A view on 2007

Viewpoint

Richard Burns, Citigroup's London-based global head of equity derivative structured products and hybrid products

The global structured products business continues to experience strong growth, and we expect that trend to continue in 2007. A surge in the number of transactions with smaller average notional sizes is driving this growth. The result is that the industry is adapting to improve transaction processing capabilities and to find ways to reduce deal issuance costs. One factor that dealers have in their favour is that this surge in volume coincides with a reduction in the emphasis on bespoke payouts as more investors are opting for simpler, standardised payouts.

Regulators are playing an increasingly important part in driving change within the industry. Greater focus on roles and responsibilities during the product manufacturing and marketing process will lead to closer partnerships between distributors and product providers. Manufacturers and distributors will spend more time evaluating suitability and appropriateness issues, and establishing procedures for deal selection, sales training, and investor education. This will not only affect the selling process at point of sale but also carry through the life of the product.

E-commerce applications for structured products will also grow in 2007, as dealers seek efficiency gains in distribution and communication. Services providing pricing, book-building, investor education, performance reporting, and secondary trading will all evolve. Web development could ultimately lead to more centralisation and the emergence of virtual exchanges for secondary trading of structured products.

Demand for multi-asset products will continue to expand due to the continued attractiveness of asset diversification combined with the ability to achieve cross-asset correlation exposure. Industry participants' capabilities in pricing and risk management of multi-asset derivatives will no doubt advance to meet growing demand.

As the market for structured products grows beyond institutional investors and the volume of structured product issuances continues to increase, structured products attract more attention in the mainstream and business press. Articles commenting on structured products refer to them as the "quirkiest vehicles on the Street" (Business Week) or "arcane investments" (The Wall Street Journal). Meanwhile, an increasing proportion of these products are directed to retail investors.

We also are seeing more products that are not principal protected, as well as more variety in payouts and in reference assets, including more commodity-linked instruments. Structured products as an "asset class" or investment alternative are competing with mutual funds and exchange-traded funds for allocations in the portfolios of high-net-worth investors. All of these developments have piqued interest on the part of regulators, both in the US and Europe.

For 2007, we can expect that regulators will remain focused on structured products. So far, most of the regulatory initiatives have come in the form of recommendations or advisory statements and have not been prescriptive in nature. Unless industry participants respond to this increased scrutiny with proactive steps that demonstrate a commitment to best practice in the sales and marketing of products regulatory initiatives may become more aggressive.

Following publication of the Financial Services Authority's discussion paper in the UK, various industry groups collaborated on a response. The discussion among participants about the responsibilities of providers and distributors for marketing retail structured products in a fair and transparent way was helpful in identifying current practices and highlighting issues that arise during the marketing of structured products. Discussions of this sort provide market context for regulators - hopefully this additional information will result in informed regulatory guidance that leaves room for innovation. Through such interactions, market participants also develop increasing awareness of the areas of risk that may eventually lead to industry wide problems.

Although some industry participants have expressed concerns about the creation of 'best practices', it is important to bear in mind that the structured products market is not particularly well understood by many regulators. As a result, self-policing by industry participants may lead to a more vibrant market.

Similarly, initiatives such as that by JP Morgan Securities and the Structured Products Association relating to the standardisation of US retail structured products may go a long way toward addressing consumer protection and other public policy concerns. In the aftermath of the dotcom crash, financial institutions have tried hard to recapture the attention of investors by marketing innovative new products that provide new ways to play the markets and are tailored to suit every possible risk-return profile.

Clients are becoming ever more knowledgeable, interested, and demanding in relation to investments. As a result, the past few years have brought about an unprecedented increase in the range and variety of underlying assets and payout structures.

Much of the added value for investors has historically come in the form of innovations in payout structures, customised to benefit from given market environments. As of today, the main payout structures seem to be relatively well established, and we see innovation in 2007 mostly coming from applying these payouts to new underlying assets.

