Quick Reactions: (STS) Taking the jargon out of structured deposits

It’s a bold caption that I ought to react to, given that I have actually done some work in the area some years ago.

Just before you enter into a tirade, I’d like to think to have made a small contribution to the bank I was working for then, as comparatively, they did not suffer a blow-up like other competitors. (hint: the bank was NOT in this list of banned distributors.) At that time, despite some aggressive lobbying by the sales force, we politely refused to distribute Lehman minibonds, and other Jubilee or Pinnacle series which had CDO backed structures. I remembered writing a long response to management detailing the complexity and opacity of the collateral that many professionals were unaware of, let alone retail investors.

So yes, it is without doubt that financial innovations such as those are unproductive…

Now back to the topic of “Taking the jargon out of structured products.” Prior the crisis in 2007, simplification of structured

products already was the pet topic of my visionary ex-boss. A project was embarked to simplify termsheets, provide comprehensive scenario analysis and setup performance trackers for post-trade monitoring – remember, this was pre-crisis, when most banks had no other cares but to just print the deal and clock revenues.

When the crisis hit, more banks began to pay heed, mostly because investors (and consequently regulators) were turning on the heat on disclosures and representations – self-preservation became the order of the day.

However, oversimplification can become a fallacy and a paradox of transparency. The author’s attempt to provide simplified illustrations about structured products is somewhat inaccurate and incomplete.

 1. For starters, the author’s illustration covers only one particular type of structured product that is not even typical. There are many other variants with a multitude of features and characteristics. Being transparent means diligently explaining every feature and describing every condition that is embedded. Over-simplification could lead to incompleteness and possible misrepresentation of the risks.

2. The author gave a flawed expectation of returns.

A call option works like the option you sign when you buy a house. You make a down payment to get an option to buy the property. If the price of the house goes up, the option will be worth a lot

more money. You can sell the option off and make a big profit, without having to buy the house.

(a) Buying a structured product is different from merely buying an option. A structured product is a bundled package of zero coupon bonds and embedded options, so the bond value also affects its termination value.

(b) In most structured products offered here, because most of the initial investment is used to preserve the principal amount at maturity, the prospect of getting outsized returns from the options needs to be tampered by the amount of risky capital that was initially allocated.

(c) In addition, investors are mostly sellers of options, not buyers. As sellers, investors pocket the premiums and do not participate in the upside. In other words, do not get too excited over the author’s scenario of making a big profit.

(d) Lastly, do not assume that there will be a deep market if you wish to terminate pre-maturely. Most option strategies embedded in structured products are more sophisticated than just having “one call option”. Every additional underlying (in the author’s example, he uses STI as an underlying) introduces other types of risks which may not be easily hedged. This means: be prepared for a large bid-offer spread. So an investor of structured products should consider the potential exit fees by the market maker, as well as the distributor.

3. In the offering of structured products by bank distributors in Singapore, there is often a distinction between structured deposits and structured notes. Here, I summarize the differences based on my experience and observations.

 

Structured Deposits (SD) Structured Notes (SN)
Format Usually booked as a separate investment account with the bank. Investor buys a note, which is a security of the issuer.
Credit Risks Investor bears the credit risk of the bank that the SD account is maintained with. Investor bears the credit risk of the issuer of the note, which may be an entirely different entity from the bank distributor he buys from.
Principal Risks for the Investor* Banks usually structure products with the combination of zero coupon bonds and embedded derivatives that are designed to minimally pay back the investor’s principal amount at maturity. The issuer has greater flexibility to structure payoffs at maturity that may NOT equate to 100% of the investor’s principal amount. A portion of investor’s principal amount is used to purchase derivatives to yield potentially higher returns for the investor. In other words, SN can be riskier than SD.
Investor Type Anyone “Accredited” or “Professional” Investor
Investible Amounts Typically from S$5,000 If the individual is accepted as an “Accredited Investor”, typically S$50,000, otherwise, S$250,000

*Post crisis, firms are banned from using “Principal Protected”, “Capital Protected” or similar terms to describe investment products. There are also more stringent requirements on suitability.

Having done some mystery shopping over the weekend with 3 retail banks, I found that none of them currently offer any structured deposits. Some good riddance there, else I’d enjoy having a go. All offered structured notes that were equity linked with higher risks in nature, i.e., prospect of losing initial principal at maturity.

In conclusion, I would urge people not to be lulled into naivety or complacency. If you really desire to know the exact make-up of a structured product, none of it will be simple. The analogies that the author introduced are unfortunately fallacies of oversimplification – they cannot pass the litmus test. Something else?