Structured note markets - Giddy.org

1 98 Financial Stability Review: June 2004 Structured note markets : products, participants and links to wholesale derivatives marketsFOR CENTRAL BANKS,understanding how the modernfinancial system fits together is a necessaryfoundation for making sense of market developments,for understanding how to interpret changes in assetprices and, therefore, for identifying possible threatsto stability and comprehending the dynamics ofcrises. Derivatives are an integral part of this, usedwidely for the management of market , credit andother risks. The associated positions and hedgingstrategies of banks and dealers are an importantinfluence on how markets respond to changes inunderlying fundamentals. It is perhaps less familiarthat derivatives are also used by investors to takemarket risk in search of additional returns often viabonds known as Structured investors purchase such notes in order toobtain initial coupons that exceed market interestrates, receiving upfront premia for, in effect, writingoptions embedded in the notes .

2 It is perhaps nocoincidence that they have been as popular in recentyears as they were in the early 1990s, both periods oflow short-term interest rates in major currencieswhen some investors have been searching for yield .1In 1994, a number of investors suffered highlypublicised losses on holdings of Structured noteswhen US interest rates rose significantly (Box 1).For issuers, Structured notes can be a way of buyingoptions to hedge risks in their business. Most,however, swap the cash flows due on the notes with adealer for a more straightforward set of economic terms, the dealer then holds theembedded options. Sometimes they may hedgeexisting exposures taken elsewhere in a dealer sbusiness. Alternatively, the dealer may seek to hedgeby buying or selling similar options in the inter-dealerderivatives markets or through dynamic hedging inthe underlying cash markets . To a significant extent,so-called exotic derivatives markets have developedhand-in-hand with the production and distribution ofincreasingly complex Structured notes asintermediaries compete to offer investors newcombinations of risk and return.

3 Potentially, tradingof exotic derivatives fills some missing markets ,leading to a more efficient distribution of risk (as wellas yielding information that can be valuable tocentral banks and others). But liquidity in suchmarkets can still be shallow and may dry up instressed conditions, complicating risk describing the Structured note markets anddiscussing the motivations of investors and issuers,this article analyses the links to wholesale derivativesmarkets and identifies some issues relating tofinancial note markets :products, participants and links towholesale derivatives marketsDavid Rule and Adrian Garratt, Sterling markets Division, and Ole Rummel, Foreign Exchange Division, Bank of EnglandHedging and taking risk are the essence of financial markets . A relatively little known mechanism through which thisoccurs is the market in Structured notes , which have embedded derivatives, some of them very these instruments can be integral to understanding the underlying derivative markets .

4 In some cases,dealers have used Structured notes to bring greater balance to their market risk exposures, by transferring riskelsewhere, including to households, where the risk may be well diversified. Butthe positions arising from structurednotes can sometimes leave dealers the same way around , potentially giving rise to crowded trades . In the pastthat has sometimes been associated with episodes of market stress if the markets proved less liquid than normalwhen faced with lots of traders exiting at the same : See the Conjuncture and Outlook section of thisReviewfor a discussion of the search for yield . market structure and sizeBroadly, a Structured note can be defined as a bond(potentially, fixed rate, floating rate or zero coupon)combined with one or more options or forwardslinked to market prices or indices. They have existedfor many years, but the variety of structures is almostlimitless and constant innovation, at least at the levelof bells and whistles , is a feature of the can take a variety of contractual forms,depending largely on the nature of the targetinvestors (eg, nationality, regulatory and tax status).

5 Most innovation in the Structured note markets inrecent years, however, has been through issuance ofEuro medium-term notes (MTNs) the size of the market globally is difficult,partly because Structured notes come in variousforms. Data sources for new issuance of structuredEuro MTNs suggest that they comprised around 15%of total MTN issuance by value in 2003 (Chart 1). Butthe value of outstanding Structured MTNs is hard todetermine because they are often callable by theissuer after an initial period (eg, twelve months). Interms of numbers of notes rather than values, morestructured than vanilla MTNs are typically are linked to almost every conceivable type offinancial asset price, and other variables too: interestrates, equity prices, commodity prices, credit eventsetc (Chart 2). And they range from the relativelystraightforward to immensely complex. As backgroundto the discussion of what motivates investors andissuers and of the links to derivatives markets , theAnnex summarises the main types.