One solution in which we see a lot of growth potential is relative performance investments. The strong performance of the past three years raises some concern about the future direction of markets, but relative performance products free investors from worries about a downturn. Credit Suisse's Beta Yield Note, for example, pays enhanced coupons in any situation and is capital protected as long as the underlying doesn't underperform its benchmark index by more than a certain percentage, independently of general market performance.

Looking at the payout, the Beta Yield Note is nothing new - it is a variation of the well-established reverse convertible structures with conditional capital protection. The innovation lies in the fact that the capital protection depends on a relative performance versus the benchmark instead of an absolute performance. Relative performance underlyings may prove very popular in an increasingly nervous market environment.

Another asset family poised to become more important next year is that of dynamic indexes. In the past, tools used by professional asset managers aimed at discovering undervalued companies and industries were available solely to institutional investors. But recently, some financial institutions have started to offer their stock-picking expertise to private and retail clients via structured products.

Given the creativity and dynamism in the structured product industry, 2007 promises to become yet another year full of innovation and added value for investors.

Opportunities for 2007

1. The convergence of the structured products and asset management businesses presents both issuers and investors with a significant potential opportunity to improve and broaden the delivery of innovative solutions to investors.

2. Structured products are uniquely positioned to provide innovative, outcome-based solutions for the 'baby-boomer' generation as they enter retirement and their investment goals increasingly shift towards capital preservation and income generation.

3. An improvement in the scope and quality of structured product education and marketing building upon the use of free writing prospectuses that debuted in 2005/06 will play out in 2007.

4. 2007 will mark a greater cross fertilisation of structured solutions between Europe and the US as investment banks properly organise their global structured product businesses.

5. There will be an increased acceptance of structured products as investors and financial advisers seek new sources of alpha and non-correlated investment returns.

6. Innovation around products that combine inexpensive sources of beta with novel, non-correlated sources of alpha will also prove popular.

Threats in 2007

1. The inability of the structured products industry to simultaneously deliver quality education while providing a coherent, well-organised product suite may hamper growth.

2. The inability or unwillingness of the structured product industry to simplify both its product offerings to broaden its target audience beyond the current niche status could also cause concern.

3. A failure to successfully move product offerings beyond reverse convertibles would leave the structured product industry as more of a 'one-trick pony' than a broad-based business.

4. The continuation of a low interest rate/low volatility market increases the challenge on issuers to produce attractively structured and priced products.

5. Finally, a continued challenge of overcoming public misconceptions and lack of understanding of structured products may hamper prospective industry growth if not adequately addressed.

In a context of low volatilities across asset classes and flat interest rate curves, the evolution of the structured derivatives market will have to look at new payouts and asset classes to design appealing investment products. Despite the low option premia implied by the current volatility environment, there is little investor interest for buying simple upside optionality because of the general perception of low risk. This is not entirely consistent with downside skew risk, which remains expensive, particularly in the equity markets. This means that interest in products that exploit skew dynamics will also remain marginal.

In terms of new payouts, the emphasis will once again be on correlation. After years of trades in intra-asset class correlations such as equity baskets or leveraged interest rate steepeners (both single and multi-currency), the market should focus on inter-asset class risks. In particular, equity and interest rates represent a relatively easy to grasp combination. With rates moving upwards, capital guaranteed products have increased up-front margins, greater still if we consider the context of generally low premia. This excess spending power can be invested in correlation up-side with a view to creating interesting yield enhancement opportunities for investors.

This poses a challenge to structurers, because of the complexities of modelling both asset classes in a consistent way and of developing a correlation framework which values the effects of simultaneous contingency. Estimating plausible correlation levels before a sufficiently liquid market will develop will pose an interesting challenge, which only the best players will manage to tackle with acceptable risk/return profiles.

On the new asset class front, longevity risk might finally take off with some experts predicting a market size one day comparable to that of the credit derivatives market. The overlap between risk management in the capital markets and actuarial techniques from the insurance world can be exploited to create a class of risk which already exists in substantial sizes and opposing interests.

If longevity is defined as life expectancy, pension funds are short longevity risk, while life insurers are long. This creates an opportunity for intermediaries to take on risks from one counter-party, transform them and pass them on to the other. Creating sufficient liquidity pools will add value to this market and this invariably depends on the ability to find a commonly accepted risk management framework.

