Manufacturing and Managing Customer-Driven Derivatives - Qu Dong

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structured products landscape was severely impacted by the collapse of Lehman Brothers in 2008. Lehman had sold many index-linked products to the Italian insurance sector, which were subsequently distributed to retail policy holders. Theoretically, the end users (retail policy holders) would bear the counterparty risk (the collapse of Lehman). However, for a variety of practical reasons, the insurance companies had to compensate retail policy holders, effectively taking up the Lehman counterparty risk even though they were technically intermediaries. Subsequently, Italy's insurance regulator ISVAP decreed that the insurers would carry the counterparty risks of any products they sell. The viability of distributing prepackaged structured products via insurers is now in question.

      For the structured products as a whole, Italy's securities market regulator CONSOB stipulates that product distributors have to formally distinguish between “liquid” and “illiquid” products. For “illiquid” products, which include OTC derivative products, strict documentation, pricing and reporting standards are required. If a distributor wishes to sell an “illiquid” product, including a structured product, it has to have an internal independent price evaluation models and provide investors with regular reports on the product's performance. Typically, separate Monte Carlo pricing and statistical analysis is needed for every product issuance, in order to meet CONSOB's prospectus requirements.

      CONSOB pays a great deal of attention to the products considered as “complex” and/or “dangerous” in the retail market. To limit retail customers' risks to such products, CONSOB compiled a list of “complex financial products” (including asset-backed securities, convertible, structured and credit-linked products, etc.) and recommended intermediaries not to offer them to retail investors. The intermediaries are expected to maintain the coherence between the products offered and customers' profiles, at the distribution stage as well as the product design stage. CONSOB also requires structured products providers to abstain from offering and placing certain “very highly complex financial instruments” to retail investors.

      Annual sales of retail structured products in Italy is in the region of EUR€35 ~ EUR€45bn. Overall the volume of issuance with equities as underlyings is broadly similar to those with interest rates as underlyings. The issuances of certificates linked to equity underlyings are on the rise in the low interest rate and low inflation environment.

For the equity-linked products, single index and single stocks are the two key categories of underlyings. Figure 1.2 illustrates the proportions of the two classes of underlyings over a 4-year period. During this particular sample period, the volumes of single stock products had increased relative to the single index. The rise of single stock products was mainly driven by the demand for higher coupons and more interesting payoffs. The pattern may fluctuate over time, and a substantial portion of the equity-linked products was still referencing a single index.

Figure 1.2 Italy equity underlying (index, stock)

      Structured certificates and fund-linked products have a range of payoffs, including protected tracker, capped or uncapped call, reverse convertibles, digital and callable. As all listed products are automatically classified as “liquid” under CONSOB's rules, there is a strong incentive to get products listed on the Borsa Italiana. Listed products tend to be the simple payoff types. Leverage products are also in demand and they are well suited to listing on the exchange. Certificates designed to suit the specific financial environment can sell well in Italy. For example, in 2014/2015, when the markets were steadily positive and moving sideways, autocallable (express) certificates and capital-protected certificates were popular with investors. These short-term (e.g. 3-year) certificates have indeed generated good returns for investors.

      United Kingdom

      In terms of the market size, UK structured products annual sales are in the order of GBP£10 ~ GBP£15 billion. The total outstanding client positions are in the region of GBP£60 billion. The vast majority of the retail structured products are equity-linked, and there is little in the way of FX, commodity or interest rate-linked products in the retail space.

      The typical product wrappers are:

      • Investment plans: These plans are typically offered via intermediaries, such as Independent Financial Advisers (IFAs). They are administrated either by a third party or the issuer. The plans are often targeted to the NISAs and SIPP investors who have no tax liability on the returns. The plans are also marketed as tax-efficient investments (within the limit) as, for the direct investors who pay UK tax, the returns of the plans will be treated as capital gain instead of income.

      • Structured deposits: These are offered by banks and building societies as fixed-term deposit/saving accounts. The returns will be treated as interest income and subject to income tax, unless it is wrapped in a NISA. The deposit/saving with authorized firms is protected by the Financial Services Compensation Scheme (FSCS).

      • Exchange-traded structures: These are typically issued as certificates, and are listed on the London Stock Exchange as full tradable securities. The listed securities have the benefit of transparency and liquidity. The exchange-traded structures are quoted throughout the trading day.

For the equity-linked products, single index is very dominant in the UK as shown in Figure 1.3. FTSE-100 is the most popular index followed by EURO STOXX 50 and S&P 500. Basket of indices is often used, but there is very little in single stocks.

Figure 1.3 UK equity underlying (index, basket)

      Apart from underlying liquidity and investors' risk appetite and familiarity with the indices, UK's stamp duty on share transactions may have depressed the single stock-based product offering. It is conceivable that financial transaction tax on stocks, which makes hedging single stock-based products very expensive, can skew the markets and product offerings.

      Over the years, the mainstream structured product payoffs in the UK have been fluctuating among capped or uncapped call, digital, reverse convertible and kickout (auto-callable). In the low interest rate and low volatility environment, kickout products are very popular and they constitute a very large portion of the business. Basket underlying is sometimes used in the kickout products to enhance the headline rate.

      China

      China's financial systems are still evolving. Its structured products markets are very different from the western counterparts in both framework and contents. The overall picture therefore seems to be more complex from a western perspective.

      Markets and Drivers

In China, commercial banks including city commercial banks, rural commercial bank and rural credit cooperatives, can issue structured products to attract short-term deposits. Trust products, private equity limited partnership products and increasingly the internet products are the other main forms of structured (fixed income) products in the market. The so-called “shadow banking” encompasses segments including trust companies, wealth management and private lending among individuals. Structured products are typically categorized as part of wealth management products (WMPs) family, as illustrated in Table 1.6.

Table 1.6 WMPs and structured products

      One of main issuers of WMPs is the trust companies. The investment trust industry is one of the main players in WMPs. The trust companies are usually selling the trust products through the wealth management divisions of commercial banks. The products distributed by banks are perceived as having “implicit guarantees”, meaning

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