Q&A: Taiwan’s finance watchdog on Tarfs and deregulation

The FSC aims to open up Taiwan’s derivatives market while guarding against the risks of looser rules, says its chair, William Tseng

FSC chair William Tseng

Two waves of import substitution between the 1950s and 1970s supercharged the expansion of Taiwan's light and then heavy industries, making it one of Asia's four tiger economies that grew at annualised rates in excess of 7% during that period. Now the country is repeating the same trick with its financial sector in a move that has major implications for both global banks and local players active in one of the region's most sophisticated derivatives markets.

The result of this policy has mostly been significant levels of deregulation since the Financial Supervisory Commission's (FSC) new chair, William Tseng, took office in July 2013. From the relaxation of rules surrounding Formosa bonds – foreign currency paper issued in Taiwan – to the reopening of the non-deliverable forwards (NDF) market, participants say the local securities and derivatives sector has become more resilient and dynamic in the past two years.

The numbers suggest this policy is working. Between June 2014, shortly after the FSC excluded locally issued foreign-currency bonds from insurers' overseas investment baskets, and October 31 this year, firms in Taiwan issued international bonds to the tune of 1.68 trillion Taiwan dollars ($51.8 billion) – 12 times the amount sold previously; that is, between November 2006, when the first international bond was issued in Taiwan, and June 2014. Foreign bonds have proven an efficient instrument for insurers to diversify their asset allocation and provide a much-needed enhanced yield – their average 4% annualised return substantially outperforms the 1–2% returns offered by equivalent local securities.

The bonds also made 2.76 billion Taiwan dollars of revenues for local securities companies and law firms, the FSC says.

Numbers for the NDF market are similarly impressive. So far, the regulator has licensed three overseas branches of two Taiwanese banks to trade local currency NDFs, with volumes hitting 1.83 trillion Taiwan dollars by September 30 this year.

In June, the regulator approved local banks and Taiwanese branches of foreign banks to trade and settle offshore-issued derivatives for institutional clients in the onshore market. By the end of September, 12 banks had obtained a licence and volumes of derivatives traded reached 194.8 billion Taiwan dollars.

But the trend hasn't completely been towards liberalisation. In 2014, the FSC sanctioned nine local banks for selling target redemption forwards (Tarfs) linked to offshore renminbi, or CNH, to inappropriate clients and in July this year it fined three foreign banks for marketing derivatives onshore without a licence.

Most recently, the regulator stepped up its scrutiny of Tarfs and discrete knock-outs (DKOs). Firms can now trade these products only with professional investors who have at least 100 million Taiwan dollars in liquid assets, banks are barred from writing contracts longer than one year and the maximum loss has been capped at 15% of the notional value. None of these measures have been taken in comparable markets in Asia, such as Hong Kong and Singapore.

These restrictions on exotic foreign exchange derivatives are likely to hit banks' profits. Tarf volumes have already declined 30% year-on-year in the first six months of 2015. Tarfs and DKOs have been a major source of profit for local banks over the past five years, with market sources suggesting some firms made as much as 90% of their derivatives income from these structures.

Unsurprisingly, a number of Taiwanese banks have been complaining about the regulatory constraints and the resulting increased competition in the local market. But, in an interview with Risk.net in his Taipei office, FSC chair Tseng is unapologetic about the commission's actions, saying they are critical to maintaining stability in the island's economy – and further changes are in the pipeline.

The FSC relaxed some regulations to enable Taiwanese banks to compete with their global peers in the derivatives market, but on the other hand it has imposed measures to limit banks' capacity to trade some exotic forex structures. Don't these moves seem rather contradictory?

William Tseng: It is not contradictory. The whole deregulation is based on the policy of gradually opening up the market and giving banks more flexibility to develop new business – only if they could manage the associated risk properly. As you mention, we have removed quite a few restrictions in the past two years to support financial institutions' development. The direction is quite clear and we will keep doing this in the future.

But we have to be wary of potential problems coming with deregulation; for example, Tarfs. Banks traded more than 135 billion Taiwan dollars of Tarfs and DKOs this year, many of which were sold to small and medium-sized corporates that may not have the ability to fulfil their contract obligation in case large-degree devaluation of the renminbi happens. In that case, 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. We saw this possibility and had to do something to prevent it.

In fact, Tarfs are one of the few products restricted by us. Banks still have plenty of room to develop other structures. Moreover, we encourage local banks to devise complex derivatives on their own, but a Tarf is actually a pretty standard and mature product that doesn't require too much know-how.

Tarfs are also traded a lot in Hong Kong and Singapore, but the regulators in those countries haven't imposed similar restrictions, despite corporates in both jurisdictions suffering large losses from two rounds of renminbi depreciation. Why is Taiwan more concerned about this issue?

