As Renminbi is expected to continue appreciating in the past few years, Renminbi-linked TRFs are very popular with domestic investors. However, Renminbi has depreciated hugely and unexpectedly since August 2015, and many investors suffered significant losses as a result.  Once investors failed to perform their obligations under the agreement with the banks, banks would have to absorb huge losses, and eventually resulted in turmoil in financial markets and endless investment disputes.

This article explains the supervisory mechanism provided by the Financial Supervisory Commission (FSC) in response to the TRF crisis, and focuses on the amendment of the "Regulations Governing Internal Operating Systems and Procedures for Banks Conducting Financial Derivatives Business" dated 30 January 2016.

1. What is TRF?

TRF stands for Target Redemption Forward, an option type of complex high-risk derivatives. Most of Taiwan's TRFs are in Renminbi against the U.S. dollar, with a US$1 million transaction threshold.  When Renminbi appreciates, the gains for the investor would be the exchange difference multiplying the principal.  However, banks usually set a barrier price, so when the exchange rate reaches the barrier price, the transaction would be early terminated, and thus the gains for the investor would be limited.  On the other hand, when the exchange rate goes against expectations, the losses would be the exchange difference multiplying principal multiplying the leverage (usually two in local practice) and the investor would have to meet more margin calls until the transaction expires, or cut losses and liquidate.  The rules result in the "limited gains and unlimited losses" characteristic of TRFs.

2. TRF Supervisory Measures

In early 2015, the FSC found that some banks revealed defects when dealing with TRF products. Soon after that, the FSC announced to fine or ban 9 banks from engaging in such transactions.  The FSC later found that the banks turn to focus on selling Discrete Knock-Out ("DKO") products instead of TRFs; however, DKOs are actually leveraged products of foreign exchange options, and such products are no less risky than TRFs.  The FSC then started to implement the second wave of supervisory policies in June 2015.It abolished the "Directions for Banks Conducting Derivatives Business" and announced the "Regulations Governing Internal Operating Systems and Procedures for Banks Conducting Derivatives Business" (the "Regulations").  The Regulations provide the definition of complex high-risk products, establish a disbursement query mechanism at the Joint Credit Information Center and stipulate the maximum losses on complex high-risk products.  Nonetheless, since Renminbi depreciated massively in August 2015, the remaining supervisory flaws of TRF products emerged one by one, and investors suffered heavy losses.  In order to strengthen the supervision of complex high-risk derivatives, the FSC has been meeting with banks and the Bankers Association of the Republic of China to share experiences and draft specific measures to further strengthen regulation since October 2015, and eventually announced the amendment of the Regulations on 30 January 2016.

3. Main Amendments

  1. The qualification of "professional juristic customer" has been tightened from having total assets exceeding NT$50,000,000 to NT$100,000,000, and a written application is required to be submitted to the bank to obtain the status of professional juristic customer (Subparagraph 3 of Paragraph1 of Article 3).

    Due to rapid development in the financial markets, there are substantial increases in the complexity and risk of all kinds of financial products. Therefore the qualification of professional juristic customer shall be tightened accordingly.

    Second, to avoid the situation that an original professional juristic customer becomes a non-professional customer due to the amendments to the Regulations and as a result, the transaction(s) made before the amendments might be treated as a violation of the Regulations, the Regulations provide that if the bank has been transacting with a professional customer whose total assets are less than NT$100,000,000 in respect of the derivatives products and the transaction is still effective before the amendments, such customer may proceed with the transaction in accordance with the original terms till the contract expires or to liquidate. Further, if such customer needs to have other new transactions to reduce its risk exposure, it may proceed with the transaction with the bank as a professional customer, provided that the term of the contract shall not exceed the remaining days of the existing contract (Article 3-1).  The Regulations aim to prevent the bank from replacing an old contract with a new contract to cause customers to take a greater risk by way of "debt on debt".

  2. The bank shall not engage in complex high-risk product transactions with natural persons or retail juristic persons who transact for non-hedging purpose (Paragraph 1 of Article 25-1).

    Considering the complicated terms of the complex high-risk product, the Regulations specify the counterparty to such transactions shall not be (i) natural persons or (ii) retail juristic persons who transact for non-hedging purposes.

  3. The term of forex type of complex derivatives shall not exceed 1 year, the number of period for the price comparison or settlement shall not exceed 12, and the maximum losses shall not exceed 3.6 times of the notional amount (Subparagraph 1 of Paragraph 2 of Article 25-1).

    Considering the wide fluctuations in the exchange rate market and the fast-changing characteristic of the financial environment, the complex high-risk derivatives which last more than 1 year are obviously unpredictable, and therefore the Regulations decide to ban the products with the term more than 1 year. Moreover, the current TRF losses could be largely attributed to the unlimited losses characteristic of TRFs, and therefore the Regulations provide that the maximum losses on complex high-risk derivatives shall be provided expressively and shall not exceed 3.6 times of the notional amount in order to respond to the unlimited loss criticism of TRFs and other similar products.

  4. The maximum transaction amount shall be 2.5 times of the verifiable financial resources of the customer (Paragraph 4 of Article 20 and February 1, 2016 ruling with Ref No.: Jing-Guan-Yin-Wai-Zi-No. 10550000351).

    To avoid the situation where a customer takes risks exceeding its risk tolerance, banks are required to establish a control system when approving a transaction. The Regulations specify that the maximum transaction amount shall not exceed 2.5 times of the verifiable financial resources of the customer (it refers to the aggregate amount of the deposits, the securities and the performance bonds of the customer and its joint and several guarantor(s) in the bank).

  5. Banks shall ask customers not classified as the high net worth corporate investors or professional institutional investors to put down an initial performance bonds when purchasing such products (Paragraph 5 of Article 20 and February 1, 2016 ruling with Ref No.: Jing-Guan-Yin-Wai-Zi-No. 10550000352).

    To avoid the situation where customers may invest without any cost and the transaction amount often exceeds the necessary hedging need, banks shall ask customers not classified as the high net worth corporate investors or professional institutional investors to put down an initial performance bonds when purchasing complex high-risk derivatives, and the initial performance bonds in each transaction shall not be less than 2% of the total notional amount of the contract. For the forex derivative lasting more than 1 year and containing an embedded put option (excluding plain vanilla forward exchanges, foreign exchange swaps and cross-currency swaps), the an initial performance bonds in each transaction shall not be less than 5% of the total notional amount of the contract.  To provide the grace period for banks, the above rulings are not effective until 1 March 2016 ("Effective Date").  Regarding the transaction amount, if the bank has signed a contract with the customer before the Effective Date and it still exists on the Effective Date, the parties may handle the transaction in accordance with the original contract until the contract expires.  As for the performance bonds, if the bank has engaged in a derivative transaction with the customer before the Effective Date, and the transaction still exists on the Effective Date, the parties may conduct the transaction in accordance with the security or performance bonds method originally agreed by the parties.

  6. In addition, considering the customers of overseas branches of local banks are mainly foreign customers, and overseas branches shall respect the local regulations, market rules and the fair competition of the local business, Article 2-1 of the Regulations provide that the Regulations do not apply to overseas branches in general; however, the oversea branches designated by the FSC shall still report their transaction information to the FSC in accordance with the Regulations.

The above supervisory mechanism provided by the FSC has overall intensified the regulation of complex high-risk derivative. The FSC is rigorously supervising banks to implement product sales policies and risk management system to protect investor interests and the soundness of banking business, and ultimately hopes to improve the reasonable order of financial markets.

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.