rel="nofollow" href="#i000008150000.png"/>SPVs for Collateral
Banks sometimes set up special purpose vehicles (SPVs) to issue structured products. SPVs can be used to hold collateral, among other tax and rating conveniences. After the SPV issuing a note, it will enter a swap transaction to completely hedge the product payoff. The SPV can then use the proceeds of the issuance to purchase collateral as security for the note principal repayment, for example. If dealers use their own bonds as collateral for the structured products they originated, then when they collapse, as in the case of Lehman Brothers, the value of collateral will also collapse. In such cases, the losses on the structured products are due to the significant decline in the collateral value, even if the derivatives embedded in the products may perform well.
A SPV with good collateral management will substantially reduce investors' counterparty risks. It is therefore very important for SPVs to seek high-quality and safer collateral for structured products.
Product Distribution
Derivative product distribution is not simply selling products. There is a comprehensive set of principles and rules one must follow to the word and in spirit, in particular relating to the retail customers.
Organization
In retail structured derivative business, organizationally there is a clear distinction between the manufacturing and distribution functions. The two functions have very different policies, processes as well as regulatory requirements. Product providers (manufacturers) and distribution functions need to agree and have distinct responsibilities towards investors. The product providers should interact with intermediaries who are the direct client-facing functions. In broad terms, intermediaries include private banks, independent financial advisors, and various modern distribution platforms that are subject to very strict regulation and compliance rules as client-facing functions.
As client-facing functions, investors' suitability and products suitability are extremely important topics that need to be included in the distribution process. In the context of product transparency, the marketing materials need to be clearly articulated to enable investors evaluating the products from the perspective of risk/reward and their specific investment objectives. One should make sure the materials are clear and not misleading, and it is also important to make proper risk disclosure, including market risks, credit risks, liquidity/unwinding costs, tax consideration. The fees and costs need to be disclosed clearly. The overall documentation standard must remain very high in stating products accurately, fairly and explaining the risks clearly and accurately.
While managing the relationship between investors and distribution functions is a key task, distribution functions also need to fully understand the new products themselves. Distribution functions should review and understand the products, whether they are developed by themselves or by a third-party provider. There should be an internal review process, taking into account the nature of the products, target investors, their risk appetite and assess the appropriateness for the intended target markets. The overarching rules in the structured products distribution should be KYC (know your customers), KYD (know your distributors) and KYPP (know your product providers).
It is also extremely important for the business and distribution functions to analyse and manage conflicts of interests around retail structured products. For example, some of the investment and debt products are indeed complex and linked to issuer's proprietary index. For firms that issuing structured products linked to their own or their affiliate's indices, addressing embedded conflicts is critical in order to avoid serious problems of favour issuers over investors. Some proprietary indices based on complicated algorithms and strategies may potentially harm investors' economic interests. Selling callable products to investors who adopt a buy-and-hold strategy could have a negative impact on investors. The firms have responsibilities to customers and managing conflicts of interest is a very important aspect of the structured derivatives business.
Due to increasingly strict regulatory rules on distributing “complex” derivative products to retail customers, banks are increasingly exploring the option to outsource certain distribution functions to third-party specialist research/marketing/servicing companies.
Documentation
In Europe, the regulation on Key Information Documents (KIDs) for Packaged Retail and Insurance-based Investment Products (PRIIPs) has been adopted by the European Council (EC). It will be deployed by end of 2016, and it is aimed at increasing market transparency for retail investors. PRIIPs covers investment funds, structured deposits and life insurance policies with investment elements. Retail investors will be provided with compulsory information on all products intended for them, and KIDs will be required to explain clearly all the risks associated with the investment products. KIDs must contain risk and performance scenarios and cost disclosures. The risk matrix and risk scenarios need to be shown and explained very clearly to investors.
The new mandatory KIDs for PRIIPs must comply with a set of uniform rules on the format as well as content, to enable better understanding by retail investors. It will include the features of the product, including whether the capital is at risk, cost and risk profile and relevant performance information. The format, presentation and content of KIDs should be calibrated to maximize retail investors' understanding and to allow them to compare different PRIIPs. As a pre-contractual information document, KIDs will be required before retail investors buy an investment product offered by a bank, an insurance company or an investment fund. KIDs will have to indicate what the product invests in, what its risks and potential rewards are and what total costs will be during the product's life cycle. It will cover a wide range of investment products that retail investors can buy through banks, financial intermediaries and on the internet. KID is designed to offer better disclosures about the features, risks and costs of products. Its more standardized information can facilitate easier comparability among investment products.
EC has made exemptions, and the new regulation on KIDs will not be applicable to the following product categories:
• deposits (only structured deposits and securities will be subject to KIDs);
• non-life insurance products;
• life insurance contracts whose benefits are only payable upon death or in the event of incapacity due to injury, sickness or infirmity;
• pension schemes that are officially recognized;
• pension products whose primary purpose is to provide investors retirement incomes;
• individual pension products whereby an employer contribution is required.
Distribution Channels
Traditional and modern distribution channels include bank branches, financial advisers, money managers, public distribution on exchanges and e-platforms. The often observed trend is that the volume per product becomes lower, but there are many more small tickets. This, together with the fact that we are in the internet age, have made e-platforms an essential part of the modern distribution mechanism. Single issuer e-platforms have automated production and distribution process and substantially reduced costs. Also emerging are the independent multi-issuer platforms, which either supplement or compete with in-house e-platforms, providing investors a single marketplace.
Each distribution channel has its own purposes and features. Through intermediary, it is typically supply-driven, rather than explicit demands from end-consumers. The end-consumers are increasingly bypassing the intermediaries to buy directly from banks and retail distributors. Public distribution for listed products, including covered warrants are mainly for vanilla products. However, the trend is a more homogenous distribution channels with increased share of e-platform. Multi-issuer platforms have become a trendy subject, and both
