Structured product

In structured finance, a structured product, also known as a market-linked investment, is a pre-packaged investment strategy based on a single security, a basket of securities, options, indices, commodities, debt issuance or foreign currencies, and to a lesser extent, derivatives. The variety of products just described is demonstrative of the fact that there is no single, uniform definition of a structured product. A feature of some structured products is a "principal guarantee" function, which offers protection of principal if held to maturity. For example, an investor invests $100, the issuer simply invests in a risk-free bond that has sufficient interest to grow to $100 after the five-year period. This bond might cost $80 today and after five years it will grow to $100. With the leftover funds the issuer purchases the options and swaps needed to perform whatever the investment strategy calls for. Theoretically an investor can just do this themselves, but the cost and transaction volume requirements of many options and swaps are beyond many individual investors.[1]

As such, structured products were created to meet specific needs that cannot be met from the standardized financial instruments available in the markets. Structured products can be used as an alternative to a direct investment, as part of the asset allocation process to reduce risk exposure of a portfolio, or to utilize the current market trend. So structured products are not derivatives.

U.S. Securities and Exchange Commission (SEC) Rule 434 (regarding certain prospectus deliveries) defines structured securities as "securities whose cash flow characteristics depend upon one or more indices or that have embedded forwards or options or securities where an investor's investment return and the issuer's payment obligations are contingent on, or highly sensitive to, changes in the value of underlying assets, indices, interest rates or cash flows".[2]

The Pacific Stock Exchange defines structured products as "products that are derived from and/or based on a single security or securities, a basket of stocks, an index, a commodity, debt issuance and/or a foreign currency, among other things" and include "index and equity linked notes, term notes and units generally consisting of a contract to purchase equity and/or debt securities at a specific time".

Structured product business, as a key part of customer-driven derivatives business, has changed dramatically in recent years. Its modern setup[3] requires comprehensive understanding of:

  • Prevailing regulatory environment, the impact of existing and forthcoming regulations including MIFID II, KYC, PRIIPs - KIDs, etc.;
  • Principles of risk-based capital/liquidity requirements specified by Basel 3, FRTB, etc.;
  • Structured product manufacture process, effective derivatives business value chain linking trading, structuring, quantitative modelling and risk management;
  • Structured product distribution channels, product wrappers, impact of e-platforms;
  • Structured product payoff features and their risk characteristics;
  • Real-life quantitative pricing models able to handle multi-curve environments, volatility smile/skew, etc.

Risks

The risks associated with many structured products, especially those that present risks of loss of principal due to market movements, are similar to risks involved with options.[4] The serious risks in options trading are well-established and customers must be explicitly approved for options trading. The U.S. Financial Industry Regulatory Authority (FINRA) suggests that firms "consider" whether purchasers of some or all structured products should be required to go through a similar approval process, so that only accounts approved for options trading would also be approved for some or all structured products.

"Principal-protected" products are not always insured by the Federal Deposit Insurance Corporation in the United States; they may only be insured by the issuer, and thus could potentially lose the principal if there is a liquidity crisis or bankruptcy. Some firms attempted to create a new market for structured products that are no longer trading; some have traded in secondary markets for as low as pennies on the dollar.[5]

The regulatory framework for structured products is hazy and they may fall in legal grey areas. In India, equity-related structured products may violate the Securities Contract Regulation Act, which prohibits issuing and trading equity derivatives that do not trade on a nationally recognized exchange.

Origin

Structured investments arose from the needs of companies that wanted to issue debt more cheaply. This could have been done by issuing a convertible bond—i.e., debt that could be converted to equity under certain circumstances. In exchange for the potential for a higher return (if the equity value would increase and the bond could be converted at a profit), investors would accept lower interest rates in the meantime. However, the worth of this tradeoff is debatable, as the movement of the company's equity value could be unpredictable.

