A hedge or a gamble? Potential claims for losses under FX derivatives
The recent depreciation of various currencies, in particular against the US$, risks significant losses for businesses under complex foreign exchange (FX) derivative products. Jonathan Cary considers the dangers of these products in the current volatile markets and explains why there is significant potential for disputes in this area.
The US Federal Reserve's hawkish monetary policy in response to rising inflation has led to the dramatic strengthening of the US$ against almost every major currency. In late September 2022, the British pound plummeted to its lowest level against the US$ since 1972 (albeit exacerbated by other factors). The Euro has sunk below US$1 for the first time in 20 years and in Asia, the impact has been equally pronounced with major currencies including the Chinese renminbi, the Korean won, the Japanese yen and Malaysian ringgit falling sharply, in some cases to levels not seen since the global financial crisis.
These steep exchange rate fluctuations mean that businesses that bought billions of US$ worth of FX derivative products in an effort to “hedge” their position against an appreciating domestic currency are at risk of facing considerable losses.
Further, in an effort to navigate these significant currency fluctuations, it appears more and more businesses are turning to FX derivatives. By way of illustration, the People's Bank of China released data in October 2022 which identified that in the first half of 2022, FX risk-hedging by PRC companies totalled US$755.8 billion which represented an increase of 29% from last year.
That activity is expected to have accelerated further in the second half of the year given the more extreme recent swings in the currency markets. This builds in yet further significant risk.
FX hedging is important to many international businesses, in particular in the import and export markets, because their income is partly dependent on an exchange rate (or rates) and not only on income generation in their own currency. As their own currency appreciates, there is a need to protect the value of their income and mitigate the commercial impact of their services or exports becoming more expensive. Conversely, businesses may be impacted by the depreciation of their own currency if they are exposed to the rising cost of imports.
There are a number of ways that a business may hedge its exposure in order to seek to mitigate these risks. However, businesses worldwide have purchased exotic FX derivative products which, rather than a low-risk hedge, represent a high-stakes gamble. These products have various positive sounding names, such as "Target Redemption Forwards" (TRFs or Tarfs), "Knock-in, Knock-outs" (KIKOs) or "Target Redemption Notes" (TARNS).
There are subtle differences between these derivative products. However, in essence, the parties nominate a notional sum in a particular currency (for example, the RMB) and agree a benchmark exchange rate between that currency and another currency (for example, the US$) 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 problems with such products for customers are primarily that:
i. there is usually 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
ii. there is an asymmetry of risk and reward. 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 exotic FX derivatives have previously 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 Fund concluded that they do not function as a hedge, nor are they even a sound option for currency speculation.
More recently, in 2021, it was revealed that Deutsche Bank may have mis-sold FX derivatives to scores of businesses in Spain after it was announced that it had reached a settlement for over €10m with J Garcia-Carrion, Europe's largest wine exporter.
However, notwithstanding these issues, these types of products persist, and the banks have continued to explore new markets into which they can be sold.
Potential for disputes
In circumstances where customers are now exposed to significant losses under these FX derivative products, they will be asking challenging 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.
It is important for such businesses to seek professional advice at an early stage, in particular as it may be possible to agree with the bank some form of satisfactory restructuring or settlement.
However, if that is not possible, customers will need to examine their legal options and potential remedies in the relevant jurisdictions. Given the choice of law and jurisdiction clauses generally included in these types of contracts, this is likely to include the Courts of the leading dispute resolution centres such as England & Wales, Hong Kong and Singapore. A number of relevant contracts may also specify that disputes be resolved by arbitration (rather than litigation) in circumstances where the customer is located in a jurisdiction in which there are issues surrounding the enforcement of foreign court judgments (for example, the PRC).
In these sorts of disputes, the banks commonly 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 has become 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. Further, efforts have been made in certain jurisdictions to curtail the banks' ability to rely on such provisions. In Hong Kong, for example, the Securities and Futures Commission has, since, June 2017, required banks to include a mandatory "suitability clause" in the customer agreement whereby they contractually agree that any financial product solicited or recommended is reasonably suitable for the customer having regard to the customer's financial situation, investment experience and investment objectives.
As the storm clouds continue to gather over the global financial markets, the ability to predict the movement of FX rates is becoming ever more challenging. Businesses which have become, very possibly inadvertently, highly leveraged currency speculators will need to proceed with caution.