As regulators have scrutinised structured products over the past few years, exchange-traded funds have managed to stay under the radar. However, with the G-20’s Financial Stability Board raising concerns about ETFs, this situation looks set to change.

Retail structured products and exchange-traded funds (ETFs) are under the regulatory spotlight as never before, as initiatives at both domestic and international level seek to ensure that investors understand the products that they are buying. In the structured products space, providers have already been driven by regulation into simpler and more transparent pay-offs. In contrast, regulators lag behind market development on ETFs, and complexity is growing.

In April this year the Financial Stability Board (FSB), which acts under the guidance of the G-20 countries to coordinate action on global financial markets, highlighted the ETF boom as a cause for concern.

“While growth in the ETF markets is at an early stage in a number of countries, the speed and breadth of financial innovation in the ETF market has been remarkable in some large financial systems over the past five years, and has brought new elements of complexity and opacity into this standardised market,” the FSB report said.

The FSB noted the size of the market, the complexity of some products, the interconnectedness of market players, and counterparty risk via derivatives contracts. It also noted that the expectation of on-demand liquidity may create conditions for acute redemption pressure on certain types of ETFs in situations of market stress.

The fact that the latest rogue trader scandal, this time at UBS, featured trading on the ETF desk, will help ensure that the regulatory spotlight remains on this market segment.

Dash for commodities

Commodities have been a popular retail play throughout 2011, and after the drop in equities, inflows have increased into exchange-traded commodities (ETCs). Product innovation includes taking out the risk associated with the highly volatile dollar versus euro exchange rate for European investors, as most commodities price in dollars. Deutsche Bank has had considerable success in the German market with its db Physical Gold Euro Hedged ETC, which it launched in 2010.

Meanwhile, the rapid growth in ETFs is expected to continue, giving both retail and institutional clients quick access to a wide variety of assets, and good secondary market liquidity. ETFs are also being used as building blocks for some structured products, including multi-asset products which rebalance according to market conditions and so need a cheap and liquid way to trade the underlying.

For example, one product on offer in the German retail market invests in higher risk assets such as emerging markets equities and oil but shifts into low-risk bonds during times of market stress. The product is mainly invested in ETFs in order to get these exposures in a liquid form.

The extreme volatility seen during August, just as market participants were hoping that the fragile financial markets recovery was still on course, has led to a temporary slowdown in new product sales.

Many lower barriers were breached in August and September, leading to principal losses for investors. More complex volatility products based on the VIX volatility index of US stocks were affected, after initially making headway during 2011 with more sophisticated institutional investors. These included the iPath exchange-traded note (ETN), launched by Barclays Capital, which was linked to the inverse performance of S&P 500 VIX Futures. A series of ETNs with a 10-year term were launched early in 2011, but hit the automatic termination level in September.

Clearly, the recent unexpected extreme market volatility has presented a challenge to structured product and ETF providers. But the much trumpeted advantage of high liquidity seems to have functioned quite well during the volatile months of 2011, with investors able to trade out of products and sell back to providers. The industry hopes that this stress test will encourage more investors to buy their products as markets recover, and investors consider their asset allocations in the first quarter of 2012.

Learning the lessons

For structured products, regulation has progressed much further. The collapse of Lehman Brothers in September 2008, and the scandal surrounding the way in which retail investors had been sold notes generating high pay-offs partly because Lehman needed access to funding and was willing to pay high interest rates, ensured that regulators had to act.

Since the 2008 financial crisis there has been pressure from local regulators in countries such as Germany, France, the UK and Belgium to ensure that structured products sold to retail investors are appropriate, and are more transparent and liquid

Alain Alev

Three years on, the changes are quite significant. Distributors are aware of being exposed to the credit risk of the product provider, and watch closely to see whether products with generous pay-offs are connected to the high funding costs of riskier institutions.

Individual countries have introduced rules in line with EU legislation on marketing information, including setting out the most important details of a product in only two or three pages.

Pay-offs are much less complex than in the boom years of 2006 and 2007, and with innovation and new gimmicks less of a market driver, banks are instead promoting service. Rapid response to pay-off requests from distributors, after-sales service and secondary market liquidity are critical in today’s market. One result is that product providers are having to spend heavily on infrastructure, including computer systems that can instantly price products upon request, and sophisticated trading systems for the banks to hedge their own exposure.

“Since the 2008 financial crisis there has been pressure from local regulators in countries such as Germany, France, the UK and Belgium to ensure that structured products sold to retail investors are appropriate, and are more transparent and liquid,” says Alain Alev, head of European equity derivatives sales at HSBC in London.

“Regulators want to see less capital at risk sold to retail, and there has been a convergence in the market towards simple pay-offs, for example, calls on baskets of major indices such as the FTSE 100, S&P 500, Eurostoxx and MSCI indices for global stocks, all wrapped into capital-protected structures,” he adds.

New requirements

With less emphasis on innovative pay-offs, retail pricing tends to converge since there are many similar products to choose from. There is also a high level of awareness of counterparty risk, and Mr Alev says provider lists are getting shorter as distributors such as wealth managers and private banks only want to do business with the most creditworthy banks. Counterparty risk rose further up the agenda following the big drop in banks stocks in August and the downgrades and drop in share prices of some French banks in September.

