Hurdles for the next big idea in retail

The latest idea to capture the imagination of bankers is to market higher-yielding products based on structured credit, such as collateralised debt obligations (CDOs) based on a portfolio of loans, to this new client base. Banks have been successfully marketing such products to hedge funds, real money investors and to high net worth individuals, and they regard the retail sector as the next logical step. Already a few products have debuted with some success in northern Europe and bankers are now hoping to transport that achievement elsewhere.

The excitement about the retail market’s potential to lap up structured credit products is growing and banks hope that there will be an appetite for these complex products in Europe and elsewhere this year. But banks face significant hurdles before they introduce these products. First, the knowledge base at the distribution level is limited; at end-user, retail level it is non-existent in most countries. Second, and worse, regulations are strict and differ widely from country to country.

Education and reputation

One of the biggest problems that bankers face is that, although they are not ultimately responsible for delivering the products to the end-buyers, they still face significant risk to their reputation if the products are mis-sold. According to Alberto Garcia Elias, head of credit and rates third party distribution in EMEA at JPMorgan in London, education is therefore the biggest challenge that all bankers face – and something that his bank takes seriously.

“Although we will not be marketing the products to the end customers directly, our reputation is [still] at risk and we need to ensure that the intermediary is properly educated about the products he is selling,” he says. “Not only that, but we also want to know that he is properly informing customers about the products and not engaging in mis-selling.”

Hubert Le-Liepvre, deputy head of structured credit at SG CIB in London, agrees. “The education process necessary prior to marketing these products to retail is quite complex because you have to find a balance between generating interest and compliance constraints. What is more, there can be a real reluctance among distributors to market these products until they have seen some evidence of success.”

Hubert Le-Liepvre: education is complex

Cedric Jeanson, head of credit derivatives marketing at BNP Paribas (BNPP), says that perfecting the documentation will also slow down market development. “We will need to ensure that the documentation is legally sound, as well as being clear and transparent, and that the products are supported by liquid secondary markets – so the process [of establishing a retail market] will not be fast,” he says.

Regulatory environments

In Europe, regulatory differences between member states means that a product that can be sold in one nation state will often be prohibited in another. Although this does not apply only to credit-based retail products, the novelty of the structures means that fewer national regulators are likely to approve them, so the idea of developing an umbrella product that would appeal to all retail investors in the so-called single market is, at least for the moment, dead in the water.

Even though this will have a negative impact on profitability, bankers remain excited about the prospect. One reason is the imminent arrival of the EU Prospectus Directive rules, which are due to come into force this year. The Single Passport rule, which is due to come into force on July 1, forms a key part of the new directive. It is designed to relax the rules governing pan-European distribution of retail products, by allowing dealers to register products in just one nation state, with automatic access to the rest of the union. Mr Jeanson says that, once it is in place, it will transform the market, making the support processes much more cost efficient and the whole business much more profitable for banks.

Although there is still a healthy dose of scepticism about how this will work in reality, most bankers are optimistic about the potential for the retail market. Mr Garcia Elias says: “We feel that there will be significant growth in retail distribution of structured credit products during 2005, even if the directive has no impact. Investors are crying out for non-equity products with absolute returns and structured credit can fill part of that gap.”

However, even if the new directive works as well in practice as it does in theory, other national distinctions will still mean that products will need to be adapted from country to country, says Mr Garcia Elias. “Fiscal differences, for example, will mean that a product will become more or less appealing to investors in different nation states, and banks will still need to accommodate different tastes – for instance, Germans tend to prefer certificates, the French funds, the Dutch notes, and so on,” he says. And distributors like to have distinctive products, which means that these products have to be adapted and re-adapted accordingly.

Preparations

Banks at the forefront of the structured products market, such as Deutsche Bank, JPMorgan, BNPP and SG, are preparing themselves ahead of the directive’s implementation.

JPMorgan set up a dedicated group to address the wider structured product market, embracing all asset classes. “What we decided to do was to pull all our product infrastructure together – credit, rates and equity, to offer a full, cross-asset class platform to this sector of the market,” says Mr Garcia Elias. “Until now, retail demand has centred on equity-based products, rather than other types, but we expect that to change and, by combining the infrastructure, we will be better able to serve that demand.”

Mr Le-Liepvre says he believes that SG’s well-developed and established retail franchise and infrastructure from its equity derivatives business will stand the bank in good stead to pursue the new opportunities.

BNPP has established a dedicated platform for marketing retail products, which facilitates delivery over several different channels and, again, crosses asset classes. “Selling credit products to retail investors through private banks and retail distributors is a relatively new development,” says Mr Jeanson. “It will be much more efficient for those banks that can leverage on existing FX, rates, commodities, equity or hybrid products and networks, and that can run cross-asset platforms to manage the secondary market business.”

Popularity competition

The race to develop popular products is already under way – and with good reason. Bankers expect to see decent amounts of these products being sold to retail clients as early as the middle of this year, but they say that only a few individual structures will take off. The key to gaining a lead in the market, therefore, will be not only establishing or exploiting existing infrastructures, educating potential partners and end clients, but also developing the most appealing products.

The Dutch and Scandinavian markets are already reasonably well developed owing to the relatively open attitude of local regulators. However, bankers say they will continue to target both jurisdictions, along with Germany, Switzerland and the Benelux countries, where they are more likely to be approved. Countries such as Spain and Italy, where credit derivative-based products are still forbidden for retail, remain firmly on the back burner.

Another area ripe for targeting, say bankers, is Asia-Pacific, where investors have shown more appetite for speculative investments and regulators have proved more relaxed than in Europe. The products there also offer a clue about what may be in store for Europe, as bankers are tightlipped when asked about what products they are designing for the retail market. ABN AMRO and Deutsche Bank have both launched structured credit products – CDOs – listed on the Australian Stock Exchange. Deutsche Bank Australia’s Nexus Bonds, launched in late 2002, are portfolio-linked floating-rate notes, pegged to the credit rating of a portfolio of loans made by Deutsche Bank to 70 companies. ABN AMRO’s so-called HY-FIs are linked to the credit performance of an international portfolio of 70 companies. Each CDO has an overall credit rating, which enables investors to assess the risk against the return offered. Since the two European banks launched their offerings, a handful of local banks have listed similar products in Australia.

The risks

Although the bankers polled were adamant that they could prevent mis-selling at the distributor level by carefully selecting their partners, some worry that less scrupulous structurers could damage this emerging market by being careless. “We prefer to err on the side of caution, even if it means we lose out on some business,” says Mr Garcia Elias. “We aim to be here for the long run and want a sustainable business, but because of the amount of excitement surrounding this growth area there is a risk that some will become sloppy with this.”

The greatest risk of all is that the market fails to deliver as expected. SG, which has an unparalleled retail capability in structured equity products as well as a noted structured credit franchise at the institutional level, is unexpectedly downbeat about the market’s prospects. If Mr Le-Liepvre is proved right, the whole exercise could prove little more than an expensive mistake for many. “Even though the retail market is growing, it is still very small compared with the institutional investor market – and I very much doubt it will begin to compare with it in terms of size in the next one or two years,” he says. “The market is interesting and developing but is it the new El Dorado? That remains to be seen.”