Countdown to quantos

Structured deposits in foreign currencies have been hugely popular in China. Range accruals, trigger swaps, cancellable swaps and currency baskets have dominated sales in retail and wealth management. Their popularity is due to their attractive returns over bank deposits, with retail products combining capital protection and yield enhancement.

Typically, the products are simple US dollar deposits with enhanced deposit rates if a certain exchange rate, such as dollar/euro, stays within a certain band. Another popular product is a structured deposit that pays out if the US dollar Libor stays within a specified band.

Structured deposits generally pay 4-5% per annum, a significant pick-up from onshore deposits on which rates are fixed by the People's Bank of China (PBOC).

One-year renminbi deposits currently pay 2.25%, following a 27 basis points (bps) increase by the PBOC in October 2004, the first rate rise in nine years. The one-year US dollar and Hong Kong dollar deposit rates currently stand at 1.625% and 1.5% respectively.

In the retail market, HSBC recently launched a callable range accrual product linked to the three-month US dollar Libor. The one-year product offers 100% capital protection, and pays up to 4.4% per annum in the form of quarterly coupons that are paid on an accrued basis based on the number of days the US dollar Libor stays within a predefined range in each quarter. HSBC has the right to terminate the product at the end of each quarter. The quarterly ranges are set at 0–4.05% for the first quarter, 0–4.25% for the second quarter, 0–4.45% for the third quarter, and 0–4.60% for the fourth.

Calvin Tso, associate director of wealth management sales, global markets at HSBC, says the product aims to meet the needs of investors who believe the US dollar Libor would go up at a steady pace. "At present, the major theme for the China market is still capital protection and yield enhancement, with interest rate and exchange rate-linked products being most popular. We also incline to keep products simple and direct so as to ensure investors understand what they are investing in."

HSBC has been offering structured products to retail investors in China through its branch network since 2004, and it also provides hedging solutions to meet the specific requirements of financial institutions such as banks and insurance companies. The bank has 10 branches, three sub-branches and two representative offices in China.

While capital protection remains a dominant theme for retail products, the institutional market in China has become familiar with a wide range of sophisticated products. Paulus Mok, head of derivatives sales & structuring at Citigroup China, says: "Demand for principal-protected products has been quite common over the years, and recently we have also seen interest in non-principal-protected products, such as credit-linked and bond-linked, from banking and institutional clients."

Meanwhile, Société Générale launched a "Constant Maturity Swap (CMS) Spread Target Redemption with Bonus" product early this year, sold through private placement in China. The 100% capital-guaranteed 10-year note in US dollars pays a guaranteed coupon of 9% in the first year, and additional annual coupons based on the formula 6 * (USD CMS 30 years minus USD CMS 10 years).

Francis Repka, deputy chief executive at Société Générale Asia, says: "It's a product that is targeted at investors and banks with a good knowledge of the financial markets or the fixed-income market. In terms of sophistication of structures in US dollars, the market is as sophisticated in Asia and China as anywhere in the world. Of course, things are totally different in terms of local currency."

Quanto demand beckons

Bankers say the need for RMB-denominated products has increased following the July 21 revaluation, which has exposed Chinese investors to currency risks.

Some bankers point to China Everbright Bank's dual currency deposit as a prototype. The one-year product – launched a day after the July 21 revaluation and linked to the renminbi/US dollar exchange rate – is principal-protected with principal redemption in renminbi at maturity on August 3, 2006 and interest paid in US dollars. While the structure is very simple – the investor takes the currency risk on interest and China Everbright Bank only needs to do a swap in the market – bankers say it is a step toward local currency products.

One Shanghai-based product specialist with a foreign bank says: "We have looked at a number of quanto products, and have been in discussions with the regulators. They have been receptive and are looking at it very carefully. I believe quanto products will fly in China because of the lack of investment tools."

But bankers concede that renminbi structured products would be possible only if currency and interest rate controls are lifted and the renminbi is made fully convertible. Assume for example a bank wants to offer a quanto product linked to the S&P 500. To hedge its risk, the bank needs to dynamically trade the S&P 500 and the renminbi vis-à-vis the US dollar.

Gary Thornburn, head of sales at ANZ in China, believes that quanto products related to renminbi are "still a long way away". He adds: "We can offer solutions across a broad spectrum of currencies except for renminbi, as there is only a limited derivatives market onshore at this stage. We have certainly noticed more interest from the local markets in structured solutions. Especially solutions driven around the interest rate markets – the US in particular – and FX markets."

Two years away

A few fund management firms have launched renminbi-denominated capital-guaranteed funds, although these do not involve derivatives and only make use of basic constant proportion portfolio insurance techniques.

The PBOC recently issued regulations allowing foreign banks in China to offer currency forwards and cross-currency swaps, as well as to trade these instruments in the interbank market. Bankers say the regulations are a significant step towards developing the renminbi structured products market.

Mok at Citigroup says he expects renminbi quanto products to be possible in the next two years. He adds "Convertibility of renminbi versus foreign currencies, flexible interest rate pricing mechanisms and liquidity of the yield curve are, among others, the few major factors for efficient pricing and risk management of renminbi quanto products."

HSBC's Tso adds: "Quanto products require a liquid FX market to manage the underlying position. China's FX (both spot and deliverable forward) market is still highly regulated and does not facilitate the environment for quanto products without the provider taking significant part of the quanto risk. Yuan NDF volume is thin compared to its neighboring markets, such as Taiwan and Korea, and therefore cannot satisfy the demand of a quanto market.

"It is technically possible to provide quanto products in China only when we have a more liquid and open FX market to access. Currently, there are regulatory restrictions that entirely segregate the onshore and offshore market in China. This is not the case in Taiwan and Korea. CDOs are sold in China based in foreign currencies, and we expect there to be demand for renminbi-denominated quanto CDOs, as well as a whole spectrum of FX, interest rate, credit and even equity structures."

Water Cheung, managing director at DBS Bank, Global Financial Markets, Greater China, says: "Currently, due to currency inconvertibility and unavailability of hedging instruments, it is very difficult to structure quanto products in China. As the renminbi derivatives market gradually develops, there will be demand for renminbi-denominated products linked to payouts of foreign currency assets."l