When we were putting together the agenda for Structured Products Americas earlier this year, a few or our contacts suggested we invite a representative of the National Association of Securities Dealers (NASD) to deliver a keynote speech. After all, the NASD had issued a notice to members - concerning the marketing of structured products - late last year that sent tongues wagging in the US market. Our conference would have been a perfect opportunity for the NASD to clear up any confusion and to explain the intricacies of the notice. Or so we thought.
Sadly, the NASD declined our invitation. "After giving this careful consideration we are declining your offer to participate in the conference," the NASD said in an email correspondence. "While NASD appreciates your attention to regulatory matters, we believe our NtM 05-59 (notice to members) has, for now, adequately addressed the issue."
Luckily, regulators from the US Commodity Futures Commission (CFTC) and US Securities and Exchange Commission (SEC) were more than happy to speak. And, in fact, one of the key points, delivered by a multitude of speakers at the conference, was that the NASD notice to members - which was issued with seemingly no market consultation - largely institutionalised already existing best practice.
In its notice, the NASD said it was concerned that its members, drawn from 660,000 securities brokers and dealers, may not be fulfilling their sales practice obligations when selling structured investment products, especially to retail customers. Its notice to members provided guidance concerning sales obligations, including the requirements to provide balanced disclosure in promotional efforts and ascertain accounts eligible to purchase structured products. One stumbling block in the notice, however, commented on by more than one speaker, was the allusion to the fact that structured products should only be used by investors whose accounts have been approved for options trading. It was this recommendation that caused concern among more than a few of our speakers, since imposing such a constraint could limit the retail potential of the US structured products market.
Amazingly, our first keynote speaker, Sharon Brown-Hruska, CFTC commissioner, called for regulators to dismiss their overly prescriptive attitude to regulation, citing the example of the NASD notice to members, in order to aid the development of the structured products market in the US.
Brown-Hruska, who was speaking on the first day of our conference at the Biltmore Hotel in Coral Gables, Florida, said she is concerned that regulators are stifling innovation in the market.
"Efforts by regulators to more vigorously regulate risk-taking are of increasing concern to me. Some discussion seems positive, like utilising risk-based methods to determine exposure and set collateral requirements, but other efforts are more prescriptive - like endowing overly simplistic and sometimes biased valuation models to define leverage or to divine the purpose of derivatives in a portfolio," she said. "While I agree that the monitoring and regulation of risk-taking may be appropriate for banking institutions, as a regulator of markets I am less comfortable with efforts to regulate risk-taking by individuals and firms. I believe that the current regulatory model we have for overseeing markets that specialise in risk shifting has proven particularly effective, without unnecessarily constraining the markets and the firms that use them."
Brown-Hruska, who was appointed CFTC acting chairman by US President George W Bush, serving from July 2004 to July 2005, noted that structured products are becoming more popular amongst US investors - particularly in the commodity-linked arena. "I believe responsible regulation entails a duty to taxpayers, market users, and the public who benefit from markets to be mindful of the benefits and costs of rules and requirements that we promulgate," she said. "Regulatory solutions must be targeted and effective."
There is often a temptation to adopt a set of regulations and stick with it regardless of the asset class or the nature of the market, Brown-Hruska noted. "Trying to fit the managed funds industry into the mutual fund box (for example would) be detrimental to that market's ability to innovated and explore uncharted territory," she told delegates. "Similarly, trying to force equity linked products into the securities regulatory box could stifle the expansion of those products if the approach that we choose is not sufficiently flexible."
Brown-Hruska also noted, no doubt to the delight of the US Structured Products Association, that industry bodies and regulators have a chance, and indeed a duty, to work together. "A recent illustration of how regulators and industry can work together is with respect to the backlog in the confirmation of trades in the credit derivatives market that has been the focus of the Federal Reserve Bank of New York and a group known as The Counterparty Risk Management Policy Group, headed by Gerald Corrigan, the managing director of Goldman Sachs and former New York Fed President," she said.
The year ahead
Regulatory questions are always a hot topic at events like this. But speakers also took the time to debate future market developments. Speaking at a champagne roundtable, Barry Finkelstein, managing director of UBS Securities in New York, told delegates that 2007 could be the year of fixed-income structured products. Dow Jones has developed indexes that provide access to credit derivatives markets and so investors should start to become more familiar with the concept, Finkelstein said. "Range accrual notes are also due to come back with a vengeance," Finkelstein added. "But it's important to remember that structured products are used in the US, and indeed across the Americas, not just as wealth creation tools but as a means for ensuring wealth preservation. It's all about finding the right product."
Kurt Overley, head of fund derivatives marketing at BNP Paribas in New York, agreed, noting that the opportunities for new products are endless, while acknowledging that increased regulatory scrutiny is making it more difficult to fully "retailise" the market. He also pointed out that funds of structured products are not all that different to funds of hedge funds, from a structuring perspective, and that investors are already asking for access to funds of structured products.
Kevin Mahon, meanwhile, senior vice-president of structured products distributor Countrywide Securities, said that it's difficult to predict what 2007 will hold, and that investor demand will very much depend on where volatility is trading and the level of interest rates. However, Charlie O'Flaherty, moderating the panel debate, noted that commodities, for sure, are set to be just as popular in 2007 as they have been this year.
Importantly, O'Flaherty called for an independent structured products risk ratings system. "If we fail to self-regulate we will be in a situation where we are regulated by people who don't understand the market. As new market participants enter the space we have to be careful to make sure that the quality of advice and of product design remains," he said.
Interestingly enough, two other speakers devoted a considerable amount of time to discussing risk ratings. Robert Bernstein, president of Chicago-based family office PRISM Partners and Jonathan Heller, managing associate with London-based Heller Associates, told delegates how they are currently in talks with a leading risk-rating company to develop a risk-ratings tool for the structured products market. No details have yet been released, but what this space for further announcements.
Another interesting observation came from Stuart Pologe, New York-based senior vice president with Tremont, who noted that stringent hedge fund regulation by the SEC could push retail investors into buying hedge fund-linked structured products.
Controversially, UBS' Finkelstein said that "we must embrace regulation." After all, he noted, "the most paralysing thing is lack of knowledge. Only though knowledge can innovation thrive. But we must also challenge regulation. We have to ask just how knowledgeable the regulators are about this market - they haven't breathed it like the delegates here today."
Overley, meanwhile, noted that whereas BNP Paribas used to have two main competitors in the fund derivatives space it's now more realistic to put that figure at two dozen. A downward pressure on spreads has led to a focus on new product development and this is where BNP Paribas has excelled, he said. Finkelstein agreed, noting how fee compression has led banks to become solutions providers, working more closely with clients.
Summing up her speech, and in many ways summing up all the speeches from the two-day conference, Brown-Hruska said: "Structured products have some hurdles to cross if they are really going to gain widespread acceptance in the broader US market, as they have in Europe and elsewhere. In my view, education is the key component of that expansion and industry has to take the lead." No doubt the delegates in attendance couldn't have agreed more.