Trouble in Taipei

Taiwanese retail investors have suffered significant mark-to-market losses across a range of structured products in the past year. This has sparked a fierce backlash against product providers, and new rules look set to substantially reduce the size of the $28 billion market. Georgina Lee reports

The meltdown in the US mortgage market, and the subsequent seizing-up of global credit markets and decline in equity markets has hit structured product investors in Taiwan hard. Traditionally comfortable with US dollar-denominated assets, Taiwanese investors have lost money at both the institutional level, through mortgaged-backed securities and collateralised debt obligations (CDOs), and on the retail side, mainly on equity-linked securities, but also through credit, interest rate, currency and commodity instruments.

Should investors seek to exit their positions, the consequent large losses, at least on a paper basis, will put the structured product market in jeopardy. The market is worth $27.98 billion, according to second-quarter 2008 figures from the Trust Association of the Republic of China (Taroc) in Taipei.

Such concerns have emerged not just because disgruntled investors, as elsewhere in the region, are increasingly wary of further investment in structured products. They are also linked to the imposition of new rules in Taiwan that will govern both the types of structures that can be sold and the ability of financial intermediaries to market such instruments. Moreover, the onus of responsibility for explaining the precise risks and potential rewards associated with structured products appears to be shifting.

Under pressure from both investors and financial regulators, banks in Taiwan have adopted a two-pronged effort to address regulatory and investor concerns. To start with, the Bankers Association of the Republic of China (Bankers Association) in April drafted a set of industry guidelines governing wealth management and the sale of financial products to retail investors. This was sanctioned by the Financial Supervisory Commission (FSC), the country's financial regulator.

The guidelines require local trust banks - traditionally the most powerful force in the Taiwanese distributor market - to focus on marketing capital-guaranteed products to retail clients and providing riskier products only on a reverse-enquiry basis. Local banks can only actively market or sell products that are 100% capital-guaranteed and have no targeted investors specified by the structuring investment banks, says Hou Li-yang, Taipei-based head of an FSC banking bureau that focuses on trust businesses. "If trust banks are found violating these requirements, they would be penalised by way of a fine and a warning and, in serious cases, this could lead to revocation of licences," he adds.

Drop in volumes

The move has effectively reduced some foreign banks' business in Taiwan by as much as 80%, say industry participants. "In Taiwan, the retail market is almost closed, as the trust banks don't look at credits anymore, thus we are focusing almost all of our time and resources on doing deals with institutional investors today," says a Hong Kong-based structured credit trader, who has a lot of experience covering the island's structured product market as a major Taiwanese institutional investor. "The impact stemming from the controversy surrounding structured products has been quite significant."

Meanwhile, Taroc is drafting another controversial set of industry standards. The trade body is developing a 'master agreement' for structured securities, which aims to define the respective roles and obligations of product providers and local distributors. This agreement - not to be confused with the master agreements developed by the International Swaps and Derivatives Association (Isda), which are used as the legal foundation for bilateral, over-the-counter derivatives trades - will incorporate the April guidelines drafted by the Bankers Association, say bankers in Taipei.

Taroc's draft guidelines are aimed at placing responsibility for structured product sales firmly on product manufacturers as well as distributors, contrary to the principles drawn up by the international Joint Association Committee (JAC) of five leading trade bodies, including Isda. Many view these two established sets of principles, one for manufacturers and the other for distributors - criticised by some for placing too much burden on distributors - as best practice for the European and US structured product markets.

But Taiwanese regulators and distributors feel it is acceptable to place a degree of responsibility on foreign bank product manufacturers, as some have failed to make good on their promises to make fairly priced secondary markets for products they have structured. Worse still, some say foreign dealers have sold down stocks and other positions in the open markets on product valuation days to avoid making payments to end-investors on the products they have structured.

Foreign bank members of Taroc have reviewed drafts of the master agreement and don't like what they've seen. "Talks haven't gone smoothly," says one market participant involved in the talks. "Foreign banks made mark-ups on six of the eight pages of the document - it's been quite contentious."

Foreign bankers are upset that Taiwanese banks - against the backdrop of numerous retail investors saying banks are to blame for losses from non-capital-guaranteed structured products - are now calling for international derivatives houses to get involved in judging client suitability. This demand was first placed on Taiwanese banks in their capacity as product distributors, as spelt out in the Bankers Association guidelines, which were sanctioned by the FSC.

