The trace race

The concept of traceability has been a great success in the food industry. Would its adoption by the structured products industry be the quickest way to restore confidence in European markets and help a shattered banking sector? Participants at last month's Structured Products Benelux conference in Luxembourg believe so. Richard Jory reports

What are the roots of the current financial crisis? Many commentators blame low interest-rate policies, but one should also look to excess liquidity in the system, the governance of incentive schemes, holding excessive risk, illiquidity and flaws in monitoring. So said Hugues Pirotte, academic expert at the Luxembourg School of Finance and professor at the Solvay Business School, citing a list compiled in an extended workshop that opened the Structured Products 2009 conference in Luxembourg on April 21. "If you want to blame someone in particular, why not blame Alan Greenspan, myself, or the Russians," said Pirotte.

"We need to enhance the way we value assets," he said, adding that "structured products are a strategy, not an asset class." But an audience poll revealed that 11% of attendees did in fact view structured products as an asset class and only 50% saw them as a strategy, while 17% said they resembled bonds, 11% said they were closer to stocks and a further 11% saw them as a hedge.

Emmanuel Naim, head of equity structured products at Societe Generale Corporate & Investment Banking (SG CIB), continued with the theme of current markets, and offered some statistical support for the idea that things are not quite as bad as people are imagining. One of SG CIB's offerings is the Codeis (collateralised debt and equity investment solution), which is registered in Luxembourg and allows the issuance of notes backed by securing assets. "The good news is that you can have a rating for the whole product," said Naim.

Talking about implied dividends, Naim said that the Great Depression in the US saw dividends fall by 55%. "The market is pricing in levels lower than that at the moment, and we think this is overly pessimistic. Implied dividends are at a bargain level and offer a distressed opportunity," he said.

"Recovery takes much longer than it takes for the market to go down. The way to play this is to take the long-term view on equity markets and to buy recovery products. It is when investors start selling that you should start buying." Vouching for the usefulness of structured products in uncertain times, Naim stressed how they "strip out the emotional part of the investment".

Return to simplicity

According to Koen Zoutenbier, director of structured products at Kempen & Co, the merchant bank subsidiary of Amsterdam-based Van Lanschot, simplicity is what counts in today's markets (see box). Selling structured products to a client nowadays was like starting a football match five-nil down, said Zoutenbier.

This return to simplicity should include making the contents of brochures and slide presentations easily digestible, he said. At the same time, sellers need to be aware of the increased significance of credit. An audience poll that asked: "How would you classify a 100% capital protected note linked to E-stoxx?" resulted in 56% of attendees saying equity, 33% saying alternative and 11% opting for fixed income. An even clearer demonstration of the change came from a question asking the audience about the risk profile of equities: 65% said they are high risk, 30% said medium risk, and 5% said low risk. Answering the same question in relation to fixed income, 70% of respondents said medium risk, with the remainder split evenly between high and low risk. Thirty-five percent of the audience comprised private bankers, and therefore potential buyers of structured products.

"Structured products are 80% fixed income and 20% equity, but they are perceived as equity when most of the risk is fixed income," said Zoutenbier, suggesting that there was still a definite need for education.

Further deconstruction was to follow from Enno Balz, managing partner in asset management at Sovereign Finance. Balz strove to dismiss the myths that risk can be quantitatively measured, that price equals value, and that financial markets are efficient. "In the old days, banks used to increase in size purely due to inflation," said Balz. "When inflation came down, banks took on a lot more risk than they had before." For 10 years that risk was mainly taken by investing in a sub-prime market that was regularly paying profits of 3%, he said.

Now that some banks earnings are showing signs of improvement and the financial markets are finally reacting to government intervention, the deterioration may have hit rock bottom. But saturating credit markets with new issuance "could cause another liquidity drought in credit, and the long-forecast rise in defaults could rapidly become a reality," he said.

The benefits for investors of investing in structured corporate credit include products that have tailor-made risk-return profiles, cash returns rather than reliance on capital appreciation, and which can be monitored efficiently, said Balz. The tangible benefit is that these products combine a fixed-income return profile with equity-like yields.

As an example, Balz presented the short-term long view in which investors take structured equity positions on corporate credit default swap portfolios with maturities of between one and two years. "Returns can be tailored to almost any kind of risk appetite," he said.

Nicholas Soerensen, assistant vice-president and product manager of global investment solutions at Deutsche Bank in Luxembourg, recommended proactive after-sales service to manage products. An example would be warning investors that they are approaching their barrier and then spelling out the implications, said Soerensen.

Julien Duniague, local head of structured products solutions for Luxembourg at SG Private Banking, and Jeremie Vuillard, associate advisor for equities, interest rates and funds for Luxembourg at the same bank, discussed a series of SG products comprising the Corporate Bonus note, the Switcher note and Autocallable Phoenix note. The Phoenix offers a short-term high return and a high degree of protection, which Vuillard said matched the needs of investors. "Instead of a five-year product that would autocall after one year, we wanted to take advantage of current conditions so we offered a six-month version in April," he said.

The European Commission issued a directive in the final week of April, but Elemer Terta, director of financial institutions at the EC's Internal Market and Services Directorate-General, offered some guidance in the conference's keynote address prior to publication of the directive. "Structured products are too complex and opaque. There is a lack of transparency and a lack of possibility for analysis by investors," said Terta.

The conference concluded with a lively champagne roundtable debate between the audience and a panel including Pirotte, Soerensen and Thierry Seynave, director for financial markets at Banque Degroof. Pirotte said the concept of traceability, which has been successfully introduced in the food industry, could be extended to structured products. This would ensure that all links in the product chain, from creation to distribution and purchase, are aware of which products they are dealing with, where they are from and who made them.

Traceability would go some way towards restoring confidence. "The biggest problem that the structured products industry has today is that people do not trust the banking system," said Seynave. "And they don't want to take any risk on bank names."

Soerensen remarked on the need for a model for the valuation of products. "We need another Black-Scholes. It has its flaws, but it is a global model and everyone is aware of it," he said. "A global model would create more competition and margins would probably fall, but we need to do this to build trust. Margins are large and predictable - we like it that way. But this is a mature business."