Recent depreciation risks significant losses under exotic currency derivatives

RMB  depreciation

The renminbi (RMB) appreciation over the last several years appears to have halted for now, which  has taken much of the market by surprise. Indeed, the RMB’s recent accelerated depreciation towards 6.20 to the US$ has already  wiped out any appreciation from last year. Some market analysts are calling this a “danger zone” for the many Chinese businesses  and exporters that bought billions of US$ worth of exotic currency derivative products in an effort to “hedge” their position against an appreciating RMB.

As the RMB depreciates (in the short term at least), many businesses and investors are facing  considerable losses. Once again, attention is being directed to the financial institutions that  sold these currency derivatives.


Until recently, China’s export led growth had resulted in pressure from its main trading partners  (for example, the EU and US) to “strengthen” the RMB in order to curtail a perceived advantage for  Chinese exporters; namely, the relatively “cheap” RMB. However, the gradual appreciation of the RMB (as with the Yen a few years back) resulted  in many businesses in China borrowing large amounts in US$ (at, in effect, negative interest rates, accounting for inflation) in order to  repatriate funds back to their domestic markets, thereby hoping for: (i) better investment returns  and (ii) further gain with an appreciation of the RMB. This phenomenon has become known as the  so-called “carry trade”. It has been seen in Japan and other economies in the Far East.

“Currency  hedging”

Currency hedging is important to businesses in the export market because their income is partly  dependent on an exchange rate and not only on sales in their own currency. As their own currency  appreciates, there is a need to protect the value of their income and mitigate the commercial  impact of their exports becoming more expensive.

As a result, many Chinese businesses have purchased complex currency derivative products. These  products have rather grand or exotic sounding names, such as: “Target Redemption Forwards” (TRFs),  “Knock-in, Knock-outs” (KIKOs) or “Target Redemption Notes” (TARNS).

There are subtle differences between these derivatives. However, in essence, the parties nominate a notional sum in a particular currency (for  example, the RMB), agree a benchmark exchange rate between that currency and another currency (for  example, the US$) and agree that on pre-determined dates (fixing dates) they will make payments to  one another through “put” and “call” options; the payments being calculated by applying the market  exchange rate on that fixing date.

In practice, the two sums are netted off against each other and the party who is “out of the money”  (ie who loses on the exchange rate) pays the other on each fixing date.

The attraction of such products is that they are generally zero-premium products (which means no  upfront cost to the customer) and offer a better than market exchange rate. The problem with such  products for customers is primarily that:

  1. there is an element of gearing; if they are on the “wrong side” of the trade they have to pay  the bank a sum based on a multiple of the original sum; and 
  2. as with “forward accumulator” share trades (that have recently been the subject of high-profile  disputes in the courts in Hong Kong), the customer’s potential gains (and the bank’s losses) are  capped by a “knock out” provision, which terminates the transaction if a certain “trigger” point is  reached; for example, a certain level of profit has been earned by the customer or the base  currency hits a certain level. However, if a customer is on the “wrong side” of the trade there is no “knock out”  provision to protect the customer. Accordingly, the potential losses are unlimited. These types of currency derivatives have already caused widespread economic misery in a number of jurisdictions, in particular in emerging  economies in South East Asia and South America in 2008 and 2009. Indeed, they have been described  as “products from hell” and the International Monetary Fund1  concluded that they do not function as a hedge,  nor were they a sound option for currency speculation.

In Hong Kong, for example, Citic Pacific suffered massive losses in 2008 resulting from TRFs  entered into with the intention of managing its US/Australian dollar exchange rate exposure.

Potential for disputes

In circumstances where customers are  now exposed to significant losses under these currency  derivative products, they will be asking tough questions about how the products were sold, whether  they were suitable for their purposes and whether the banks made them fully aware of all of the significant  risks; particularly, given that it is highly questionable whether such products can ever function  as a hedge.

Of course, liability turns on the facts of each case.

In these sorts of disputes, the banks usually turn to their contractual disclaimers for protection  and/or claim that they are not acting in an “advisory” capacity. While circumventing these types of  “defences” is by no means easy, it is becoming apparent that many of the banks’ customer-facing staff did not understand some of the complex products that  their banks sold and/or had little or no regard for the suitability of such products for their customers.

Some of these customers will now be looking at their options and potential remedies in the relevant jurisdictions and dispute resolution venues. Given the choice of law and jurisdiction clauses generally included in these  types of contracts, this is likely to include England and Hong Kong. We would also expect many of the relevant contracts  to specify that disputes be resolved by arbitration  rather than litigation, given issues surrounding (for example) the enforcement of foreign court judgments in Mainland China.

Gary Yin, Smyth & Co in association  with RPC