“Third-party distributors typically keep a shortlist of product providers, for diversification purposes and to reflect the fact that different houses have their specialities,” says Wolfgang Gerhardt, head of financial products Germany at Bank Vontobel Europe in Frankfurt.

“These lists used to be more informal, but there are now often formal lists that set out who advisors or asset managers can do business with,” Mr Gerhardt explains. “There is a heightened awareness of counterparty risk, with attention paid to credit ratings and measures such as Tier 1 equity.” Switzerland-based Vontobel Group had a Tier 1 capital ratio of 24.9% as of June 30 this year.

The main focus of regulators so far has been complexity... For example, French regulations require that any retail product has to be described to investors in a limited number of steps

Jean-Eric Pacini

“There is also less appetite for complexity from institutional investors, though we are seeing a growing number of products with volatility control mechanisms, and with a cross-asset view,” says Mr Alev. “Here too, regulation is playing an important role, since there are more volatility and correlation requirements from regulators, especially for insurance companies, which have generated a significant amount of structured products solutions business.”

Institutional cross-over

Bankers note that technology that was once used primarily in the retail space has moved across into the institutional segment, with, for example, German life insurance companies and pension funds looking for tailored solutions to hedge mismatches that exist between their assets and future liabilities.

Jean-Eric Pacini, head of structured equity distribution at BNP Paribas in London, says the evolving regulatory landscape across Europe has had a significant impact on the product mix. Regulators such as the Financial Services and Markets Authority in Belgium, and the Autorité des Marchés Financiers and Autorité de Contrôle Prudentiel in France have all driven the market in terms of product design.

“The main focus of regulators so far has been complexity,” says Mr Pacini. “For example, French regulations require that any retail product has to be described to investors in a limited number of steps.”

Low rates, high volatility

Outside of regulation, the biggest challenge facing all structured product providers is the low-interest environment. With high volatility making options more expensive, it is difficult to structure attractive pay-offs with total capital protection.

But providers such as BNP Paribas are having success in designing products that benefit from the high volatility conditions to generate high coupons (as high as 7%) and featuring a low barrier that ensures that capital is only at risk with a drop of 70% or 80% in an index such as the Eurostoxx 50.

The latest bout of market instability, beginning with the big drop in equities markets in August, required providers to offer liquidity and buy back many retail products. And with many investors sitting on the sidelines, the fourth quarter of 2011 promises to be a poor one for new product launches, especially since many third-party distributors have postponed expensive marketing campaigns.

In the medium term, growth prospects look best in the UK, which is a much less developed market than Germany or Belgium. Many investors are looking at listed products such as ETFs, rather than those traded over the counter with the bank provider.

Investors are looking for simple and easy to understand pay-offs, and they want to manage their investments during the overall term of a product, and not just hold until maturity

Alexandre Houpert

“There has been a change in the behaviour of retail investors, who are increasingly trading in the secondary market,” says Alexandre Houpert, head of listed products for northern Europe at Société Générale in Paris. “The key for issuers is to provide liquidity, and during the equity market falls over the summer we maintained a high degree of liquidity, allowing investors to sell back their positions if they wanted to.

“Investors are looking for simple and easy to understand pay-offs, and they want to manage their investments during the overall term of a product, and not just hold until maturity,” he adds. As a result, Société Générale has focused its efforts on listed structured products.

In current market conditions, with low interest rates, it is difficult to structure products with an attractive pay-off if the investor requires full capital protection. But investors willing to put capital at risk in case of a big market drop can generate high yields. Autocalls continue to be a popular product, and in September Société Générale was able to structure six-year products with an annual yield of 15%, with capital protection as long as the FTSE 100 did not fall by 40% from its levels on the product launch date, which would mean retreating to levels last seen in 1993.

Investors go home

The UK market has traditionally been heavily skewed towards the FTSE 100 and its constituent stocks as underlyings. German investors used to be more open to emerging markets themes, but in a risky environment have become more conservative, and invest mainly in products with DAX or EuroStoxx underlyings.

“There continues to be a strong domestic focus for German retail and high-net-worth investors, since in spite of economic uncertainty the profitability of German companies has been quite good,” says Heiko Weyand, director, derivatives public distribution, at HSBC Trinkaus in Düsseldorf.

“The German structured products market faced backflows in August, as retail investors realised losses and sold some products back to the issuers,” says Mr Weyand. “Some of these retail investors may decide to wait until January to get back into the market. But institutional investors, reacting to the high level of implied volatility in equity markets, were quick to turn around their positions and buy new products after the fall in equity markets in August.”

The German structured products market has recovered well from the lows seen in 2009, though total outstandings of about €110bn still remain far below the record of €140bn in 2007. At the same time, spending on infrastructure has increased. Reaching clients direct via the internet has become important, and the number of products has proliferated, requiring computer systems that can instantly generate products upon request. It has become an expensive area for banks to play in, while modest growth in total outstandings means that the fight for market share is fierce.

After the big drop in equity markets in mid-2011, and the subsequent peak in volatility, discount certificates and reverse convertibles with either indices or baskets of stocks as underlyings have been launched with potential pay-offs not seen since 2009. For example, one of a series of barrier reverse convertibles launched by Vontobel in October features three German stocks as the underlying: Bayer, Daimler and industrial group Linde. The one-year product pays a 14.9% coupon, with full capital protection as long as none of the three stocks falls by more than 50%.

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