Tarfs: the derivatives 'from hell' that keep burning banks and their clients
When UBS clients lost millions of dollars in April following sudden swings in foreign exchange markets, the culprit was a risky type of derivative with a familiar-sounding name: the Tarf.
Finance is fond of using acronyms to popularise complex, and often risky, products. Tarfs represent the worst of both those worlds, notorious for repeatedly inflicting eye-watering losses on people that buy them – and getting the banks that sell them into hot water.
As UBS engages in compensation talks with its Swiss wealth clients, some of whom argue they were sold products they didn’t understand, lawyers and consultants are asking how long banks will keep peddling these high-risk derivatives to unsuspecting clients.
“Given their history, you’d think there’d be a reluctance from banks to sell these products and a reluctance from their customers to buy them. But, for whatever reason, they always seem to quietly come back,” said Jonathan Cary, partner at law firm RPC.
“Unfortunately, both the banks and their customers haven’t necessarily learned the lessons of the past.”
Buyer beware
Tarf stands for target redemption forward, a type of derivative contract that redeems automatically, usually once a client's agreed profit target is met. Banks typically pitch them to corporates looking to protect themselves against adverse currency moves.
Their appeal is simple: Tarfs offer users a cheaper way to hedge FX risk than more standard financial products. Unlike other strategies, Tarfs also require no upfront payment – another bonus for cash-strapped company treasurers.
The problem is that while Tarfs' redemption feature caps the profits a client can make if the currency moves in their favour, there is no mechanism to protect them from sustaining potentially unlimited losses if the currency moves against them.
Let's hedge
Critics argue this asymmetry of risk makes Tarfs more speculative investments than legitimate hedges – and ones that are only suitable for highly sophisticated investors.
“To me, these products are not hedging products because if the market moves a certain way you could end up worse off than you were had you not bought the product,” said Jackie Bowie, head of EMEA at hedging advisory firm Chatham Financial. “No client would use these products for hedging on our watch.”
Bowie has been involved in helping clients to unwind Tarfs once they realise “they don’t work as a hedge” and have “potential downside risk attached to them".
Significant damage
The damage Tarfs inflict can be substantial. An International Monetary Fund report estimated 50,000 emerging market companies suffered losses from Tarfs and related products when currency markets swooned during the 2008 financial crisis.
The IMF estimated losses ran to more than US$40bn across Brazil, Mexico, Poland and Indonesia, while China’s state-owned conglomerate Citic Pacific alone took a US$2.4bn hit. Little wonder the head of Poland’s business roundtable subsequently dubbed Tarfs a “product from hell".
More recently, Bloomberg reported in June that the Reserve Bank of India was reviewing Standard Chartered's derivative products and risk governance processes following the sale of Tarfs to small and medium-sized Indian enterprises.
“We’d like to state that there are no lapses highlighted by the RBI in the bank’s derivatives sale processes and risk controls in India," a spokesperson for Standard Chartered said. "The bank offers structured products to only eligible client segments and follows appropriate risk disclosures norms in line with regulation. The bank maintains the highest level of compliance, transparency and customer centricity, which are the cornerstones of the bank.”
In February, Spain’s financial watchdog fined Deutsche Bank €10m for failing to properly inform clients about the risks associated with Tarfs between 2018 and 2021, exposing clients to heavy losses as a result. Reuters reported that several hundred UBS clients were affected by the April Tarf losses, with some taking significant hits to their investments.
Spokespeople for UBS and Deutsche declined to comment for this story. A source close to UBS said the size of the losses were far smaller than Reuters reported.
Money talks
The sheer amount of money banks can make from selling Tarfs instead of simpler FX products may explain why they keep this business up despite its chequered history. The more complex a financial product, the heftier the premium a bank can generally charge.
“There’s definitely a tendency among banks to shove Tarfs into attractive brochures and mass market them to all their wealthy clients to generate more volumes and more returns for themselves, at the potential detriment of their customers. That’s where nuanced and detailed assessment of a customer’s potential suitability get lost,” said Abhishek Sachdev, founder of consultancy firm Vedanta Hedging.
Tarfs, along with their acronymic cousins Tarns and Kikos (target accrual redemption notes and knock-in, knockout forwards) tend to follow the same playbook. A bank and its client agree to make payments to each other that will fluctuate in line with a currency pair’s exchange rate until the instruments mature or knock out.
This design makes Tarfs benign as long as FX markets are stable. Problems start to emerge during volatile periods, as seen in April following US president Donald Trump’s sweeping tariff announcements. If the FX rate moves against the Tarf holder, their payments to their bank counterparty will increase. Making matters worse, clients have to keep up those higher payments until the Tarf matures. Unless it knocks out, the typical Tarf tenor is 12 to 18 months, said Sachdev.
While there are variations between how banks market Tarfs, the prevailing view among critics is that many still gloss over these risks to a certain extent – opening themselves up to potential misselling claims further down the line. Sachdev said he has seen banks “bury” the risk clients face in small print spread across 20 to 30 pages of disclosures.
“That’s ultimately not a good enough way to explain risks to clients,” he said.
Cleaning up
Despite these criticisms, banks say they have cleaned up their act on Tarfs in the aftermath of past controversies. Sources close to Deutsche Bank, for instance, said the bank has significantly tightened up internal processes and controls so that only "professional" clients can buy Tarfs, while also implementing rigorous pre-trade assessments to ensure client suitability.
Bank traders also note that Tarfs remain a popular product among more sophisticated investors, suggesting the stories of misselling are the exception rather than the rule.
"[Clients] are aware of the risks and they're very happy with the returns generated, typically," said one industry insider. "There have been very few exceptions, otherwise these products continue to be widely used. A lot of [clients] have made quite a lot of money with these products this year, [especially] over the past few months.”
Still, critics say banks could do more to ensure history doesn't repeat itself. Providing a concrete figure of exactly how much money clients could lose is one potential measure critics have proposed. This could be part of a broader overhaul of the internal metrics banks use to assess a client’s suitability for Tarfs.
Specific red flags to look out for include the profitability of a client’s business being directly correlated to the successful performance of their Tarfs and a client not having deep enough pockets to pay for hefty potential losses, said a former senior bank trader with experience selling Tarfs.
“My suspicion is that most banks already have policies like these in place to a certain extent," he said. "The issue is that if things haven’t gone wrong for a long time and market volatility remains low, then it’s more likely that ambitious salespeople start getting clients into situations where the risk of these products is too big relative to their ability to cope if something went wrong – which is when clients sue you."