face these clients directly, on an uncollateralised basis, it was not counterparty credit risk – which is managed separately to overall market risk – that was the main concern during the August episode, it was the cost of rehedging the complex risks in the book.
Risk management of the product is challenging because of the immediate impact the US dollar/renminbi forex spot rate has on the Tarf risk profile. A weakening renminbi causes the forex vega, the price sensitivity to changes in volatility of the underlying, and renminbi interest rate risk to move to longer tenors. This reflects an increase in the expected maturity of the product, since the product is less likely to accrue the profit needed to knock-out early.
This lengthening of the Tarf risk profile is not matched by a similar change in the maturity of its hedging instruments – typically, forex forwards and vanilla forex options – meaning dealers have to dynamically rehedge their books at the portfolio level as spot moves.
However, as all dealers selling Tarfs have the same risk exposures, they crowd into the same hedges when the underlying suddenly shifts, pushing up hedging costs. So when spot moved dramatically on August 11, it set pulses racing on HSBC's forex trading floor.
However, the bank had a secret weapon – a Tarf dashboard developed by the bank's market risk managers. This is a weekly management information report showing its current Tarf population and risk profile, with a strong focus on renminbi-denominated Tarfs – a market that Ed Jenkins (pictured), the investment bank's chief risk officer and the global head of wholesale credit and market risk, admits has received "a substantial amount of focus and attention" at a number of levels within the organisation.
Following the August 2015 move, the dashboard clearly showed the impact of the two main renminbi Tarf risk factors – forex spot and forex-implied renminbi interest rates.
"The impact of renminbi spot is visible in the Tarf dashboard, in charts showing the performance of the hedging strategy as a function of large renminbi moves covering more than the moves observed in August 2015," says Francois-Xavier Faure, global head of rates and forex market risk at HSBC in London.
"As a result of the sudden August devaluation episode, the risk profile showed an unusual imbalance – the interest rate exposure was showing a large net risk along with a tenor mismatch between the longer maturity Tarfs and the tenors in which the vanilla hedges had their rate risk," he adds.
Having this information to hand allowed the risk function to inform senior management immediately, and obtain permission to run higher risk limits, which allowed it to roll out a more nuanced rebalancing strategy compared with other banks, which made losses rushing out to immediately rehedge their Tarf books.
HSBC's forex traders immediately covered their delta – the sensitivity of the option price to a change in the underlying – but left the other greeks they could not proxy hedge using the delta unhedged until liquidity returned to the market.
We ran the book more realistically than you would normally run a market-making book
Ashwath Venkataraman, HSBC
"We ran the book more realistically than you would normally run a market-making book," says Venkataraman. "We tried to largely trade and offset whatever we could on the delta – the rest of the market wasn't liquid," he adds.
The impact of the move was far smaller than if they had hedged their book all at once. Plus, a net long renminbi forex volatility exposure helped further offset losses from the move.
The bank rebounded from the impact of the move within a couple weeks by taking advantage of dislocations in other correlated markets such as the South African rand and the yen.
The whole process was helped by the close proximity of the front office, and the risk function also helped with communication around the market move. "The key is that we are in the dealing room," says Mike Clarke, global head of traded risk at HSBC in London. "We have instant access to traders and they have instant access to us. We view each other as partners – it is not adversarial."
The front office agrees: "Because of strong communication between the risk functions, trading, management and a variety of other stakeholders, the event didn't paralyse the desk in any way. We removed a lot of pressure from the traders and allowed them to continue to service clients and capitalise on opportunities. This allowed the bank to profit from opportunities in other markets and have a profitable month overall," says Venkataraman.
HSBC's fortunes, however, were more positive in the other major currency risk event of the year – the removal of the floor on the euro/Swiss franc rate. The unexpected move by the Swiss National Bank, which caused the rate to fall nearly 40% in 20 minutes, led to significant losses at other dealers, but turned out to be favourable for HSBC.
This was the result of a last-minute position-switch by the business, which deduced it wasn't being compensated enough for its exposure to losses if the Swiss franc was to strengthen.
"Their overriding view was that they weren't being ‘paid' to take that risk. The risk-reward profile was just not there," says Jenkins.
HSBC's risk team had also been preparing itself for the much-anticipated Fundamental review of the trading book (FRTB), the Basel committee's overhaul of the market risk framework at banks, which was released on January 14.
As banks see more of these trades, they would want to have a view of what exactly they were holding in all these financing trades
Mike Clarke, HSBC
In the last two years, HSBC managed to move many of its hard-to-model risks, which attract additional charges under the current capital requirements for UK banks, to the modellable bucket. Currently, hard-to-model risks are capitalised under the risks-not-in-value-at-risk (RNIV) framework, in addition to the Pillar 1 capital charge imposed on UK banks. The FRTB has its own version of requirements for non-modellable risks, which was estimated to result in 4.3 times more capital than the RNIV framework.
To gain capital relief, HSBC started a firm-wide process in 2014 to review its risk-weighted assets, and, with one objective to incorporate previously non-modelled risk factors into value-at-risk by improving the quality of the data used, resulting in a reduction in capital requirements.
"We ended up using the data that was internally stored by the front office over the years, and tested that data quality by risk factors to see it was satisfactory in terms of our assessment of the quality of data required to meet our current regulatory obligations," says Clarke. "It was a reasonably material reduction in risk-weighted assets," he adds.
HSBC also began a project in mid-2014 to keep track of so-called financing trades more rigorously as it noticed they were becoming much more popular with clients. The project marks a transition from looking only at the notional values of these trades to breaking them down by collateral type, desk, accounting treatment, maturity, top-up mechanism and whether they were recourse or non-recourse.
"We had a number of experiences where the underlying structure collapsed, and we were left with a security, which we then needed to sell to get our money back," says Clarke. "As banks see more of these trades, they would want to have a view of what exactly they were holding in all these financing trades."
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