What does the future hold for Structured Products?: Entering a new world

Concerns over counterparty credit risk are ever present, but the extent to which they determine trading and investor behaviour is rarely evidenced in benign conditions. In much the same way that everyone is aware they must pay their taxes at fiscal year-end, it is only when it is time to actually sign the cheque that people remember they should have been putting money aside to cover it. Many structured product investors, who spent the best part of a decade refining their investment habits, chose to ignore counterparty credit risk. They probably knew that it was there somewhere, in the form of the credit component or pay-off of a structure, but preferred instead to switch between counterparts, perhaps moving from AA to BBB, just for a few basis points upfront.

In the past 18 months, their approach to this risk has changed dramatically. "The two major shocks - Bear Stearns and Lehman Brothers - have altered investors' perception of structured products dramatically. Something that was pretty much unthought of by many before - a bank default - has occurred," says Richard Ager, director at Barclays Capital.

That this did not have too great an impact on the European retail market is, in Mr Ager's view, because relatively little Lehman paper ended up in retail hands. Most of the products sold in the region were structured deposits or structured funds and therefore both the structures and their hedges were generally collateralised. But in Asia and in the private banking space, events have really shaken confidence. "In Asia there was a lot of Lehman paper issued through minibonds, while private banking clients were large holders of Lehman structured notes. There was also a significant secondary market impact on all of the other banks' paper as their CDS [credit default swap] spreads widened", he says.

Nonetheless, the credit risk phenomenon has taken its toll right across the structured product universe. "Today, clients and their distributors carefully consider the solidity of the issuing firm, its credit standing and how long they have been in the market," says Mr Ager.

Bertrand Delarue, head of structuring for equity derivatives at BNP Paribas, agrees: "Much more attention is now being paid to the issuer; before the Lehman collapse, investors didn't really distinguish between names, but now there is a huge differentiation between banks."

Shift of focus

According to Ronald Friend, head of equity derivatives repackaging at JPMorgan, distributors are distinguishing between counterparts by focusing on credit spreads and ratings, whereas individual investors tend to be more focused on name recognition and brands that they do and do not trust.

Education about counterparty credit risk and how this affects a structured product investor has, understandably, become a key issue. Mr Friend says: "We have been working hard to make sure investors and distributors understand what would occur to each product and structure in any given scenario and, in turn, they have been much more inquisitive about how products work. We typically issue through guaranteed subsidiaries in Europe and investors are now asking very seriously what the mechanics behind these structure are."

Arnaud Sarfati, head of engineering, Europe, at Société Générale, agrees: "We have had to do a lot of educating on counterparty risk - many investors, for instance, didn't understand that the price of structured products could move if our bond price moved."

Counterparty credit risk has also played out in other ways. "A lot of things we used to price for free - or didn't really have to price in - now really have an effect on the cost of doing business," says Mr Sarfati. "We have to price in the basis, use of balance sheet, counterparty credit exposure, funding rates and hedging rates." This includes the pricing of delta exposure that SocGen has with all of its counterparties, one by one.

While these costs are now being computed, factored into products and passed on to investors, the structurers themselves have been facing an additional challenge. At the product-provider level, certain providers have had to withdraw; either because they have been effectively excluded by their ratings or because they have chosen to reduce their presence in the market. A lot of counterparties have also exited the business. Not just Bear Stearns and Lehman, but large dealers that have come under stress due to their own positions.

"As a result, it has been quite difficult to hedge positions," says Mr Sarfati. "We have had to do short-term rather than long-term hedges, and on macro index rather than single stock hedges. This has resulted in a growing proportion of index-linked products as it is easier for issuers to structure products linked to indexes rather than single names."

Neither have the distributors enjoyed any immunity. One recent episode illustrates just how costly it has become to manage counterparty risk at this level. Earlier this year, SocGen participated in an auction for a swap on a retail product. The bank won the auction; however, owing to changes in local regulation, the issuer was unable to place the product and therefore to unwind the swap position and get out of the trade. It organised another auction and, although SocGen tabled only the third-best offer, the issuer still elected to unwind the position with the bank because it did not want any mismatch in counterparty risk on the wind and unwind.

"This would never have occurred before," says Mr Sarfati. "But the issuer realised it could be extremely costly to face two different counterparties for the duration of the swap."

Seeking safety

One of the side effects of mounting credit risk concerns has been that the focus of investors has shifted away from the pay-off of the product to the safety of the structure. Some investors are not just monitoring counterparty risk, but seeking to eradicate it altogether. And with precipitous equity market falls still fresh in memory, there is much greater desire for principal protection. This naturally makes the credit aspect all the more important, encouraging investors to focus not only on the issuer's name, but also to plump for the safety of UCITS 3 and collateralised structures.

In the wake of Lehman's collapse there was a rush to roll out structured products backed by government debt, but opinions vary on the extent to which these naturally more costly structures have gained traction.

