The impact of low interest rates, new EU regulations and the predicted lessening of quantitative easing in Europe and the US mean structured product providers are being called upon to provide innovative solutions to reduce risk in both retail and private banking. 

As investors try to sense the direction of markets, and gauge the likely impact of the eventual tapering of central bank quantitative easing programmes in the US and Europe, structured product providers are being asked to provide solutions to reduce risk in both mass retail and private banking portfolios. Product manufacturers are themselves facing a challenging structuring environment. Very low interest rates make structuring attractive capital-protected products traditionally favoured by mass retail customers difficult as the purchase of the zero-coupon bond used to guarantee capital leaves little surplus to buy the options on which the pay-off is based.

This has led to a move towards partial protection, perhaps 90%. But providers worry about the reputational risk of investors suffering losses, especially in an environment where retail investors are happy to take their gains but quick to lodge a complaint with the regulators when they incur losses. Giving up what one banker calls "the sacred cow" of full capital protection is a step that providers are taking with caution.

Meanwhile product manufacturers are facing heavy back-office overheads as they prepare for the implementation of EU rules governing packaged retail investment products that will come into force by the end of 2014, as well as specific national regulations under entities such as the new Financial Conduct Authority in the UK.

Distributors are acutely aware of the risk of being accused of mis-selling, and of having to show how they are conducting themselves at the point of sale. At mass retail level, the result is a focus on providing a relatively simple product range that advisors can be trained to explain to the end client, rather than a race for complexity and innovation.

Credit in demand

Nonetheless, providers report solid structured product volumes. During the first quarter of 2013, the European Structured Investment Products Association (Eusipa), which includes major continental European associations as members, reported that exchange turnover was up by 19.97% over the same period in 2012.

And bankers suggest that this strong trend has continued into the second quarter. Certainly the structured products market has recovered well from the hit to its reputation taken as a result of the Lehman Brothers capital-protected notes debacle in 2008, as well as the general pullback of investors in the years after the Lehman bankruptcy triggered the global financial crisis.  

Providers have in particular had a lot of success with credit underlyings, often packaged as credit-linked notes (CLNs). The investor is exposed to the credit risk of both the bank issuing the CLN structure plus the reference entity, which can be a single name, a tailored basket of names or an index.

A year ago, the funding spreads of many eurozone banks were running at high levels, with wide variations between different countries, and investors were able to get high coupons on CLNs. Eurozone bank funding spreads have since tightened, so returns are not as high, but remain attractive.

"If you look at structured product assets under management by product type in Germany, you will see that over the past 12 months most investors have focused on conservative coupon-generating structures and so missed out on the big gains in equity markets," says Dominik Auricht, product expert at the HypoVereinsbank (HVB) onemarkets structured products platform in Munich.

He explains that investors clearly still feel very uncertain about the direction of equity markets, and the possible inflationary effects of all the money being printed by central banks. HVB onemarkets has seen strong demand for CLNs where the investor takes the issuer risk plus the credit risk of a well-known company such as BMW or Volkswagen. And even where investors want a reference to stock prices, the main focus is on generating a clearly defined return. For example, the HVB onemarkets Express Plus Certificate with Volkswagen as an equity underlying generates yield as long as the Volkswagen share price has not fallen dramatically at maturity.

Equities look expensive

The situation for retail investors is comparable in the UK. Even though investors tend not to be as risk averse as in Germany, many were cautious during the run-up in the benchmark FTSE Index.

"As poor sentiment prevailed in previous years, a lot of investors have remained on the sidelines in cash and missed the run-up in equity prices," says Oliver Gregson, global head of discretionary portfolio management at Barclays Wealth and Investment Management in London. For those now looking to engage, there are concerns about entering at current price levels, he adds.

"For those who have been invested in equity portfolios that have benefited from the rally, their focus has shifted to looking to partially rotate out of their holdings in equities, and put on some degree of protection. Currently our preferred asset class is developed market equities, which still look attractively valued on both a relative and absolute basis," says Mr Gregson.

One product currently being offered by Barclays is a four-year, US dollar developed equity supertracker, with 90% capital protection. It offers geared and uncapped exposure to the positive performance of the worst of the S&P 500 and Euro Stoxx 50 indices, with a participation of at least 120%. The S&P 500 has been growing in popularity as an underlying for continental European investors, as well as those from the UK. And they are also looking for exposure to baskets of blue-chip US stocks and even single names.

"One effect of the eurozone crisis has been more openness from retail investors for US underlyings, especially since emerging markets equities have not performed that well since the beginning of the year," says Jean-Eric Pacini, head of Europe, Middle East and Africa (EMEA) structured equity distribution at BNP Paribas.

And Mr Pacini expects to see stronger appetite for exposure to equities. He notes that so far institutional investors have accepted that liquidity conditions have helped create a disconnect between negative macroeconomic fundamentals and positive momentum on equity markets. Retail investors, however, are not so familiar with this concept and so have reacted a little slowly to the run-up in European equity markets.

But the lack of other asset classes providing adequate returns means retail investors are progressively moving into equities. As quantitative easing gradually comes to an end, there is likely to be higher volatility, thus creating better conditions for autocallable structures, where the bank automatically buys back the product if the price rises far enough, allowing investors to lock in the gains.