WT: The primary reason is [that] the proportion of non-hedging trading of Tarfs in Taiwan is much higher than in Hong Kong and Singapore. We did some investigations and found over half of Tarfs traded in Taiwan are for speculative purposes, while in Hong Kong and Singapore it's only 40% and 8%, respectively. As the renminbi is expected to continue to be volatile, these speculative positions are exposed to the huge risk of renminbi devaluation.

Also, we think banks and clients in Hong Kong and Singapore are more disciplined than those in Taiwan. As I said, some banks in Taiwan sold complex, high-risk derivatives to unsuitable clients, so we have to strengthen our supervision of their conduct.

The FSC bears three goals when performing its duty. First, maintain financial stability; second, prompt the proper development of the financial industry; and, third, protect investors. We prioritise the stability of financial markets and the protection of investor interest over the domestic banking sector's profitability.

How did you get these figures – 40% and 8%?

WT: We are in close touch with the regulators in these two markets and drew the figures based on their information.

When will the FSC lift the restrictions on Tarfs and DKOs?

WT: We expect the renminbi will continue to be volatile in the next few months and there is a chance it will devalue further against the dollar, so we would not consider relaxing the rules until it stabilises. Most importantly, banks should know who the appropriate clients are to sell these products to, and investors must become sophisticated enough to trade.

Some local investors are not willing to face the fact when they lose money [and default, leaving the bank to absorb the loss], although they sign all the necessary documents with banks before trading. There was a surge in the number of investor disputes regarding how banks misled them to trade after the renminbi depreciated suddenly. In the past few months, banks have improved a lot in know-your-client practices, but it is not enough. They should continue the investor education.

Most of the deregulatory measures introduced by the FSC are under the broader policy dubbed 'financial import substitution' and, so far, figures show this appears to be working. What is the FSC's ultimate goal with this policy?

WT: Taiwan has very successful experience in import substitution in light and heavy industries – for example, textiles and shipbuilding – between 1960 and 1990. We tried to replicate this successful experience in the financial sector. Taiwan banks, securities firms and insurers have 12 trillion Taiwan dollars' worth of investments overseas. In the past these funds simply flew out and contributed nothing to the country's economy, so we need to do something to change this situation.

The policy has two phases. Firstly, let the foreign financial product transactions happen in the domestic market. In plain wording: retain the money and people onshore, with the aim of benefitting domestic financial institutions, investors and intermediaries. This phase has been largely completed since December 2014 and we have seen some pretty good results.

The second phase is encouraging local financial institutions to strengthen their own product development and innovative ability through learning know-how from global houses, or by directly acquiring their platforms and technology. Many institutions have started doing this: for instance, CTBC Bank acquired Tokyo Star Bank in 2014 and Cathay Life bought out Conning Holding Corporation this year.

Ultimately, we want to beef up Taiwanese financial institutions' competitiveness in Asian and global markets.

Financial reform brings new opportunities and is changing the business landscape, but it also brings new risks and challenges. For example, when local players expand into other markets, are you confident about the ability of the regulator and the domestic players to manage those risks?

WT: That's why we only support certain parts of the financial sector going overseas. There are 38 banks and 16 financial holding groups in Taiwan, some of which are very small – we encourage this type of firm to stay in Taiwan. But some players – for example, CTBC Bank from the banking sector, insurer Cathay Life and securities firms KGI and Yuanta – have grown to a considerable size. They are competent to expand overseas and are believed to have robust risk management systems.

On the regulator's side, we are going to introduce a new systemic risk-detecting system in the near future. Under the new system, the FSC will be able to more actively and comprehensively detect risks faced by domestic financial institutions. For example, previously we only inspected banks' losses, but now we analyse their profits as well. If a bank's profit surges in a short period of time, such as from Tarfs, it provides reasonable grounds to suspect they have conducted illegal transactions.

In the past we only reviewed banks' assets on the balance sheet, but now we also pay attention to their off-balance-sheet items, especially derivatives gains and losses marked in the footnotes of financial reports. We will also extend the inspection from domestic to their overseas branches and increase the frequency – a random check versus a former regular check. Moreover, we will cross-reference findings by other regulators, such as the Financial Examination Bureau and the Central Deposit Insurance Corporation.

What is the next step in financial reform?

The whole deregulation is based on the policy of gradually opening up the market and giving banks more flexibility to develop new business

WT: From a holistic perspective, we will continue to review deregulation and promote measures to further open up the market. We continue to support domestic financial institutions to develop their product innovation and overseas acquisition. Furthermore, we give a special focus to developing financial technology to help financial firms capitalise on business opportunities generated by digitisation and to beef up their competitiveness. We have set up the Financial Technology Office and the Advising Committee to promote digital application among domestic players in the next three years.