London, according to Mr Weinstein, has had the biggest success with collateralised vehicles, while on the continent there is more interest in structured funds.

Eastern Europe, says Mr Delarue, has had the biggest success with collateralised vehicles; but in more mature markets such as France, he says there is more interest in structured funds (although again the funds are independent of the issuer).

Mr Friend believes, however, that the idea of any major shift to collateralisation has been overplayed. "After Lehman, there was an initial reaction as investors turned towards collateralised products; the problem is that collateralised structures are expensive, which reduces the returns on products and may not be appropriate for all investors. As a result, we have seen a reduction in demand for this type of product and much more focus on the issuer name," he says.

Mr Ager agrees: "Collateralising comes down to cost. AAA government bonds are very expensive and when investors see that in context, they often seek out alternatives."

Matthieu Fortin, vice-president for structuring, equity derivatives at SocGen, believes that one of the most dramatic changes in the past several months is that investors are putting far less focus on the pay-off, and much more on the wrapper itself. Thereafter, every investor will opt for different levels of safety through collateralisation, depending on their risk appetite.

SocGen had, somewhat fortuitously, developed a vehicle to address the wrapper issue well before the crisis escalated. In February 2008, it set up Codeis, a public Luxembourg-based company which as a debt issuer is approved and supervised by the local regulator, the Commission de Surveillance du Secteur Financier. It has all the flexibility offered by euro medium-term note (EMTN) programmes and - due to an asset-backed structure comparable to investment funds (such as UCITS 3 products) - offers a safeguard against credit risk but with lower costs. The assets securing Codeis's products are fully isolated from the bank's balance sheet and, with a structure based on segregated components, investors can identify the particular credit exposures they want, be it government bonds, SocGen's own debt or a diversified basket of risk. Finally, the issuance programme is fully compliant with the EU Prospectus Directive, which facilitates the distribution of Codeis products throughout Europe.

One of the first trades made by SocGen through Codeis was for an institutional investor which could only be exposed to World Bank paper, but which required a pay-off linked to a hedge fund. SocGen asked the World Bank to issue some paper solely for this transaction, placed the bond into a Codeis structure and entered into a swap with it to provide the pay-off desired. In this way, the bank was able to deliver to the client exactly what it requested: AAA exposure through an AAA rated vehicle, with a return linked to a specific hedge fund-based pay-off.

The Codeis platform is being used in three other ways. First, it is a powerful tool for smaller distributors who want to raise money but do not have their own issuance programmes. For such distributors, raising index deposits can be inefficient, and EMTN programmes can be operationally quite onerous. By creating specific Codeis departments, SocGen can give them the opportunity to have their own issuance programme and raise money directly.

Second, Codeis is being used as a mass retail product platform. A new range of fully collateralised certificates indexed to commodity performances has recently been listed on Euronext Paris and the London Stock Exchange where they can be traded on a real-time basis.

Third, Codeis can be used as a collateralised vehicle to warehouse the pay-off element of a structured product. Several insurance companies in Italy, for instance, previously chose to construct their own index-linked insurance policies, buying the pay-off and using a single bank's structured debt as an underlying. Due to recent regulatory developments, these insurers now require greater security and some have opted to use Italian treasury bonds as the fixed-income component, while buying collateralised options exposures through secured warrants issued by the Codeis vehicle.

A certain future

So how have all these different alternatives paid off? At first glance, not fantastically well. First-quarter sales of structured products in Europe fell by 40%, even by 85% in Italy in the case of insurance wrappers. But these figures have to be viewed in the context that global inflows to equity funds have also fallen strongly. Notwithstanding the headline figures, Mr Sarfati says his team has been extremely busy, and longer term, he expects that the crisis will prove to be good for structured products. "Investors have realised that alternative scenarios can and do occur and that protection is very important," he says.

Mr Ager agrees: "It is a good time to be selling and structuring structured products - there is lots of negative talk, but much of it is untrue as proven by the recurrent demand. If you look at the cost and value perspective for mass retail, the structured products proposition compares very well. Most retail products had capital protection and, with a few exceptions, investors holding to maturity have got their money back. Those who invested in products with lock-in mechanisms may have done even better - much better in fact than they will have done with anything else, as we have seen dismal performances across asset classes in the past 12 to 18 months."

The future of the structured product universe is not therefore as stark as some would suggest. Depending on their risk appetites, investors can choose from a whole menu of different options with differing degrees of safety, while the structurers, provided they are able to navigate the more constrained waters, are at least facing significantly less competition.

And there is a further reason to be optimistic. One factor that played a part in the original impetus towards structured product investing - tax optimisation - is again coming to the fore. "It would be wrong to say that it is only credit concerns that are driving things; tax remains an important factor," says Mr Friend.

The tax-based argument is only likely to get stronger as income tax rises and earnings fall - particularly in the UK, where the anomalous treatment of capital-protected structures and proposed hikes in income tax rates are combining to form the perfect storm for structured products.