Sophisticated clients

In the UK market, Société Générale has been generating good volumes for more sophisticated clients with buy-write strategies, where a long equities position is combined with selling call options. These strategies aim to generate extra income and reduce the overall volatility of the portfolio in return for giving up some of the equity upside. The underlying could be an index such as the FTSE 100 or a basket of high-dividend stocks.

"Buy-write overlay, otherwise known as covered calls, has been around for a long time as a yield-enhancement strategy used by institutional investors. But for private wealth clients, you need to offer the full package of long equities exposure combined with risk reduction via systematic call selling and rolling put option protection," says Didier Imbert, head of UK sales in cross-asset solutions at Société Générale Corporate & Investment Banking (SG CIB).

The UK Defensive Income Fund combines equity growth potential via investment in the FTSE 100 Total Return Index with a high fixed income of about 6% a year from the sale of options. UK investors remain highly focused on the FTSE, but other underlyings such as the S&P 500 are also popular with discretionary wealth managers and other clients.

As its cross-asset solutions name suggests, the Société Générale platform aims to move seamlessly between asset classes, taking advantage of trends in credit and equities, and sometimes combining them in hybrid structures.

Over the past two years there has been strong demand from independent asset managers, wealth managers and private banks for credit underlyings. Private banking clients often choose a basket of three credit default swaps (CDS) on companies with which they feel comfortable, and are then exposed to the first to default. By combining the CDS risk with the issuer counterparty risk associated with a CLN, high coupons can be generated.

Credit indices are also used as underlyings, such as the iTraxx Main (Europe), which comprises 125 European investment-grade corporates, and the iTraxx Crossover (Europe), which contains the 50 most liquid sub-investment-grade European names. Investors can choose from senior or equity tranches, depending on the coupon and the level of risk they want to take.

"Products with iTraxx and Crossover underlyings have been heavily sold over the past two years, and in general credit has taken up a large proportion of total structured product issuance," says Benoit Petit, head of cross-asset solutions sales for Europe excluding France at SG CIB.

Into the loan market

Investors are always on the lookout for new names, but some mid-size corporates they feel comfortable with, usually in their home country, may not have bonds outstanding or CDS. In a new development for the structured products market, Société Générale has begun to offer sophisticated private banking clients access to loans from such companies.

The background is that many European banks are currently pursuing a less balance sheet-intensive strategy, and are relying on an originate-to-distribute model. Some have already begun by signing agreements with investors, such as insurance companies, who take a slice of loans originated by the arranging bank.

But this loan exposure has now been made available to high-net-worth individuals at private banks, who may be able to gain exposure to the loans for as little as €100,000.

"The corporate risk exposure that we generate via arranging loans can be passed on to private banking clients, giving them access to illiquid assets that would normally be hard to access," says Aurelien Rabaey, head of cross-asset solutions engineering, Europe, for retail and private banks at SG CIB. "We have already done several deals with private banks and clients have welcomed the possibility of diversifying their portfolios with new names. We have started with corporate loans, but more esoteric asset classes such as aircraft or project finance loans are also a possibility for the future."

New frontiers

At HSBC there is also a strong focus on hybrid or combination products, with private banking clients choosing their own building blocks to construct pay-offs. "We are seeing a bit more interest in long-only equity strategies, but the main focus is still on yield enhancement, including more hybrid equity/credit products," says Alain Alev, head of EMEA equity derivatives sales at HSBC in Paris.

These are bespoke products for private banking clients, who will typically invest in an equity pay-off such as the S&P 500 or Euro Stoxx 50, but combine this with a familiar local currency or high-yield bond in their own country to generate some yield pick-up.

And HSBC is also finding a high level of investor interest in foreign exchange strategies. One very popular theme in 2013 is the appreciation of the Chinese renminbi versus the US dollar, with players such as hedge funds trading directly on over-the-counter derivatives, but also reaching private banking clients via structured products. 

"We are structuring exposure to offshore deliverable renminbi derivatives via a euro medium-term note wrapper, and this trade is popular with private bank distributors not only in Asia but also in Europe and the US," says Vincent Craignou, global head of foreign exchange and commodities derivatives at HSBC in London. "It is unusual to have such a unified global theme for private banks, and the last time this occurred was around 2004 when there was a focus on the appreciation of the BRIC [Brazil, Russia, India and China] currencies."

Looking forward to the second half of 2013 and into 2014, structured product manufacturers expect to see a continued improvement in volumes, as fragile investor confidence returns, although across continental Europe another bout of uncertainty over the future of the euro would negatively impact business.

Meanwhile, the entire structured products industry has to focus on upcoming regulatory changes. Eusipa, in particular, has taken exception to some of the more onerous rules surrounding marketing materials for self-directed investors, and has noted that many segments of today's markets are dominated by proactive retail customers who have solid product understanding and deliberately invest without consulting their account-holding bank first.

In the mass retail space, Eusipa is lobbying hard against measures that it feels will result in an overly bureaucratic exercise that hampers innovation, and delays and diminishes the offerings available to customers, thus depriving retail investors of access to market opportunities.

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