Taiwan's Financial Supervisory Commission is drafting a proposal to address the prevalence of structured products in the hope of staving off another run on the mutual funds industry.

Kong Jaw-sheng, chairman of the FSC, says, "We'll have a plan out within a month."

Last year domestic investors dumped NT$300 ($8.8 billion) worth of bond funds in five days. The liquidity crunch was caused by market inefficiencies that built up over several years of falling interest rates, but were shattered when interest rate trends reversed in 2004.

Because illiquid assets are valued at the original purchase price (there is virtually no secondary market for corporate bonds), fund managers relied on ramping up NAVs, a practice that requires both constantly accumulating assets and never marking to market. The reversal in interest rates left bond funds unable to offset loss-making positions, as funds cannot play in derivatives. When bond houses were forced to reduce NAV, it sparked the run and led a number of firms to be closed or acquired.

Many bond funds also have indulged in structured bonds in order to boost yields in a low-interest rate environment. In 2002, when Taiwan's interest rates dropped faster than America's, investment banks issued a raft of Libor-based inverse floaters (bonds with floating-rate coupons inversely related to interest rate movements).

In 2003, structured bonds accounted for 52% of all issuance by corporations and banks, to the tune of NT$449 billion ($13 billion). The first half of 2004 saw a similar bonanza, with another NT$149 billion ($4.4 billion) issued in the first half, just before the market collapsed.

These structures remain in the bond funds. The more interest rates rise, the more damage to their returns to investors. Although most products have a five-year life it is already likely that investors are going to lose money on these, and the regulators are concerned that once this realization seeps in, the mutual funds industry could suffer yet another crash.

This would be a huge embarrassment for the FSC, which has otherwise been working hard to liberalize financial services in order to transform Taiwan into an international centre for asset management.

Kong, who made his comments yesterday (Tuesday) at a conference in Hong Kong sponsored by the US-based Investment Company Institute, indicated no further cleanup was necessary for the bond fund industry, aside from addressing the issue of these structured products.

"We have an action plan," he says. "This year we'll promote a secondary market for bonds."

Next it needs to pay more attention to liquidity issues. Over 70% of bond funds were actually invested in money market instruments for liquidity purposes, he says, and the FSC has already forced these into separate categories.

It also facilitated Fubon Securities Investment Trust's buyout of the troubled players at the centre of the crash. But that is enough, Kong says. The FSC has discussed the issue of liquidity with Chunghwa Post and the Central Bank of China, and has determined that it is comfortable with the present amount of liquidity in the system.

"Other fallback measures are not as yet required," Kong says.

Foreign fund management executives have criticized the FSC for not addressing the underlying structural issues that led to the bond fund fiasco. But one such exec now says the perception gap between the industry and the FSC has narrowed. Still, the message from the FSC continues to be one of "trust me" rather than actively engaging the industry on this issue, he adds.

Kong says the FSC was established out of several previous regulatory bodies because the government had matured away from using financial services merely as a policy tool, and wanted a strong financial industry for its own sake. The next step is to create a unified financial regulatory body, similar to Britain's Financial Services Agency, albeit one grafted onto a financial industry model inherited from Japan.

Within two years, the FSC will draft a proposal for a "Single Financial Services Act" that the Premier's office can introduce to the Legislative Yuan, he says.