Taipei Exchange

Introduction of Over-the-Counter Derivatives

(I) Types and Features of Over-the-Counter Derivatives

1. What are over-the-counter derivatives?
“Over-the-counter derivatives” means trading contracts and structured instruments, whose value, in conformity with regulations or common practice on domestic or foreign over-the-counter (OTC) markets, is derived from an interest rate, exchange rate, equity, index, commodity, credit event, or other interest, or from a combination thereof.
2. Type of OTC derivatives
Basic OTC derivatives include forwards, swap, options or combinations of two or more contracts above, or structured products linked to a fixed-income instrument.
3. Features of OTC derivatives
(1) There are no standard form contracts. They are usually traded over-the-counter by negotiation on a case-by-case basis.
(2) Both parties to the transaction must bear counterparty credit risk, i.e. the risk of default by the other party.
(3) Because of the buy-sell spread, an OTC derivative transaction usually does not incur additional transaction costs.

(II) Common types of OTC derivatives

1. Forwards
Forward is a contract between two parties to buy or sell a specified quantity of an asset at a specified price on a future date Commonly traded forwards include FX forwards and forward rate agreement (FRA).
2. Swap
Swap is a contract between two parties to exchange a series of cash flows within a certain period of time in the future. Commonly traded swaps include CCS, IRS, asset swap and CDS.
3. Options:
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.
4. Structured products
A structured product is an investment tool that combines a fixed-income instrument with a derivative to link investment return to the performance of the underlying asset. Commonly traded structured products include principal guaranteed notes (PGN), equity-linked notes (ELN), and dual currency investment.

(III) Rules and regulations concerning investor rights and interests

1. Investor classification system
When providing derivatives trading services, a securities firm shall classify its customers into professional customers and retail customers. Retail customers are protected by the Financial Consumer Protection Act and 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
(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, 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 securities firm for the status of a high net worth corporate investor and meets all of the following criteria:
- 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 securities firm for the status of professional customer:
- Having total assets exceeding NT$100 million;
- The person authorized by the customer to undertake trading possesses sufficient professional knowledge, trading experience in financial products; and
- The customer understands fully that the securities firm 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 securities firm for the status of professional customer:
- 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 securities firm 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 securities firm 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
A securities firm 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 derivatives that are suitable for a customer.
4. Things to Note in Investing in Derivatives
(1) Make sure the securities firm has obtained to qualification to operate the financial derivatives business.
(2) By trading a derivative, an investor must bear the credit risk of the securities firm. Thus an investor should carefully evaluate the financial and business status of a securities firm before engaging in any transaction with it.
(3) Financial derivative is a rather complex investment instrument. Before trading a derivative, 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 securities firm, such as “Product Prospectus” and “Risk Disclosure Statement” and has been explained to by the staff of the securities firm. After a transaction is executed, the investor should obtain a written trade confirmation from the securities firm.
(5) A securities firm 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 securities firm 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 securities firm has the qualification to operate financial derivatives business
Investors can search the TPEx website (www.tpex.org.tw) to find out whether a securities firm has the qualification to operate financial derivatives business (Home > Derivatives > TPEx Derivatives > Application & Services > Securities Firms and Leverage Transaction Merchants).
6. How to file a complaint in case of trading dispute
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 securities firm for communication, coordination or filing a complaint. If the complaint is not satisfactorily addressed, the investor can file a complaint with the Taiwan Securities Association, Financial Ombudsman Institution, Securities and Financial Supervisory Commission.