Foreign bankers say it is not fair for them to assume the responsibilities of knowing end-customers, with many unwilling to offer more input than details already spelt out in term sheets. "As a product provider, we have internal guidelines, in that when (we) design products we have to think about who would be the potential clients, be they institutional, private bank or retail," says a Hong Kong-based derivatives banker at a European bank. "Based on that, we come up with suitable products targeting each type of client. But in Taiwan, these products are sold to the clients by the distribution team of retail banks, so judging client suitability should be handled by the distributors."

In Taiwan, structured products sold to retail investors through banks' wealth management arms are provided in the form of a trust, whereby banks invest general retail investors' money as a trustee. Such investors could include individuals who do not possess net worth of at least $1 million, a commonly used denominator of high-net-worth individuals. The foreign bank members of Taroc - ABN Amro, BNP Paribas, Citi, DBS, Deutsche Bank, HSBC, ING, JP Morgan and Standard Chartered - have licences to operate trust businesses. This means they are allowed to distribute structured notes to retail directly, although only a few are doing so.

The trust banks are in a strong position in Taiwan. Although insurance companies are allowed to sell policies linked to structured notes, they are not seen as operating a trust business, as they do not qualify as 'trust enterprises' under Taiwanese law. But the monopoly of Taiwanese commercial banks in operating trust businesses is expected to end soon, given that the FSC has proposed this year that fund managers be allowed to operate trust businesses.

Nevertheless, foreign banks say the stranglehold enjoyed by Taiwanese banks as the only distributors means product manufacturers have less bargaining power when conflicts of interest arise. They say that they cannot fall back on other distribution channels, such as securities brokerages or asset managers, in the event of a major dispute, as they do in other markets such as Hong Kong.

This anomaly has inadvertently disincentivised local trust banks from developing structured products in-house, says Keith Noyes, Isda's Hong Kong-based Asia-Pacific regional director. "While local banks are allowed to structure their own products, many do not have the depth of expertise or the trading books in international markets to offer these products," he says. "As long as they can get good distribution fee income as the middlemen, they don't have much incentive to move up the learning curve in their structured product business."

Isda representatives visited Taroc and the FSC in June and August to try to help resolve the matter. The association also sent a letter to Taroc saying the latter's draft master agreement differed significantly from best practice adopted in most of the rest of the world.

The draft master agreement deviates from the JAC principles, which state that only intermediaries that know the clients - which in Taiwan means the local distributors - can judge client suitability, adds Noyes. "Many trust banks don't have the infrastructure to review the product themselves. They appear reluctant to invest in internal product review departments," he says. "Taiwan is the only market where I've seen a master agreement that attempts to define the business relationship between product providers and distributors."

The FSC declined to discuss the matter, saying it had left market practitioners under the auspices of Taroc to develop the master agreement guidelines. The commission adds that it has no records of complaints about structured note investments filed by Taiwanese investors. In other jurisdictions, such as Australia and Hong Kong, regulators require intermediaries to place internal controls on product due diligence, such as understanding product features and risks.

"The banking bureau of the FSC has told us that they want someone to take responsibility for client/product suitability and they are willing to leave it to the market to decide whether it is the product provider or the distributor who takes that responsibility," says Isda's Noyes. "The Taroc master agreement is an attempt to assign that responsibility to the product providers."

Shirking responsibility?

Wu Chun-yi, secretary-general of Taroc in Taipei, who has chaired meetings with foreign banks on this issue, says he cannot understand why Isda and foreign banks rejected a proposed master agreement draft that Taroc felt was largely in line with the JAC principles. "They just want to rely on the JAC principles," says Wu. "But what we are dealing with in Taiwan are commercial principles (between providers and distributors). The JAC is international best practice and represents the highest standards, but can it govern every single market? If we have the United Nations, why do we bother to have the Chinese government, the Hong Kong administration or Taiwan?"

Referring to the relationship between providers and distributors, Wu adds: "Besides, what's wrong with honouring a contract for two parties involved in a trade? I think (foreign dealers) are scared (of taking more responsibility)."

Wu says talks with foreign banks have been going on for more than two months. He adds that foreign dealer concerns centre on fears that Taiwanese banks would shed all responsibility for judging client suitability - and liability, if more structured notes were to blow up - to the foreign banks.

"They have two demands I cannot accept," adds Wu. "First, they have asked us to forget about the master agreement, I've told them I can't do that." The second demand, he says, is to set up a working group to discuss the development of the master agreement. Wu feels the latter is merely a ploy by the foreign banks to stall progress of the agreement, with a view to ultimately forcing Taiwanese banks to back down.

