After a tough few years during and after the financial crisis, the structured products market has pulled itself back together and is in reasonably good shape. However, dealers say new capital rules from the FSB could kill off the business altogether, just as it has begun a shift towards more automation and greater execution efficiency.  

After a few years on the ropes in the aftermath of the financial crisis, the structured products market is, by common consent, in pretty good health. Increased product standardisation has led to an uptick in volumes, and investors are becoming more mobile, looking beyond domestic markets for returns. 

Banks have also made their peace with the treatment of asset-backed securities (ABSs) in the Basel III liquidity coverage ratio (LCR). The LCR requires banks to hold a buffer of high-quality assets that will help it survive a 30-day period of intense market stress, and after initially rejecting a role for ABS within the measure, Basel regulators now allow banks to allocate up to 15% of the buffer toward these instruments. Structured product dealers still see the ratio as flawed, but not in any irredeemable or fatal way for their market.

The TLAC threat

The same cannot be said for the total loss absorbency capacity (TLAC) proposals now under discussion at the Financial Stability Board (FSB). As things stand, these will ensure that global systemically important banks will hold a minimum amount of loss-absorbing capacity equal to 16% to 20% of risk-weighted assets (RWAs), far larger than the 8% capital requirement specified by Basel III. This belt-and-braces approach will further reduce the level of risk that large banks can take on, and is likely to force dealers even further away from traditional market-making activity across a number of different business lines. As a result, it has provoked a storm of protest across the industry. 

In structured products, the specific problem posed by TLAC is its rejection of structured notes as valid instruments for loss absorption. A number of banks, particular those in continental Europe, use structured notes as wholesale funding and are willing to pay a decent spread to investors because of the importance of such notes to their balance sheets. If they cannot be counted in a bank’s TLAC ratio, the incentive to issue them will drop, and pricing is likely to deteriorate accordingly. Rather than being offered up at Libor plus an additional basis point spread, the pricing could fall to Libor flat, or even Libor minus a basis point spread. 

“At the moment, the TLAC proposals are the biggest consideration for the structured product market,” says Rui Fernandes, international head of equity derivatives structuring at JPMorgan in London. “If banks are discouraged from issuing structured notes for funding purposes, they may have no choice but to either take that issuance off the table or reduce the return offered to investors. Why would an investor still buy those notes when they can get better yields from exchange-traded funds or other products?” 

Other dealers echo Mr Fernandes’ warning. “Concerns over the LCR or other bits of regulation pale in comparison to the danger posed by the TLAC proposals,” says one UK-based structurer. “They could mean the literal death of the structured products market.” 

Dealers admit they are in the lap of the gods, or more specifically the FSB decision-making process, with regard to TLAC. The FSB released a consultative paper on the subject in November 2014, and any final recommendation will not appear until at least the end of this year. If the TLAC process echoes the generous lead times given to banks implementing the less onerous Basel III capital rules, a final implementation date could be many years further beyond that.

MiFID II moves 

In the meantime, other regulatory initiatives are changing the market in more subtle ways. The second Markets in Financial Instruments Directive (MiFID II) is not due for full implementation until January 2017, but market participants are making a start on aspects of the directive that can be put into place now. MiFID II affects structured products in a number of ways. First, it defines them as ‘complex products’, meaning that any dealer must engage with clients on an advisory basis, rather than just offering an execution-only service. Banks must set up internal structures that guarantee and can prove that the issuance of a product corresponds to the specific needs of the target audience. The UK already has an equivalent system in place, and has run into problems during industry stress tests. 

MiFID II also spreads the pre- and post-trade transparency requirements contained within its first iteration from equity trading to all asset classes. These requirements apply only to assets that have been deemed as ‘liquid’, which is proving a tricky concept to capture. The European Securities and Markets Authority (ESMA) has categorised structured finance products – ABSs, essentially – as generally illiquid, but lumped the remainder of the structured products universe into a ‘packaged trade’ definition. This means that the trading of any fixed-income, commodity or equity instruments contained within a structured product and deemed liquid at the point of execution must be swiftly reported by the dealer. Banks say this means they will be forced to reveal their exposures before they have time to hedge them, as finding an opposing position to elements of a complex structured product can take time. 

The International Swaps and Derivatives Association is pushing for a change to this approach that would remove the need to report any liquid component of a structured product if it was accompanied by other illiquid components in the same deal. In the US, regulators have solved the problem by issuing a set of no-action relief letters suspending the implementation of transparency ruled to packaged trades. 

Dealers also complain that the criteria set out by ESMA by which instruments are deemed liquid are flawed. Based on the size of the original issuance, in fixed income these range from €2bn for sovereign bonds to €500m for senior financial and subordinated bonds. Opponents say this is too blunt a tool, and will result in many illiquid instruments being defined as liquid.

Liquidity problems 

Liquidity in the bond market is swiftly becoming a major problem for dealers and investors alike. Due to heightened capital requirements, banks have been shrinking their balance sheets for a number of years and are pulling back from market-making and warehousing risk in fixed income. According to data from the Federal Reserve Bank of New York, corporate bond positions among major-market makers have declined by 40% since April 2013. This has left the fixed-income markets vulnerable to sudden price shifts, often produced by the trading of relatively small, notional amounts.

