Tarf crackdown forces Taiwan banks to offer alternatives

Target redemption forwards with a capped loss are expected to be launched later this year following approval from Taiwan's FSC

A variation of the target redemption forward (Tarf) is now being sold by Taiwanese banks following a crackdown on the sale of Tarf products by the Financial Supervisory Commission (FSC) due to losses experienced by investors following the depreciation of the renminbi against the US dollar from March to May earlier this year.

In April, the Taiwanese regulator sanctioned Bank Sinopac for derivatives sale breaches and banned the bank from marketing Tarfs for one year. Soon after, the FSC issued a notice on the sale of what it deemed "high-risk" products such as Tarfs linked to RMB, threatening further sanctions for banks not adhering to proper guidelines on Tarf sales.

In addition the regulator has now required Tarf products sold to investors to have a stop-loss. Corporates with underlying currency exposure are still free to purchase Tarfs without any stop-loss.

"In selling Tarfs, some banks have recently failed to properly familiarise themselves with their customers, assess product suitability, and fully disclose risks," the regulator said in the notice.

Discrete knock-out forwards are now being offered by banks as an alternative to Tarfs, say market participants. Discrete knock-out forwards are forwards with the addition of a knock-out barrier which terminates the structure once a predetermined level is breached. 

This recent shift to discrete knock-out forwards is a result of the bad publicity following losses and the increased scrutiny on these products from Taiwanese regulators, says the head of foreign exchange structuring at a European bank in Singapore.

"What is being traded currently are discrete knock-out forwards which are similar to the target redemption but as soon as you have one fixing beyond a certain barrier the whole product knocks out. These are one to two year structures but designed to knock out after one to three months," the head says.

"In terms of the product, it hasn't really changed. They might trade new variations but the essence of it is still the same target redemption forward."

According to the head of FX structuring at a global bank in Hong Kong, the discrete knock-outs are a temporary measure, before new Tarf products with a stop-loss are introduced into the market later this year.

"The Taiwan regulator has required that for clients who cannot document hedging needs, such as investors, Tarf products can only be sold with a cap-loss feature. Taiwanese banks are preparing to launch this new product, and it should be ready in the next few months," he says.

This view is shared by Adam Gilmour, Citi's head of Asia-Pacific currency and derivatives sales in Singapore, who says the bank will be among the international dealers offering the new Tarf with capped loss.

"We didn't have the product in our offering before the Taiwan issue so we had to go back and create the product and get the internal approvals. The product has not been seen in the market before due to the lack of demand from clients. In terms of how the customer views it, it gives the client a slightly worse upfront rate as a trade-off for downside protection. For example, it might make a 20 pips difference to the strike price but in the scheme of things if you are still picking up 200–300 basis points that is not a big deal," he says.

Gilmour also says the bank has not seen as much demand for discrete knock-out forwards because of the approach it has taken during the regulatory review process.

"We heard that many of the other banks were moving to offer discreet knock-out forwards during the regulatory review but we decided to wait and see what the regulator had to say on these products. What they now require is a cap-loss for investors. Clients should have some form of downside protection but it is extremely difficult to convince them of this because it makes the payoff less attractive. Therefore it is very welcome if a regulator comes out and says we have to do it," he says.

In implementing a cap on losses, the Taiwanese regulator has said that the investor should not lose more than 50% of their initial investment.

Gilmour says Citi is looking to offer a protection level that is significantly better than what is required and looking to cap the loss at 20–25% of the initial investment.

The new products are expected to be rolled out to local Taiwanese banks before the end of the year with draft proposals undergoing review by the FSC.

However volumes for target redemption products linked to RMB are unlikely to hit the heights achieved prior to the depreciation of RMB earlier this year, says Gilmour.

"What was very evident out of the last shock was there wasn't the liquidity in the CNH market to correctly risk-manage such a large notional of this product. So I don't think we will see the volumes we saw previously simply because the risk managers at the banks will not allow such large notionals any more," he says.