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Introduction of Leverage Contract

Introduction of Leverage Contract

(I) Types and features of leverage contract

  1. What is a leverage contract
    2. “Leverage contract” is a financial derivative contract entered by and between a leverage transaction merchant and a customer regarding the trading of derivatives of commodities, currencies, securities, interest rates, indexes, or any other interests conducted at the business place of the leverage transaction merchant pursuant to the regulations or practices set forth by domestic or foreign futures markets, in which one party undertakes to pay a specific percentage of an amount or to obtain a specific credit line granted by the other party, and the parties will offset their obligations and rights by settling the difference in price or delivering the underlying interest within a specified future time period pursuant to the terms under the contract. Simply put, a leverage contract involves the trading of over-the-counter financial derivatives operated by a leverage transaction merchant (a futures commission merchant who operates concurrently as a leverage transaction merchant).
  2. Types of leverage contract
    3. Basic leverage contracts include forwards, swaps, options, contracts for differences, or combinations of two or more contracts above, or structured products linked to a fixed-income instrument.
  3. Features of leverage contract
    4. (1) Commodities under the contract are not standardized. They are traded over-the-counter by negotiation on a case-by-case basis.
    (2) The rights and obligations of the parties must be agreed on in the contract.
    (3) Both parties to the transaction must bear counterparty credit risk, i.e. the risk of default by the other party.
    (4) Because of the buy-sell spread, a leverage contract usually does not incur additional transaction costs.

(II) Common types of leverage contract

  1. FX margin
    2. FX margin means the customer pays a specific percentage of an amount as security deposit or obtains a specific credit line granted by the leverage transaction merchant and the parties engage in foreign exchange transactions within the limit of security deposit paid and credit line granted pursuant to the terms under the contract.
  2. Options
    3. An option is a contract under which the option buyer pays a premium to the seller in exchange for a right to purchase (call option) or sell (put option) a specified quantity of a certain underlying interest at a specified price on a specified date, whereas the option seller has the obligation to fulfill obligations pursuant to the contract. Commonly traded options include FX options, bond options and asset swap options.
  3. Structured products
    4. A structured product is an investment tool that combines a fixed-income instrument or gold with a leverage contract to link investment return to the performance of the underlying asset.

(III) Rules and regulations concerning investor rights and interests

  1. Investor classification system
    2. When providing leverage contract services, a leverage transaction merchants (LTM) shall classify its customers into professional customers and retail customers. Retail customers are protected by the Financial Consumer Protection Act and the regulatory requirements with regard to the types of products retail customers may trade, product suitability, risk disclosure, written contract and handling of trading dispute are more stringent.
  2. Types of investors
    3. (1) Professional customers:
    1. “Professional institutional investor” includes domestic and foreign banks, insurance companies, bills finance companies, securities firms, fund management companies, government investment institutions, government funds, pension funds, mutual funds, unit trusts, securities investment trust enterprises, securities investment consulting enterprises, trust enterprises, futures commission merchants, leverage transaction merchants, futures service enterprises, and other institutions approved by the competent authorities.
    2. “High net worth corporate investor” is a juristic person that applies to a LTM for the status of a high net worth corporate investor and meets all of the following criteria:
      3. - Having a net worth exceeding NT$20 billion;
      - Having a dedicated investment unit that is staffed by capable professionals;
      - Holding securities position or derivatives product portfolio exceeding NT$1 billion; and
      - Having an internal control system containing suitable investment procedure and risk management measures.
    3. A juristic person or fund meeting all of the following criteria and having applied in writing to a LTM for the status of professional customer:
      4. - Having total assets exceeding NT$100 million;
      - The person authorized by the customer to undertake trading possesses sufficient professional knowledge and trading experience in financial products; and
      - The customer understands fully that the leverage transaction merchant may be exempted from liability for derivatives trades conducted with a professional customer, and consents to sign to trade as a professional customer.
    4. An individual meeting all of the following criteria and having applied in writing to a LTM for the status of professional customer:
      5. - Having proof of assets worth at least NT$30 million; or having carried out a transaction exceeding NT$3 million in value, and in addition, total assets at the LTM worth more than NT$15 million, and having provided a statement undertaking that he or she has assets exceeding NT$30 million;
      - Having sufficient professional knowledge and trading experience in financial products; and
      - The customer understands fully that the leverage transaction merchant may be exempted from liability for derivatives trades conducted with a professional customer, and consents to sign to trade as a professional customer.
    (2) “Retail customer” refers to a non-professional customer.
  3. Product suitability
    4. A LTM should carry out “Know Your Customer” (KYC) process to understand a customer's investment experience, financial condition, trading purpose, understanding of the product and risk tolerance, and carry out “Know Your Product” (KYP) based on the product characteristics, risk and probability of loss of principal, liquidity, structural complexity, and term of product to sell leverage contracts that are suitable for a customer.
  4. Things to Note in Investing in Leverage Contracts
    5. (1) Make sure the LTM has obtained the qualification to operate the business.
    (2) By entering a leverage contract, an investor must bear the credit risk of the LTM. Thus an investor should carefully evaluate the financial and business status of a LTM before engaging in any transaction with it.
    (3) Leverage contract is a rather complex investment instrument. Before entering a leverage contract, an investor should make sure he or she has sufficient understanding of the product and make sure he or she can tolerance loss in the worst-case scenarios.
    (4) An investor should read carefully the contract documents provided by the LTM, such as “Product Prospectus” and “Risk Disclosure Statement” and has been explained to by the staff of leverage transaction merchant. After a transaction is executed, the investor should obtain a written trade confirmation from the LTM.
    (5) A LTM that provides structured product trading services to retail customers shall fulfill its duty of disclosure. For products with sale to 10 or more persons planned and with a durations in excess of 6 months, the retail customers shall be given a review period of not less than 7 days. In addition, the LTM shall read aloud to the customer the important content of disclosure statement and retain an audio recording of the process.
  5. To inquire whether a LTM has the qualification to operate leverage contract business
    6. Investors can search the TPEx website (www.tpex.org.tw) to find out whether a LTM has the qualification to operate leverage contract business (Home > Derivatives > TPEx Derivatives > Application & Services > Securities Firms and Leverage Transaction Merchants).
  6. How to file a complaint in case of trading dispute
    7. In case of trading dispute, an investor can first try to resolve the dispute through the dispute handling procedure and complaint channel provided by the LTM for communication, coordination or filing a complaint. If the complaint is not satisfactorily addressed, the investor can file a complaint with the Chinese National Futures Association, Financial Ombudsman Institution, Securities and Futures Investors Protection Center and Financial Supervisory Commission.