to provide level-playing fields. Institutions must ensure pre- and post-trade transparency, timely reposting etc.
• Much-increased investors' protections: The requirements will govern how financial firms should design, advise on or distribute MiFID instruments. MiFID II makes clear that complex products, including complex structured deposits, cannot be sold to investors on an execution-only basis. The requirements will promote greater price transparency, allowing retail investors to see more clearly the actual prices of various financial instruments, enabling them to compare prices and find the most competitive offer available.
Table 1.5 summarizes some key MiFID II features and coverage, and the relevant regulations derived from it relating to structured products.
Table 1.5 Regulations and key features
EU-11 Financial Transaction Tax
The EU-11 Financial Transaction Tax (FTT) will be introduced in 11 EU countries: Austria, Belgium, Estonia, France, Germany, Greece, Italy, Portugal, Slovakia, Slovenia and Spain. It will levy tax on financial transactions involving EU-11 counterparties. The financial instruments covered by FTT include cash management products, securities, derivatives and repos. FTT will impact the financial markets in a variety of ways and it will also impact derivatives pricing. The affected derivative instruments can impact end products pricing, either directly or via hedging.
Corporate and retail customers will be exempted from FTT. Market-making activities will also be excluded from FTT, although the definition of “market-making” involves some details. The FTT will be levied at between 1 and 10 basis points per transaction. The direct and indirect impacts of FTT include:
• Transaction costs: Additional transaction costs due to FTT can be substantially higher than the headline tax rate (1 ~ 10bps). The real cost will be the sum of the entire transaction chain, for example from an asset manager, via a broker, through a clearing member to the clearing house, and round trip. Each one of them has to pay, say 10bps. So a headline tax rate of 10bps for a government bond transaction could on average become 40bps (for the tax collector) after going through the whole chain.
• Indirect costs: If financial institutions cannot or won't absorb the additional transaction costs, they will pass some or all costs to the end users. This will have knock-on effects on bid-offer spreads, liquidity, volume etc., increasing the indirect costs of financial transactions.
The impact of FTT on the derivatives business could be substantial. It will make certain hedging and risk management activities more expensive. EU-11 domiciled banks and counterparties who are subject to FTT can potentially lose their competitiveness in the affected derivatives markets. Specific to the derivatives business:
• Derivatives pricing: Transaction costs due to FTT cannot be ignored any more in some affected derivative products. Pricing in the transaction cost is therefore important, considering increased hedging costs. Intuitively, options with larger Gamma will be affected more by the transaction cost, as one needs to rebalance the delta hedge more often if Gamma is larger. Pricing in transaction costs can be challenging, though, as calculating local Gamma and/or cross Gamma is a computationally heavy task.
• Derivative package/product: A derivative product transacted with an end user often consists of and is hedged by a number of simple instruments. For example, a cross-currency swap can be replicated and hedged by single currency swaps, plus basis and FX swaps. The total cost of FTT on such derivative products can potentially mushroom during the course of risk managing and hedging. It is important for practitioners to understand FTT impacts properly, and make appropriate business adjustments accordingly.
Structured Derivative Products Geographic Features
Structured derivative products markets are very different in size and product types across geographic boundaries. The dominant business model for structured products has been to develop and distribute country-specific products tailored to specific markets (e.g. country indices or stocks) and appetites. The United States is by far the largest market in terms of issuance and complexity of products. In Europe, Germany and Italy have the largest structured derivative products issuances, followed by the United Kingdom. China's structured derivative products business is sizeable in volume but still in its early development stages. Every country has its own market features and product preferences. In the following, we shall summarize some of the key market and product features in the selected countries, to obtain a holistic snapshot of the geographic characteristics.
United States
The US structured product market has evolved for many decades since the 1980s, and is more mature than the others. The majority of the structured products are now issued in the forms of structured notes, structured funds and structured deposits. These products are typically sold over-the-counter, although some may be listed on the exchanges. The annual sales do vary from year to year, and it is estimated to be in the range of USD$55 ~ USD$75 billion.
In terms of product types, US has certainly the most complex structured products in all major underlyings, including equities, interest rates, commodities, credit and currencies. Even in the era of credit crunch and European debt crisis when most of the other countries only having very simple products, one can still find rather complex products in the US across all major asset classes.
The equity-linked products are among the most popular categories, with underlyings in equity indices and single stocks. In the prolonged low volatility environment whereby the structured products pricing is difficult, there are more single stock underlyings as they tend to have larger volatilities than those of equity indices. From time to time, theme-based investment demands also drive the creation of single stock structured products. For example, auto-callable products based on internet single stocks are popular in the aftermath of giant internet company IPOs.
The issuances in currency basket, hybrid basket (e.g. CMS and S&P500), commodity index and long-dated equity for leveraged return products are also frequent. Although the embedded callable or auto-callable features can shorten the durations, in general the products in the US are longer-dated than their European or Asian counterparts.
Compared to other countries, the US market has more retail structured products based on interest rate exotics. For example, products such as callable inverse floater, callable (step-up) fixed-rate note, callable CMS steepener, fixed to floating rate notes are often issued by banks to retail investors. In Europe, these types of interest rate exotic products are deemed as more suitable for professional (institutional or corporate) clients.
European Union
In the European Union, structured product landscapes are very different in different countries. Germany and Italy are the largest in terms of market size and volume, followed by Switzerland, Spain and the UK. In each country, usually only one or two asset classes (e.g. equities and/or interest rate) are the dominant reference underlyings that driving the vast majority of the issuances. In the following, we shall have an overview of Germany, Italy and the UK.
Germany
In Germany, the annual sales of retail structured products are in the order of EUR€40 ~ EUR€50 billion, and the open positions are in the region of EUR€100 billion. Many structured products are listed in exchanges, and the exchange annual turnover is in the order of EUR€45 billion. Public distribution is a very important distribution mechanism in Germany and product demands are often driven by macroeconomics.
The major underlying asset classes are equities and interest rate. Equity-linked products tend to be larger in the number of issuances, although interest rate-linked products can sometimes be larger in volumes. While simple interest rate
