Regulators should beware structured product bubbles

Closer scrutiny as they emerge could help avoid nasty surprises

analytics-under-scrutiny
Regulators should keep a closer eye on potential problems in structured products

Korea. Brazil. Mexico. Indonesia. China. Taiwan. Japan. Korea again. It's not Taylor Swift's tour schedule; it's the countries that have suffered problems with structured products in recent years.

The first six came from target redemption forwards (Tarfs) or their close cousin, the knock-in, knock-out (Kiko) product. Both allow an investor to sell US dollars at an above-average foreign exchange rate so long as spot continues on a predictable path.

In Japan, and more recently Korea, autocallable products have also been popular. In a low interest rate environment, they allow investors to get a high coupon as long as spot – forex in Japan's case and equity indexes for Korea – moves toward a knock-out point.

The products have one thing in common – the potential for a nasty surprise if spot lurches in the wrong direction. Investors face mark-to-market or principal losses, while dealers have to rush for the same hedges en masse in often illiquid markets, leading to crowded trades and heavy losses, both for international and local banks.

In many cases, regulators have taken action after the dust has settled. In Brazil, for instance, the country's financial watchdog started requiring listed companies to improve their disclosures about Kiko investments, including off-balance-sheet positions, but stopped short of banning the products. In Taiwan, the Financial Supervisory Commission last year required stop-loss features to be included in Tarfs if they were sold to investors, while Korea's regulator is said to have asked banks to slow autocallable issuance after losses emerged earlier this year.

Korea’s autocallable market grew by 190 times between 2005 and 2015 – a huge spike that should have rung alarm bells

But the damage was already done. In Brazil, Kikos led to an estimated $28 billion of losses when the real started to depreciate in 2008, sending a number of companies into bankruptcy. Korean corporates were also hit badly by the product that year, with car manufacturer Daewoo losing $1.1 billion. Several firms followed up with lawsuits complaining that they weren't made aware of the downside risks they faced.

Banks have not been immune – in Japan they faced losses of around $500 million when the Nikkei index unexpectedly rebounded in late 2012 and hit their autocallable books. In Korea, again, unexpected falls in Hong Kong equity indexes earlier this year led to autocallable losses of more than $300 million for local and international dealers.

Given how often this has happened, the question is how aware regulators were of the bubbles forming in these products. In the most recent example, Korea's autocallable market grew by 190 times between 2005 and 2015 – a huge spike that should have rung alarm bells given the products are so dependent on the continuation of one-way
momentum in equity indexes.

While the products have an obvious popularity among investors, regulators must keep a closer eye on the risks that build up when structured product bubbles form in their jurisdiction.

That's not to say they should always launch pre-emptive strikes on what are usually safe and effective products simply because they're popular. But if history is any guide, closer supervision of this market can only be a benefit.

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