The predominant theme of the three-day 2005 Structured Products Association (SPA) annual conference in New York in March was that the US structured products industry is in transformation. For the most part, the changes to the industry will be profound and positive, with a few bumps in the road for some, and tremendous opportunities for others.
Below are five of the major themes from the conference:
1. Convergence of underlyings and the emergence of the 'hybrid' structured product
Several panel discussions focused on the next generation of structured products, and how they are characterised by mixing and matching underlyings. For example, credit derivative exposures are now being dropped in next to equity index underlyings for institutional clients. Pension plans, foundations and endowments continue to demand 'portable alpha', which are most cost-efficiently delivered through structured products or derivatives. FX overlays to quanto-out currency risk was a hot investment strategy, particularly in first-to-default credit-linked structured products.
In 2004, some Latin American investors preferred to have their principal-protected S&P 500 exposure wrapped in local sovereign debt, which had much higher yields (and therefore greater exposure) than US structured product issuers' funding. John Neubauer of JP Morgan and Kurt Overley of BNP Paribas both described interesting new innovations in hedge fund structured products, as well.
2. Distribution still rules the world of structured products
One panellist described US mass-market distribution channels as 'ocean-front property' – highly in demand, priced at a premium, and precious in its limited supply. Some of the most popular presentations of the SPA Conference included a case study of how Matt Ginsburg's team turned Wells Fargo's broker network into a powerful distribution channel for structured products – while outsourcing the derivatives exposure to third-party sell-side firms. Brian Jones of InCapital discussed innovations in mass market US retail for regional brokers and wirehouses – but innovations outside of reverse convertibles and yield-generating structured products were slow to move from the drawing board to customer demand among the mass market (InCapital acts as a riskless principal to distribute other firm's structured investments to 500 broker-dealers in the US).
Citigroup's Samir Mathur described the 2004 success of Smith Barney's $1 billion call-overwrite note with CPPI, which required a strong commitment from the internal salesforce. Many firms with or without captive distribution are continuing to invest human capital in third-party distribution (which is still in its ascendancy), and do so under the belief that open architecture among the best private banks and broker-dealers is just a few years away.
3. The equity derivatives business is shifting emphasis and resources away from monetisation and into structured products capabilities
The panel on equity derivatives – including Michael Dweck of Goldman Sachs and Natasha Yeoh of Merrill Lynch – observed the continuing trend of resources migrating from the monetisation of concentrated single-stock equity positions toward growing the equity structured products business. Others – including Eric Glicksman of Wachovia – have observed that monetisations may suddenly jump back into the forefront of equity derivative efforts if market conditions (IPOs and private equity) provide such an opportunity.
4. Capital markets divisions at the major firms no longer distinguish between equities and fixed income as lines of demarcation
Historically, Wall Street firms had separation of equity derivatives and fixed income (credit and rates) derivatives. As the US structured products markets have prospered, these lines have become blurred, and many firms have now reorganised their structured products businesses to be asset-class neutral. Some firms have decided that structured products apply the same technology and legal/regulatory/compliance issues regardless of the reference securities, and it makes administrative sense to have a combined infrastructure to produce these products.
At these firms, a consolidated marketing group now calls on clients and customers with one-stop shopping for structured products. At least six New York based financial institutions have combined equity and fixed income structured products groups, with another three or four studying the possibility. More convergence is expected in the near future. Eric Weber of Freeman & Company gave a brief luncheon talk on how structured products are transforming the alternative asset world, and how structuring technology will completely transform the way in which asset managers approach delivering alpha to their clients.
5. Legal and regulatory scrutiny of structured products is expected given recent developments
The Securities and Exchange Commission continues to be highly focused on hedge funds, and the registration of hedge fund advisers. Structured products penetration in the US is not at a saturation point, and there have been few customer complaints, given the conservative nature of most structured investments sold into the US. Michael Butowsky of Mayer Brown Rowe noted that this environment provides a perfect opportunity for structured products firms to create policies and procedures to govern the marketing and distribution of structured products. Self-regulation is the best approach to this rapidly growing business. But regulatory scrutiny is inevitable – and should be welcomed – as the industry prospers at a rapid pace.
It was highly apparent by the energy level at the conference that the attendees were overwhelmingly optimistic by the rapid developments in the structured products industry over the last few years, and the current status of the asset class as the predominant growth opportunity on Wall Street. This opportunity, however, comes with a great responsibility – one which was discussed and debated repeatedly at the Davis Polk-sponsored cocktail party, at the lunches, and at the post-conference after-party. The responsibility is this: the development of best practices is imperative, and the industry needs to coalesce on this effort to stay ahead of the game instead of playing catch-up.