Currency Derivatives - a Case Study in Asia
Derivative product is a contract that derives its value from the performance of an underlying asset, be it foreign exchange, equity or credit spread etc. It has been vital part of the financial markets where companies rely on it to hedge its risk exposures, hedge funds use it to bet against the markets at a low cost, and banks have been providing these products to make profits. However, these creative products have caused multiple problems in the real economy sector when companies get into trouble with the usage of derivatives that are originally designed to hedge their risks. Over the past decades, derivatives linked to foreign exchange have been particularly popular for emerging markets corporates and individuals, but sometimes the loss is large enough to have macroeconomic impacts.
In the past decades, many emerging markets have seen massive derivatives losses based on corporate hedging activities. According to data, total cost to non-financial firms of these derivatives losses is about $530 billion. Around 50,000 firms in at least 12 economies have suffered these losses.
One of the most recent cases happened in Korea with KIKO Option. Korea was hit by these exotic derivatives with losses that hurt many small enterprises as well as several large firms during the financial crisis of 2008, where USDKRW exchange rate spiked from 950 to 1550. High profile cases reported include Win4Net, a security solution company who had to sell its headquarters building as it sustained 5 billion won in losses from a Snow Ball contract.  Similar cases are also found in Sri Lanka, India, etc and all involve innovative volatility products that have caused loss during adverse market movements.
2CNH Market Derivatives
The Renminbi has long been a managed currency. However, to coincide with China’s plan to internationalize its currency, an offshore version of Renminbi–so-called CNH is introduced in Hong Kong on July 2010 and offshore entities can trade on CNH market.
The CNH market has grown rapidly in recent years. Currently Hong Kong institutions hold around 617 billion CNH in deposits as of December 2018. All the other forms of pot, forwards, and options market has developed quickly too. Through 2008 until 2015, coupled with strong economic performance, CNH has undergone a continuous trend of appreciation against the USD, starting from around 7.80 to the lowest of 6.10 for about 22%. During this period of time, numerous exporters in Hong Kong and Taiwan have found it increasingly necessary to hedge themselves against RMB appreciation as they need to sell their receivables of USD into CNH to repay onshore producers and distributors.
The hedging of USDCNH started with spot and quickly moved towards forward, as typically exporters would sell their inventories and receive USD payments periodically. The financial institutions quickly realized the design of a short volatility product in such market environment could prove to be profitable. The product, though new to USDCNH market, is in essence the same as the ‘accumulator’ that was popular in equities during before the financial crisis, and the KIKO of Korean Won.
In the long period of CNH appreciation from 2008 up to 2015, the product was extremely popular as people viewed this as ‘free money’ by hundreds of enterprises in Greater China areas ranging from small exporters to multinational corporates. Such ‘easy money’ has gained the attraction of speculators and the original hedging purpose of this product has span out of control in some cases.
On 11th August, the People’s Bank of China unexpectedly weakened its daily fixing for CNY by 1.9% against USD. The next day PBOC moved the CNY fixing another 1.6% weaker against USD. Such move has caught the market off guard and has caused tremendous impact in the derivative market. The mark-to-market of the derivative product depends on multiple factors, among which the most important factors are spot rate, forward points and volatility. All these factors together have caused all the Target Redemption Forward contract mark-to-market to move massively negative to the client, causing significant mark-to-market loss.
3Thoughts and Regulatory Analysis
The financial industry is a highly-regulated industry, and regulators have always been cautious around the issue of miss-selling. Over the years, they have tightened controls around these derivative products, both in selling process and client segment restrictions. The regulators reactions for the specific case mentioned above are different cross the markets. In Taiwan, new rules restricted the tenor of product to 1 year and asked the loss to be floored at certain percentage of the total notional. In Hong Kong, HKMA conducted industry wide on-spot survey and report, asking banks for trade-by-trade analysis.
As we have analyzed, the product itself is purely an innovative way to hedge risks. Only by speculative nature of the market participants the product might become abused and causes big loss. The delicate balance between encouragement of innovation in products in the derivative markets and controlling abusive use or over-leveraging of derivatives has always been difficult to maintain.
Some may argue that excessive usage of derivatives may cause financial instability in a broader sense. In currency cases, especially when local currency starts to depreciate, the loss on derivatives will further local currency markets selling pressures. This can in turn create market panic due to the lack of transparency for these derivatives. This will boil down to a vicious cycle where further depressed currency values cause greater losses on derivatives. Thus, financial institutions should keep in mind that public interest is at stake with these exotic transactions.
Looking ahead, as far as the author concerns, regulators should focus more on improving the robustness of selling process in banks, rather than simply banning certain products for certain clients. What the industry should do is to have stricter hedging standards, while giving room for investors with higher sophistication. As long as the products are clearly identified as being exotics with high risk features adequately highlighted and explained, the products should still be seen adequate to manage risks and better offering to clients. Another way to supervise these products is to tie-in the use of derivative to hedge risks with IFRS accounting rules. By clearly defining the hedging rules requirement, regulators can to some extent limit the corporates derivative frenzy under the pretext of hedging.
 Bloomberg wire, April 25, 2009.
 HKMA Deposit Data
 Exotic Derivatives Losses in Emerging Markets: Questions of Suitability, Concerns for Stability – Randall Dodd, IMF White Paper, July 2009
 Geczy, C., Minton, B., & Schrand, C. (1997). Why firms use currency derivatives. The Journal of Finance, 52(4):1323–1354
 Dodd, Randall, 2009, “Playing With Fire,” Finance and Development, June 2009
 Kamil, Herman, and Chris Walker, 2009, "Corporate Losses on Currency Derivatives in Mexico and Brazil: Facts and Policy Lessons,” Finance & Development,(forthcoming). Appeared earlier in Global Markets Monitor, Friday, November 14, 2008