6 The nature of themarket risk exposures being transferred gives someidea of the associated exposures of dealers in the market include investors, issuers,swap counterparties, arrangers anddistributors/aggregators. Issuersfrequently enter intoa swap to receive the cash-flows on the note and paya more straightforward floating interest rate, such as aspread relative to LIBOR. Often, but not always, theswap counterpartyis the dealer that arranges anddistributes the notes (the arranger).2 Finally, where thenotes are being distributed to retail investors, theymay be sold initially to distributors such as retailbanks (sometimes called aggregators because theypool together the exposures of many small investors),which will usually repackage them into retail financialproducts, such as tax-efficient deposits or lifeinsurance policies (Diagram 1). Structured note markets : products, participants and links to wholesale derivatives markets Financial Stability Review: June 200499050100150200250300350Q1Q2Q3Q4Q1Q2Q 3Q4Q105001,0001,5002,0002,5003,000 Structured issuance amount (LHS)Number of vanilla issues (RHS)Number of Structured issues (RHS)20020304 Vanilla issuance amount (LHS)Number of issuesIssuance amount (US$ billions)Chart 1:Issuance of vanilla and Structured Euro MTNsSource: rate-linkedEquity and equity index-linkedCurrency-linkedInflation-lin kedCommodity-linkedCredit-linkedBond-lin kedFund-linked20020304 Issuance amount(US$ billions)Chart 2:Issuance of different types of Structured Euro MTNsSource: :principalSwapcounterpartyIssuerAggregat orInvestorsFloatingrateNotecouponNotecou ponAt issue: principalAt issue: principalAtredemption:principalNotecoupo nDiagram 1:Typical Structured note cash-flow structure withaggregator2.

7 For example, Japanese banks have been frequent arrangers of power reverse dual currencynotes (see Annex) but rarely the swap , there are three main groups of structurednote investors: high-net-worth individuals, financialinstitutions and retail precise pattern of demand, for each of thesegroups, affects the shape of dealers individualsMany Structured notes are issued in smalldenominations (eg, less than US$10 million) for saleto high-net-worth individuals. Private banks will oftenapproach dealers, or sometimes aggregators, on behalfof their customers in search of a particular targetyield and with ideas about the nature of the risks theywant to take (called reverse enquiry because theinitiative comes from the investor rather than theissuer or arranger). Dealers then compete to offernotes with structures that meet these individuals also approach dealers the past couple of years, contacts suggest that thebiggest purchases of Euro MTNs by high-net-worthindividuals have been of US dollar and, more recently,euro-denominated notes predominantly by Asianand Middle Eastern investors, as well as by customersof Swiss private banks.

8 For the most part, theseinvestors have been buying notes linked to US dollaror euro interest rates, selling embedded interest rateoptions in order to enhance the initial coupon,perhaps taking a view that interest rates would notincrease as quickly as implied by the forward yieldcurve (Chart 3).A rise in such individuals purchases appears to liebehind the increased issuance of such notes in 2002and 2003, both in absolute terms and as a proportionof the Structured note markets . For example, almostall US dollar-denominated range-accrual notes themost frequently issued type of Structured Euro MTNin 2003 are said to have been bought by privateinvestors (Chart 4).In the US domestic market , purchases of callablenotes by private investors are also said to haveincreased markedly. This appears to have been onemanifestation of the so-called search for yield .Against a background of low short-dated US interestrates (Chart 5), obtaining premia for writing interestrate options has been one way of enhancing initialcoupons, taking the risk of possible sub-marketreturns in the institutionsAs well as high-net-worth individuals, financialinstitutions such as insurers, pension funds and smallregional banks have also been buyers of structurednotes as part of the recent search for yield.

9 In theUnited States, for example, a number of regional100 Financial Stability Review: June 2004 Structured note markets : products, participants and links to wholesale derivatives markets01234567024681012141618US$ 28 May 04 28 May 04US$ 2 Jan. 03 2 Jan. 03 Years aheadPer centChart 3:Interest rate forward yield curves(a)Source: Bank of England.(a) Three-month forward nominal interest rates, derived from the Bank's bankliability amount (US$ billions)Chart 4:Issuance of range-accrual Euro MTNsSource: 93949596979899 2000 010203 Per cent DM/ US$04 Chart 5:International three-month interest ratesSource: Bloomberg: 3-month British Bankers Association fixings for US$,Deutsche mark/ and .banks and brokers in states such as Arkansas andTennessee specialise in the distribution of callablebonds to smaller US banks and financial have become significant players in that marketand, relative to their capital, smaller US banks havebigger holdings of Structured notes than do largerones (Chart 6).

10 But a rather different motivation lies behind the largepurchases of Structured notes in recent years byEuropean and Asian life insurance companies. Asdiscussed in various issues of this Review, many havesold retail products with guaranteed nominal returns in effect, they have sold options to their guarantees can take various forms, such asminimum returns on savings products and guaranteedannuity rates, and are often such guaranteed rates were adjusteddownwards for new business as Asian and Europeannominal interest rates declined in recent years(Table 1), many insurers have liabilities under oldercontracts that guarantee returns above currentrisk-free interest for dealing with this problem appear tohave taken two forms: either taking risk in their assetportfolios in search of above- market returns sufficientto meet the cost of their liabilities, or seeking tohedge the options they have sold by buying similaroptions. Insurers have used Structured notes withembedded interest rate options for both and Asian insurers are said to be thebiggest buyers of long-dated, zero-coupon US dollarand euro callable bonds in effect, selling interestrate options to obtain higher yielding assets.