It is early days for such pricing model convergence, however the comparison with credit derivatives might not end just with the potential market size. Pricing techniques might transfer and be re-adapted to create a potentially vast new market. Again, only innovative, flexible players will be able to participate in this new challenge with profit. David Kemp, Zurich-based director in the UBS Islamic Finance GroupIslamic finance will continue to be a major theme in 2007, driven by enormous wealth creation, particularly in the Middle East and South-east Asia (although Europe and North America also show strong demand for sharia-compliant products).

The potential size of the market is vast, with Islamic assets estimated - perhaps conservatively - to be between $300 billion and $500 billion and forecast to grow at 15%-20% per annum. However, of this liquid financial wealth in the the Gulf region, only about 15% is invested according to sharia principles. The disparity between available liquid financial assets and the percentage invested in sharia-compliant assets might be due to several factors, including the shortage of product - both in terms of asset class and tenor - which in turn contributes to the lack of a liquid secondary market.

This year will see the continuation of a number of the themes that were evident in Islamic finance in 2006, namely:

n innovative structured products accross an an ever widening range of Islamically acceptable asset classes;

n increased sukuk issuance from Islamic and conventional issuers, with a wider geographic spread; and

n the development of a genuine secondary market in Islamic products.

Islamic investors are seeking sharia-compliant investment solutions with economic characteristics similar to conventional products, and with tenors that complement existing products by filling the maturity void between short-term murabaha and longer-term sukuk.

In 2006, the market saw several participants respond to this investor demand by launching innovative structured products. For example, UBS developed a sharia-compliant issuance platform from which it launched tradeable commodity-linked investment certificates. Using this platform, UBS will extend the product range in 2007 to augment the existing commodity, FX and equity products by adding additonal asset classes - real estate for example. UBS will not be alone in extending the depth and range of sharia-compliant structured products and would expect to see continued collaboration between Islamic institutions and conventional investment banks to leverage off the former's distribution capability and the latter's structuring and execution expertise.Heiko Geiger, data and analytics at Deutsche Börse in FrankfurtThe European structured products market in 2005 was marked through an overall 22% growth compared to 2004. The German Derivate Forum expects for the end of 2006 an open interest in structured products for the German market of E110 billion. This reflects a growth rate of more than 35%. According to Swiss National Bank figures, the open interest for September 2006 in the Swiss market was about E160 billion compared to E128 billion the year before which indicates a growth rate of 25%.

The main drivers we have seen in 2006 look like they will continue into 2007. Issuers constantly want to extend their product portfolio, and this extension is basically done in two ways. One is to offer more complex and exotic structures and payout profiles. The second is to introduce new - mainly index-based - underlyings. Due to the currently high correlation of small-, mid- and large-cap equities, as well as developed countries and emerging markets, we expect product portfolio extension through new asset classes that exhibit lower correlations. The main focus is on commodities. Institutional investors such as hedge funds, pension and endowment funds heavily invest in this asset class. Strongly-rule based and transparent commodity indexes such as the new CX Commodity Indexes from Deutsche Börse provide valuable added-value as tradable underlying for structured products. Further drivers are hedge funds but also tradeable private equity as well as tradeable real estate.

Whereas we have already seen initial delta-1 products in these asset classes, the next generation of these alternatives will be based on respective investment strategies. Taking into account regulatory frameworks like MiFID and Ucits III indexing is still going to be a major investment issue. Exchange-traded funds as well as structured products will further diversify with strategy indexes but also indices based on new investment trends or styles. Therefore we expect strong demand for new index-based underlyings and growing market share of index-based structured products.

We are also seeing a consistent trend towards emerging markets and Brics investments, and sector-driven investment approaches such as alternative energy, infrastructure and biotechnology. The structured product lifecycle starts with active-managed funds and equity baskets as underlyings, but is already - or soon will be - substituted by new indexes (for example, DAXglobal Bric, DAXglobal Alternative Energy, and so on).

