Yuan Derivatives Blowup Curses Taiwan Businesses With Defaults

  • Currency's 8% drop spells losses on Target Redemption Forwards
  • `It's even worse than a casino,' says businessman of bank

On Aug. 7, Kevin Kuo was having his fortune told at a Kyoto shrine in the Japanese tradition of picking out bamboo sticks. He got two that read "curse."

For the 39-year-old home appliance importer, calamity came in the form of a shock yuan devaluation four days later. Kuo’s Taipei-based firm was holding two Target Redemption Forward contracts, a structured product used to bet on yuan appreciation. By the time both matured in early January, he had lost a net NT$11.6 million ($347,200).

Kuo is among TRF investors hit by the yuan’s 8 percent plunge from the end of 2013, following four straight years of steady gains. The risk that holders of the leveraged derivatives will default have fueled an 8.5 percent loss in Taiwan’s local financial stock index this year, compared with a 2.5 percent drop in the overall benchmark.

“It’s even worse than a casino -- at least you can eat and drink at a casino,” Kuo said, adding that the banks that sold him the products should have made the risks clearer. “Can the financial regulator please explain to me how this is a hedging product?"

Kuo’s firm doesn’t use yuan, and he says he knows very little about the Chinese currency.

Unexpected swings in exchange rates devastated buyers of similar products during the 2008 global financial crisis. Chinese firm Citic Pacific Ltd. sought a bailout from its parent after losing about $1.9 billion on derivatives that bet on gains in Australia’s dollar, which tumbled 20 percent that year. South Korea’s government spent around $3.2 billion bailing out exporters who couldn’t repay Knock-In Knock-Out contracts sold as a hedge against the won’s appreciation when the currency plunged.

Taiwan’s Financial Supervisory Commission said on Jan. 26 that it will penalize nine lenders for inadequacies in their TRF business. Among them was Bank SinoPac, which sold Kuo the products. Its president, Michael Chang, said in an e-mail referring to general TRF sales that all buyers have to sign documents on risks and product and transaction details. The bank stopped selling new TRFs in May 2014, with all contracts ending by end-March. FSC data show the outstanding notional amount of TRFs and DKOs dropped to NT$95 billion in mid-January, compared with NT$135 billion at end-August.

The regulator tightened derivative rules last week, including doubling the asset threshold for qualified investors, mandating initial margin payments and limiting contracts to a year. Credit Suisse Group AG estimates TRF sales may fall as much as 80 percent this year because of the rules and the yuan’s outlook. The currency will drop to 6.8 a dollar by year-end, according to the median estimate in a Bloomberg survey.

TRF Structure

In a typical TRF, the client gains when the yuan spot price is stronger than the strike rate, and the contract terminates when a cumulative profit target is met. When the yuan weakens beyond what’s called the European knock-in, the client pays the bank. The typical contract lasts two years. If a product doesn’t have a stop-loss feature, losses can be many times the gains, depending on how fast and far the currency depreciates.

Taiwanese lenders started selling these derivatives to small businesses and wealthy individuals in 2013, when the yuan posted its fourth annual gain in a row. With persistently low rates squeezing lending margins, many local banks generated income by selling the products to global investment banks.

Taiwanese investors have failed to honor losses on almost NT$2 billion of yuan TRFs and discrete knock-outs, a similar derivative, and there are probably NT$2 billion more of defaults to come, Austin Chan, director-general of the FSC’s banking bureau, said last week. The potential losses are probably much higher than reported as lenders are restructuring clients’ losses into loans or new TRFs, Macquarie Securities wrote in a Jan. 27 note.

’Too Confident’

“Everyone was too confident the yuan will keep appreciating," said Chung Hsu, a financial analyst at Credit Suisse in Taipei. "Taiwan banks are eager to grow fee-based income to offset weak lending profitability."

The onshore yuan has dropped 5.6 percent since August’s devaluation to 6.5795 a dollar in Shanghai. Spot rates can be affected by TRFs as well, playing out a vicious cycle where traders buy the yuan to hedge exposure, and rush to sell when the products are unwound.

“Theoretically, the losses should now be absorbed by the client, but because there’s a risk banks missold the products, some clients may now be unwilling to honor the loss," said Andy Chang, an analyst at Taiwan Ratings Corp., the local affiliate of Standard & Poor’s.

Alan Chien, a lawyer at the SinoStrategy Group and former chief legal officer of Sinopac Financial Holdings Co., Bank SinoPac’s parent, said he has been helping about 20 TRF clients, most of whom plan to negotiate with banks to share the losses. He said some lenders helped clients set up offshore firms to purchase the products.

Banks Penalized

Among the lenders to be penalized, Taipei Fubon Commercial Bank Co. said it will help clients reduce TRF positions, while Cathay United Bank said it will strengthen risk management in accordance with new regulations. Shin Kong Bank stopped selling the products after August and risks are manageable for the bank, according to spokesman Daniel Chen.

Bank of Panhsin’s head of compliance Shih-Chi Wu said it followed relevant Know Your Customer procedures and sold complex derivatives to clients with hedging needs. E. Sun Commercial Bank declined to comment on its penalty, saying it hasn’t received details from the FSC. Standard Chartered said it has sound risk management and complies with all regulations. Hua Nan Bank said its clients’ TRFs were in very small notional amounts. Citibank Taiwan declined to comment.

Limited Losses

Fitch Ratings says Taiwan banks’ actual losses from TRFs should be limited as about 60 percent of mark-to-market losses are covered by margin payments. About 80 percent of outstanding products will expire in February, so as long as the yuan stays at about 6.5 or 6.6, the losses shouldn’t expand further, said Taiwan Ratings’ Chang.

Sandra Fang, an owner of a machinery maker, has lost almost $200,000 on her three TRFs since August. She opened an Offshore Banking Unit account at Taipei Fubon Commercial Bank just to buy the contracts, and was told the yuan would keep rising and she could just roll the TRFs into new ones if they incurred losses, she said. Fubon said it complies with regulations in its derivatives business.

“These losses have shaken the very foundation of my company,” Fang said. Her most recent TRF started Aug. 7 -- just four days before the devaluation.

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