The responsibilities of Taiwanese banks to their clients are regulated by the law, adds Wu, and a new master agreement cannot override legal responsibility or allow local institutions to shed responsibilities to the investment banks. That's because the master agreement is not a legal document, but a document that industry players can make reference to, he says.

Meanwhile, as far as the structured note retail market is concerned, foreign investment banks are not regulated by the FSC, as the distributors are the local trust banks, not the investment banks themselves. For those few international banks that do distribute their own in-house products under their own trust business licences, says Noyes, their relationship with the end-investors should be captured by the Isda principles.

While the master agreement is not legally binding and Taroc cannot guarantee that investment banks would fully comply with it, Wu says he is confident that the foreign banks would observe these industry standards "if and once they agree to sign on it".

An expectation for foreign banks to share responsibility in judging the suitability of end investors when they are seeking to buy a structured product is also expressed by Wilber Wu Wen-jenq, deputy chairman of the risk management committee of the Bankers Association. While Wu has helped draft the association's new guidelines, he stresses his comments are made in a personal capacity and do not necessarily reflect the views of his association.

An important area not covered in the JAC principles is the relationship between product providers and end clients, says Wu. This has made it all the more important for Taiwan to have its own master agreement to safeguard healthy development of the market, he says.

"If the issuing banks want some good business, if they want to have the risks (involved in selling these structured notes to the retail public) controlled at a reasonable level, both sides have their shares of responsibility in resolving on (this missing area of coverage)," says Wu. "A global investment bank should have the ability, or the moral courage, to face up to these issues, because only then (we will have a) win-win-win situation for the product providers, distributors and investors. There is a genuine need to establish this market order."

For now, in a bid to facilitate better understanding of the JAC principles - and ultimately better understanding between the foreign banks and the Taiwanese banking industry - Noyes says Isda is preparing a Chinese version of the JAC principles to send to Taroc.

Meanwhile, the FSC is expected to meet Taroc representatives to discuss the master agreement in September, and more meetings are expected to follow.

Taroc's Wu says he hopes a finalised version of the agreement will be published by the end of 2008. "I'm looking forward to a finalisation by the end of this year, but I am not confident, because a good master agreement should represent a consensus for every side involved," says Wu. "With (the foreign banks')stance being so strong, there is always a chance the master agreement could be delayed."

Protecting retail clients - Chinatrust's approach

The downturn in equity markets worldwide combined with an uncertain global economic outlook has significantly dampened retail investor interest in equity-linked structured notes in Taiwan this year. As a result, retail investor interest has switched to interest rates and other fixed income-related structured notes, notably constant maturity swaps linked to US yield curves.

Charlie Tseng, Taipei-based head of structured product sales in the wealth management department at Chinatrust in Taipei, says his bank and other local firms are at pains to ensure they do not sell products to investors that they do not understand.

"We have invested in an internal risk control department specifically targeting investors in structured notes, mutual funds and investment-linked insurance policies," says Tseng. "If our sales team in our branch offices has been asked to sell a structured note that, for example, costs over NT$3 million ($95,260), the sales staff would have to call this department and put the client on the phone. Our headquarters staff will then ask the client questions to re-confirm that he or she is clear on the risks related to the product."

When clients reach 70 - not their physical age, but a figure based on a formula that adds the tenor of the product to their age - they must sign a disclaimer explaining that they fully understand the risks. And investors buying a particular type of structured note for the first time must undergo a similar process. "This requires extra investment as, after all, we need to put in extra staff (and) IT facilities," says Tseng. "We are keeping the recordings for five years."

Chinatrust sells two main types of structured products: structured deposits that are developed by its own dealing room and structured notes linked to asset classes such as interest rates and equities, which are provided by the foreign investment banks.

Under Taiwanese law, individuals' offshore income is exempt from tax. But as structured deposits are issued by local institutions, both income gains and capital gains from structured deposits are taxable. The tax rate may be as high as 40%. Since Taiwanese retail investors must pay capital gains tax (CGT) on structured deposits, they are more inclined to invest in structured notes, to which CGT does not apply, as they are categorised as offshore investment products.

"We have sold so many structured notes that the Financial Supervisory Commission has asked us, 'why don't you put together structured notes instead of just being a distributor?'" he says. Chinatrust would like to have that capability, adds Tseng, and is working towards that goal.