The Taiwan financial regulator's recent move to further restrict the sales of target redemption forwards (Tarfs) and discrete knock-outs (DKOs) was driven by a focus on financial stability and protecting investor interests, says William Tseng, Taiwan Financial Supervisory Commission (FSC) chairman.
Taiwan corporates have experienced significant losses in the past 18 months after the renminbi unexpectedly reversed its appreciation versus the dollar; this happened first in February 2014 and then again in August. The last reversal exposed local investors to total unrealised losses of 50 billion Taiwan dollars ($1.5 billion) from trading Tarfs and other exotic foreign exchange derivatives.
The Taiwan regulator rolled out another series of measures on November 3 to regulate CNH-linked derivative trades – the second such move by the FSC to rein in volumes of complex foreign exchange derivatives sales onshore. Previously it censured nine banks for selling products to inappropriate clients and required them to implement loss limits on these types of products.
The regulator has now specified a loss cap of 3.6 times the average one-term nominal principal – meaning clients can't lose more than 15% of the notional value of a one-year contract.
The FSC has also limited the maximum duration of Tarfs to 12 months and has doubled the minimum amount of liquid assets that clients must have before being allowed to trade to 100 million Taiwan dollars. Additionally end-users will be required to post both initial and variation margin from January 2016.
In July, Risk.net reported trading volumes of Tarfs had seen a 30% year-on-year decline in the first six months of 2015 and are likely to fall further following this latest round of restrictions. Tarfs and DKOs have been a major source of profit for local banks over the past five years with market sources suggesting that some banks made as much as 90% of their derivatives income from selling these stuctures.
While this may be an issue for dealers, FSC chief Tseng tells Risk.net, in an interview at his Taipei office, that bank sector profitability is not his organisation's main focus.
"The regulator prioritises the stability of financial markets and the protection of investor interest over the domestic banking sector's profitability," he says.
As of August 11, there were 135.1 billion Taiwan dollars of Tarf and DKO contracts outstanding in the market and research by the regulator has shown that speculative use of Tarfs and similar instruments is greater than in comparable markets with a high demand for the Chinese currency.
"We did some investigation and found that over half of Tarfs traded in Taiwan are for speculation, while in Hong Kong and Singapore it's only 40% and 8% respectively, Tseng said. "Apparently, this proportion is too high in Taiwan and as the renminbi is expected to continue to be volatile, Taiwanese banks and investors are exposed to the risk of renminbi devaluation."
The regulator is not just concerned by excessive speculative use; Tseng says that despite better know-your-client practices by dealers in the past 18 months, a small number are still trying to sell Tarfs to small and medium-sized corporate clients who don't have the knowledge or experience to trade complex derivatives.
The FSC is concerned by the counterparty risk that banks are exposed to from such transactions and is further tightening up the trading of these instruments.
"Some small corporates may not be able or willing to fulfil their contract obligation in case large-degree devaluation happens, which means banks may have to absorb these losses by themselves. If the outstanding size is too large, it would threaten the stability of the overall financial system," Tseng says.
The market should not interpret the FSC move as aiming to stifle local banks from developing sophisticated derivatives, Tseng says, adding that the FSC supports moves by Taiwan banks to develop their derivatives business if this is focused on improving risk management practices.
"We would consider relaxing the rules when the renminbi stabilises and most importantly, when banks know who are the appropriate clients they should sell these products to, and investors become sophisticated enough to trade."
An in-depth interview with the FSC chair will appear on Risk.net next week.
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