Before offshore funds may be publicly offered and distributed in Taiwan, they must be registered with the Securities and Futures Bureau of the Financial Supervisory Commission (SFB). In order to be registered with the SFB, the funds must meet the eligibility qualifications stipulated in various laws and regulations. The funds must also comply with certain limitations including investments (investment targets, investment markets and a limitation on investment in derivatives), fund sizes, year of establishment, investors’ holdings and other matters.
On June 28, 2013, the SFB issued a ruling that amended the calculation method for financial derivative instrument (FDI) positions. The ruling affects positions held by offshore funds registered in Taiwan for distribution to the public, as well as the review procedure for applications for exemption from the 40% FDI investment limitation (the 40% limitation), as described below.
Under the new calculation method, some offshore funds, which met the 40% limitation under the old calculation method, may now need to apply for an exemption, or may need to deregister their funds.
Pursuant to established SFB rulings, the 40% limitation means that:
the total value of an offshore fund’s non-offset position in FDIs for efficient portfolio management may not exceed 40% of the net asset value of the fund
the total value of the offshore fund’s non-offset position in FDIs for hedging purposes may not exceed the total market value of the relevant securities held by the fund.
An offshore fund must apply for an exemption whenever it exceeds this restriction. If it does not obtain an exemption, the fund will not be able to be registered, or if registered, will no longer be permitted to be offered or sold in Taiwan.
The major amendments in the June 28 ruling took effect when the ruling was issued, but offshore funds already registered with the SFB have a grace period of six months to comply.
Calculation of FDI Positions
The SFB previously adopted the calculation method for FDI positions set forth in the UCITS III directive. However, beginning June 28, 2013, the SFB has instead adopted the commitment approach for calculating derivatives exposure set out in CESR 10-788 issued by the Committee of European Securities Regulators (CESR) on July 28, 2010.
The major differences between the previous and current calculation methodologies are explained below.
Netting and Hedging Principles
Hedging: According to the amended rule, hedging arrangements must comply with the following criteria:
they must offset risks linked to fund assets (physicals or derivatives)
investment strategies that aim to generate a return should not be considered hedging arrangements
there should be a verifiable reduction of risk at the fund level
the risks linked to the FDI may be offset
the FDI and the hedged assets must relate to the same asset class
they must achieve the purpose of hedging even in stressed market conditions.
These criteria are all new, except item (3).
Netting: Under the amended rule, an offshore fund may net the following non-offset positions for efficient portfolio management, provided that the following netting principles are met:
between long and short positions of FDIs, the FDIs must refer to the same underlying asset, although the maturity dates may be different
between FDI and spot positions (the underlying asset of which is a transferable security, a money market instrument or a fund), the underlying assets of the FDI and the spot positions must be the same type of asset
a fund that invests primarily in interest rate derivatives may make use of duration-netting rules to offset their positions, provided that the interest rate derivatives are not for hedging purposes.
The amendment adds the duration netting and the netting between FDI and spot positions in items (2) and (3). The closely connected price change between different underlying assets is no longer a criterion for netting positions.
Formulas for Calculating Relevant FDIs
To illustrate the method of calculating FDI positions, the previous SFB ruling set out the calculation formula for standard FDIs. However, after the amendment, in addition to the formula for standard FDIs, formulas for calculating embedded FDIs and nonstandard (exotic) FDIs have been added. In particular, convertible bonds are now included in embedded FDIs. The Funds whose investment targets contain convertible bonds may be aware that, under such circumstances, their investments in FDIs may much more easily exceed the 40% limitation.
The Valuation of Standard FDI Positions
According to the calculation formula for the FDIs described in the amendment, FDI positions, in principle, are valued based on the market value of the equivalent positions in the underlying assets. However, these FDIs may instead be valued based on the notional value or the contract price if that method is more conservative. This position differs from the previous rule, under which standard FDIs were valued based only on market value.
Because of the grace period noted above, existing offshore funds may use their current calculation method until December 27, 2013. Applications for exemption from the 40% limitation should be submitted to the SFB through the fund’s master agent before this date. Offshore funds which apply for exemption may continue to follow their current calculation method until the SFB acts on their applications. For full details of the new calculation method, please refer to June 28 ruling.
Two-tiered Review Process
According to the June 28 ruling, an application for exemption from the 40% limitation must now be reviewed first by the Securities Investment Trust & Consulting Association (SITCA) and then by the SFB, not just by the SFB.
A SITCA officer will review the documentation and relevant data, and a task force committee composed of professionals and scholars in the industry organized by SITCA will review the risk management mechanism of the offshore fund. In principle, the committee will hold regular monthly meetings to discuss exemption applications. After SITCA completes its review, it will then transfer the application and its recommendation to the SFB for final review.