Investment banks then decided to add features to the basic convertible bond, such as increased income in exchange for limits on the convertibility of the stock, or principal protection. These extra features were all strategies investors could perform themselves using options and other derivatives, except that they were prepackaged as one product. The goal was again to give investors more reasons to accept a lower interest rate on debt in exchange for certain features. On the other hand, the goal for investment banks was to increase profit margins since the newer products with added features were harder to value, and thus harder to gauge bank profits.

Interest in these investments has been growing in recent years, and high-net-worth investors now use structured products as way of portfolio diversification. Nowadays the product range is very wide, and reverse convertible securities represent the other end of the product spectrum (yield enhancement products). Structured products are also available at the mass retail level—particularly in Europe, where national post offices, and even supermarkets, sell investments on these to their customers.

Product Design and Manufacture

Structured products aspire to provide investors with highly targeted investments tied to their specific risk profiles, return requirements and market expectations.

Historically, this aspiration is met with an ad hoc approach: the structure of the product is postulated in a way that seems appropriate for the client. Within this approach it can be difficult to articulate the precise problem the product is designed to solve, let alone to claim the product as optimal for the client. Nevertheless, this approach is still widely used in practice.

A more advanced mathematical approach to product design has been proposed.[6] It allows the structure of financial products to be derived as a mathematically optimal solution to the clients' needs. This approach demands higher proficiency from both the structurer who designs the product and the client who needs to understand the proposal.

Once the product is designed, it is manufactured through the process of financial engineering. This involves replicating the product through a trading strategy involving underlyings like bonds, shares, indices, commodities as well as simple derivatives like vanilla options, swaps and forwards.

Pros and cons

The market for derivatives has grown quickly in recent years because they perform an economic function by enabling the risk averse to transfer risk to those who are willing to bear it for a fee.

Pros

Benefits of structured products may include:

  • Principal protection (depending on the type of structured product)
  • Tax-efficient access to fully taxable investments
  • Enhanced returns within an investment (depending on the type of structured product)
  • Reduced volatility (or risk) within an investment (depending on the type of structured product)
  • Ability to earn a positive return in low-yield or flat equity market environments

Cons

Disadvantages of structured products may include:[7]

  • Credit risk – structured products are unsecured debt from investment banks
  • Lack of liquidity – structured products rarely trade after issuance and anyone looking to sell a structured product before maturity will have to sell it at a significant discount
  • No daily pricing – structured products are priced on a matrix, not net asset value. Matrix pricing is essentially a best-guess approach
  • Highly complex – the complexity of the return calculations means that it is difficult to determine how the structured product would perform versus simply owning the underlying asset
  • Intuition-based methods of product design often produce trades that are mathematically equivalent to gambling.[8] (the Quantitative Structuring approach[6] can be used to eliminate this problem)
  • Lack of clarity on what exact problem the product is actually solving (does not apply to products built through the Quantitative Structuring approach[6]).

Types

Structured products are not homogeneous—there are numerous varieties of derivatives and underlying assets—but they can be classified under the following categories:

See also

References

  1. ↑ Mehraj Mattoo (1996). Structured Derivatives: A Handbook of Structuring, Pricing & Investor Applications. London: FT Press. ISBN 978-0273611202.
  2. ↑ "Regulation C – Registration", U.S. Securities and Exchange Commission
  3. ↑ Qu, Dong (2016). Manufacturing and Managing Customer-Driven Derivatives. Wiley. ISBN 978-1-118-63262-8.
  4. ↑ Nathaniel Popper (April 18, 2013). "Wall St. Redux: Arcane Names Hiding Big Risk". New York Times. Retrieved April 19, 2013.
  5. ↑ "Another 'Safe' Bet Leaves Many Burned", Wall Street Journal
  6. 1 2 3 Soklakov, Andrei N. "Why Quantitative Structuring?". Introductory Paper. SSRN 2639383.
  7. ↑ "Structured Notes: Buyer Beware!", Investopedia
  8. ↑ Soklakov, Andrei N. (December 2016). "Elasticity Theory of Structuring". Risk: 81–86. SSRN 2262963.
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