The Financial Supervisory Commission (FSC) last week meted out a fifth round of fines against several domestic banks that have broken client verification rules relating to sales of derivatives such as Chinese yuan-linked target redemption forwards (TRFs).
The commission said the NT$18 million (US$597,470) fine could be the last, as the derivative contracts are expiring, but the total value of fines imposed on banks in relation to the issue has reached more than NT$100 million since May 2014, involving as many as 17 domestic banks.
The commission has taken strong action on the sale of TRF contracts over the past two to three years, amid growing concerns about banks’ selling practices and resulting disputes with clients.
The commission last year required banks to seek regulatory approval before selling derivatives to certain clients, one year after it tightened TRF sales regulations, including doubling the asset threshold for qualified investors, limiting the maximum duration of typical TRF contracts to 12 months and mandating initial and variation margin payments on investors.
A TRF is a complex set of currency-linked, structured products that provides corporate investors with above-market forward rates to hedge for foreign-exchange risks. Among the foreign currency-denominated options, the yuan-based TRF was especially popular about four to five years ago — a period when the Chinese currency appreciated strongly and corporate investors bought those products to manage fluctuations in exchange rates, while earning extra income by betting on the yuan’s continued strength.
For banks, the sizable commissions from the sale of TRF contracts had positive effects on their earnings in Taiwan’s low interest rate environment.
However, the yuan’s depreciation beginning in 2014 led to a rapid fall in speculative demand for the currency and prompted investors to book losses or sell their holdings to meet margin calls.
TRF contracts have a skewed payoff ratio, as the maximum gain is limited, but possible losses are theoretically infinite. The sale of this kind of financial derivatives has created not just mounting losses for investors, but risk management headaches for banks.
The FSC’s handling of TRF disputes has drawn criticism over the regulator’s intervention in business issues and its rigid regulatory guidelines.
Since the commission has ordered banks to settle TRF-related disputes with their clients through mediation or arbitration by third parties, some critics have raised the issue of moral hazard, arguing that the action would invite investors — mainly small and medium-sized enterprises — to continuously beg for government bailouts.
However, the commission’s experience in 2008 of handling disputes over investments in structured notes linked to Lehman Brothers Holdings Inc’s bond holdings proved the foolishness of confusing the side effects of moral hazard with crisis management.
The question with TRFs is not whether the design of the product is flawed, or whether the risks of such a highly leveraged instrument are reasonable, but who should bear responsibility for any negative outcomes that might arise from TRF sales.
As the commission continues to uncover irregularities in TRF sales, it appears that the penalties doled out to banks on grounds of inadequate client verification and risk disclosure are actually negligible, and that the financial regulator has still not shown enough teeth to ensure rigorous market discipline.
If the commission fails to regulate banks effectively, the judiciary might be left to deal with the problem. Perhaps implementing some form of loss-sharing between banks and investors would reduce the risk of banks mis-selling products.
It is in the interest of the market’s long-term development that the FSC encourage the introduction of new financial products, but these need to be marketed in a legal and appropriate manner.
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