This phenomenon has even afflicted the multi-trillion-dollar secondary market for US treasuries, where liquidity was once thought to be impregnable. In mid-October, US government bonds experienced their biggest bout of volatility for more than a quarter of a century, caused by no discernible market information. 

This is a huge concern for all fixed-income dealers, and for structured products issuers who source their underlyings from this asset class. 

“This is big topic of conversation right now among sell-side and buy-side participants. Regulators are also starting to address the issue,” says Francois Banneville, global head of execution services at Société Générale. 

One slightly counter-intuitive solution to this liquidity problem might be fewer bond issuances. “If you look at European equity markets, about 1500 to 2000 stocks are traded on a regular basis. Compare that with European bonds, where there are upwards of 100,000 instruments in circulation. Every time a corporate issues debt, another one gets added to the list. The fixed-income market is too fragmented to deal with the recent loss of market-making capacity,” says Mr Banneville. “We have to find a way to rationalise this. For instance, there have been studies on the possibility of reopening existing bonds for additional subscription, rather than establishing an entirely new instrument every time a firm needs funding. The same notional amount would be issued, but in fewer distinct chunks.”

Another option is the growth of exchange or matching platforms for bonds, so that investors can trade or swap bonds directly with one another without recourse to market-makers. Fixed income has been one of the most resistant asset classes to non-voice trading, but further automation looks more and more irresistible. Banks used to be opposed to bond exchange platforms because it would negate their role as market makers, but this activity is a smaller source of revenue now. 

The automation game 

Automation is on the march in structured products, too. Increased capital requirements have reduced banks’ abilities to offer long-term, bespoke, complex products in large numbers and as a result they have gravitated to more shorter, simpler and more standardised structures. 

“Cost pressures have been a driving factor towards automation, but there is also a push from the clients themselves. More and more investors are interested in shorter term, vanilla products with a typical maturity of between one to three years that are easily understood and managed. You need a highly automated trading and client facing set-up if you want to compete in this business,” says Renaud Meary, global head of structured equity at BNP Paribas in Paris. 

Though structured products is hardly at the hyper-quick trading level of spot foreign exchange or equities, trade turnaround times have been cut significantly. “There is a huge demand for traditional payout products that are easily commoditised – autocalls, index-based products. For these products we are going farther and farther down the automation route, with online price discovery, automated pricings and execution,” says Yann Garnier, head of global market sales for Asia Pacific at Société Générale. 

Mr Garnier points to just one specific product as an example of this change. “Hybrid range accruals have become popular across Asia; we used to trade roughly one or two of these per month back in 2012, [but we] have scaled up and industrialised our processes. Now, we often trade 30 to 50 per week across all asset classes, with the help of automated pricing and execution mechanisms. It ranges from hybrid options for fast-money clients, hybrid payoffs for third-party distribution in Taiwan or Japan, to long-term notes for institutional investors across the region,” he says.

This push toward automation has hollowed out the medium-complexity products that used to dominate the market, and left its shape looking rather like a weight-lifter’s dumbbell – lots of automated activity at one end of the complexity scale, not much in the middle, and plenty of bespoke instruments at the other end. Some clients, particularly those with long-term liabilities such as participants in the insurance sector, still need highly customised products.  

Research beefed up 

Investors are also willing to pay up for the research that banks can offer in addition to execution. MiFID II does not allow banks to subsidise their research service with execution fees. Clients must pay separately for each, and on the research side this is likely to involve a one-off payment unrelated to the frequency of trades executed with the bank in question, or their notional size. Banks now have an incentive to beef up their research capabilities to bring in more revenue. 

“We are currently running six large research studies for different clients on execution matters and the best solution for them. We still have our menu of off-the-shelf products, but there is far more focus on working with clients to find the right strategy for them, and constructing complex, one-off deals if necessary,” says Mr Banneville. “It’s a more time-consuming process, and involves the work of a lot of very clever people, but it’s a more rewarding process and results in a better relationship with our clients. When I go to clients, I don’t just give them our product menu and ask them to pick one they like. I ask them what their needs are and work from there.” 

It is against this backdrop that many banks have pushed forward a cross-asset approach to structured product execution. Asset class-specific teams are still in operation, but product construction and distribution is increasingly taking place under one roof and under one management structure. Large macro funds increasingly expect dealers to be agnostic, able to navigate across a multitude of asset classes and arrive at the right solution for them. Many are organised on a completely cross-asset basis, and expect that to be reflected at the bank they execute with. Some clients are happy to keep alive the old specialisms in fixed income, equities or commodities, but many investors are being pushed out of their comfort zone by market realities. 

“At a time of exceptionally low rates, traditional fixed-income investors are struggling to find enough yield to match their liabilities,” says Mr Meary at BNP Paribas. “They are increasingly open to an agnostic view of asset-class allocation. Cross-asset services at banks help them find the right trades in equities, foreign exchange or commodities, as well as their usual fixed-income patch.”


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