Derivatives house of the year, Taiwan: CTBC Bank

Equity-linked notes (ELNs) have long been popular in Taiwan, but issuance has largely been confined to foreign dealers. Last August, following a great deal of discussion with regulators, CTBC Bank became the first domestic bank to be permitted to trade the structures – a testament to its robust risk management framework and strong warehousing capabilities.

The particular type of ELN traded on the Taiwanese market are fixed coupon notes (FCNs), where the investor receives an unconditional periodic coupon. They can include a number of exotic features, such as rainbow options, memory knock-outs and reverse knock-ins. Such structures are not easy to risk manage.

“Foreign institutions used to dominate the ELN issuances, and so I am pleased to be able to share with you this breakthrough,” says Jack Wang, CTBC Bank’s head of treasury sales division. “Being one of the leading banks in Taiwan, we have constantly offered recommendations in terms of product innovation to seek business opportunities for the industry.”

One of the reasons the regulator is so cautious about this type of product is because of what happened a decade-and-a-half ago, when Lehman Brothers collapsed. At the time, the US bank had sold a large number of structured notes to Taiwanese investors, through domestic banks. When Lehman Brothers collapsed, investors in the country were left sitting on large losses.

The stamp of approval the regulator has given CTBC’s new FCN products is recognition of the sophisticated treasury management system the Taiwanese bank has developed over the years. It also demonstrates CTBC’s ability to warehouse fairly complex risk.

So why are these structures so challenging to risk manage?

For one thing, the structures are priced according to the Monte Carlo approach. This requires a large amount of computing power, forcing traders to balance speed and accuracy.

Secondly, the rainbow feature of this product introduces correlation risk into the trading book, for which there is no tradeable contract available for hedging. To manage the correlation risk, CTBC has to create a basket of index single-stock stock options. This correlation basket must be dynamically managed and adjusted whenever the structure slips into or out of the money.

CTBC Bank is not only able to warehouse such correlation risk in order to support its own ELN issuances, the Taiwanese dealer also acts as the counterparty of local banks to square their equity risks.

According to CTBC’s own calculations, based on data provided by the Taipei Exchange, offshore ELN issuance grew 116% year on year in the first quarter of this year. As of May 2024, CTBC had issued 29 ELNs, with a total notional value of $11.3 million. Since CTBC only launched ELNs in August, the Taiwanese bank has not yet had time to accumulate the same amount of issuance as those foreign issuers that have been cultivating the market for decades. Nonetheless, Wang says this is a healthy level of issuance for a new product.

JPY exotic rates

Over the past few years, CTBC Bank has been building out its Japan business so that it can capitalise on interest rate differentials. This year, the dealer added a new component: an offshore Japanese yen exotic rates platform.

This platform is in answer to a problem that CTBC’s Tokyo subsidiary faced. Due to market segmentation, the subsidiary found it difficult to find hedging counterparties with which it could offset its JPY interest rate risks. This platform allows the risk to be backed into the head office in Taipei, which can warehouse it and make sure the exposure is at acceptable levels for the bank as a whole.

This initiative has helped the Taiwanese dealer capitalise on another exciting year for Japanese yen interest rates. For nearly a decade, interest rates in Japan have been in negative territory. Then, in March this year, the central bank suddenly raised the base rate to 0.1%. At the same time, it abandoned its yield curve control policy, which the Bank of Japan had put in place to prevent long-term interest rates from rising.

In response to the expected yen fluctuation this year, CTBC released a new reverse strike, which offers an alternative way to settle under different market conditions.

“We continue to invest in the business operations to extend services, from long-term FX options to other products. By continuously strengthening the platform, we expect to satisfy the hedging needs as well as the investment needs of clients,” says Wang.