Rules-based, transparent and liquid indexes can provide tremendous added-value because it allows the structuring of products. So, investors are able to invest with valuable features like bonus-levels, outperformance-features or capital protection instead of delta-1 long-only investments. The third generation of Bric products underline the combination of capital-protection and emerging market investment. Mike Fullalove, co-head of the international equity derivatives team at Nomura in LondonSeveral key trends dominate the discussion about what to expect for structured products in 2007. These trends include the need to take into consideration the differing interests of the end user, the continued opportunity for growth in different and new marketplaces as well as the changing regulatory climate with regard to product structures and wrappers.

Right now, there are definite movements in the market that could potentially be both positive and negative for the structured products industry. A key force, as always, is the investor. The market has seen a continued interest for more protection driven and income generating products in the major developed markets, which have more aging populations. While this market still will seek alpha-producing strategies, there will be a growing need for income particularly as large groups of the population choose to retire. This is in contrast to some developing economies, where a younger and newly emerging middle class is hungry for the opportunity offered by more performance-driven structures.

Opportunities exist for pioneers in both spaces. Some successful examples have been the rapid growth in Singapore's private banking industry as well as the exponential growth in the number of high-net-worth individuals in emerging markets such as Latin America, Asia and the Middle East.

There is also strong opportunity for growth in the number and type of Ucits III funds as regulators become more familiar with this wrapper and the opportunities it presents for product innovation and begin to compete to offer faster and more expedient approvals of these products. In addition, more and more markets - particularly outside the EU - are opening up to these structures in recognition of the hallmark of quality that Ucits certification denotes. For example, Switzerland, Hong Kong and Singapore have all established fast-track approval procedures for these funds.

The continued expansion and acceptance of Ucits III products in both the asset management and investment banking worlds will also continue as a trend in 2007.

Threats

To balance the positive movement in the marketplace with regard to the increased acceptance of structured products, there are still some lingering questions about complexity and the potential for opaque structures that can slow down the review and approval process with regulators. If these concerns are not correctly addressed by structured product providers, for example in their marketing literature, this may cause regulators to clamp down on certain types of products.

Another area of concern is regulatory delays leading to lost opportunities for structurers and investors. The delay in the CESR's timeline for its consultation on the eligibility of hedge fund indexes in Ucits III products has already slowed progress in a key area for structured products.

Other threats that could effect the success of the structured products markets in 2007 are more macro in scale and could arise in the form of a major hedge fund collapse, poor equity market performance, a recession in the US, or even a more widespread global slowdown. However, all of these events, despite their drastic nature, have the possibility of being turned into opportunities for the structured products market with the support of protected products that can weather such storms.

Roger Studer, head of financial markets at Vontobelin Zurich

The shift towards investing in certificates will continue this year. This trend is embedded in a considerably longer one, which started several years ago. In the 1990s, the listed derivatives market in Switzerland was typically dominated by leverage products. This started to change after 2001, and the amounts of traded certificates has grown constantly since then.

A second key factor in the continuing growth of structured products holdings during 2007 will be their use in a portfolio management context. More and more investors include structured products in their portfolio holdings, for several reasons. One of the key advantages of structured products is that they can be tailored to meet specific objectives, in terms of both return and risk, offering different levels of both exposure to upside potential and downside protection. Structured products can also be used to give investors access to an asset class that they weren't previously exposed to or didn't feel comfortable with.

Commodities are a good example of this. Clients who aren't exposed to commodities in a traditional portfolio may want to diversify their assets without incurring risks of capital loss and they can do that through capital-protected structured products. This is the reason for what has changed since 2005 in the underlying asset class of structured products. The past year has seen a marked change in the emphasis of client demand, from interest rate-based products to equities, commodities and emerging markets.

Where once structured products centered on equities and bonds to provide the underlying assets, now ever-more exotic financial assets are coming into play, driven by increasingly sophisticated investor demand. Products based on interest rates, commodities, real estate or combinations of different asset classes, or products providing complete capital protection or partial protection with differing levels of participation in the upside, are increasingly used by clients in their portfolio management context. This aspect will be a main driver in the upcoming years of the expanding demand in structured products.

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