FREE: The five hottest structured finance products of 2012

Author: | Published: 14 Feb 2012
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In a difficult economic market with low interest rates, widespread austerity measures and a substantial volatility, it can be difficult to get a grasp on where the structured finance market is heading in 2012.

However panelists at IFLR’s Structured Finance and Derivatives Forum at the Grand Connaught Rooms in London on February 9 were brave enough to give their thoughts on where the market was heading.

Julian Velarde, head of derivatives London, CIB legal at BNP Paribas said it’s important to first understand the drivers from an investor and issuer’s perspective.

Investors are looking for three elements from their structured products: a reduction of issuer risk, especially financial institution risk post-Lehman; increased transparency; and less leverage.

Issuers and distributors on the other hand are driven by the need to comply with new regulation, protect their margins and raise funding and liquidity.

Other drivers will be Europe’s ageing population and the concurrent dismantling of final salary schemes, and increasing wealth and therefore interest from the developing world.

1. Segregated or collateralised programmes

Programmes that are segregated or collateralised are already popular, and it’s likely to stay that way, according to Velarde.

Segregated programmes allow investors to have a pure exposure to clearly -defined risk and should strip out issuer risk. Collateralised programmes are similar – investors take exposure to the full credit of the issuer but also get collateral in part or whole.

"We believe both of those structures will be very successful in 2012," said Velarde.

Regulatory change is likely to be a complicating factor however. The European Market Infrastructure Regulation (Emir) will require compulsory clearing, and these products usually have a derivatives component between the SPV issuer and sponsor bank.

"So where those derivatives are relatively vanilla they will need to be cleared, and where they’re not vanilla they may require bilateral collateralisation," he said.

In addition, segregated programmes may not be able to use the intra-group exemption in Emir as they typically use an orphan SPV.

Darren Greenberg, director and senior legal counsel at the Royal Bank of Scotland said collateralised programmes can be beneficial, but it’s important to look at the collateral backing the programmes.

Collateral rated AAA is good but can be scarce, making it more expensive and potentially impacting the investor.

"I query whether that AAA collateral can be used in a cost effective manner for the investor," said Greenberg.

2. Fundraising products

All structured finance issuance raises funds, but some structures raise more than others.

Banks will be the key issuers of these fundraising products, said Velarde. In particular, this year is likely to see segregated programmes established by smaller entities (who are not normally issuers) accessing the capital markets to effectively provide investors with a product linked to their credit.

An SPV issuer under a segregated programme will issue securities, take in the funds, and can then invest a large part of those funds in a deposit with the small bank, which may well be the distributing bank.

The SPV then invests the rest of the proceeds in a derivatives product with a sponsoring bank. This gives investors a pure risk product tied to the credit risk of the distributing bank.

"In order to strip out the sponsoring bank credit risk you can have collateralisation of the derivatives product, and at the same time provide small banks with funding. That’s got to be a win-win situation," said Velarde.

3. Yield-providing products

In an economic environment with low interest rates and where leverage is out of fashion, investors will be on the lookout for yield. According to Velarde, one way will be to invest some of the upside in the performance of the underlying in exchange for a higher yield.

Another way is to combine a number of different risks; rather than multiplying risk with leverage, he said, some investors may look to take on more than one risk in any particular product.

Selling credit protection is one example, although this can only be used for sophisticated investors.

"But we do see sophisticated corporate buyers coming to us and saying 'we’re happy, or happier than the market, with the credit risk of our sovereign, so we’re willing to sell credit protection on the sovereign as part of this product," he said.

But regulatory change is likely to cause problems – for example, short selling regulations are likely to restrict the short selling of sovereigns.

4. Products that provide diversification

Despite increasing correlation across asset classes, diversification is still seen as a useful way of maximising yields, said Velarde.

There are three ways to achieve this. First, by using multi-asset proprietary indices that are built around a number of different classes of asset.

Second, by using managed account platforms that can be similar to classic fund of funds but without the Madoff risk.

Finally, by using managed algorithmic funds which use an algorithm to select the best performing proprietary indices for a particular economic set of circumstances, and have a human being involved for when markets move in strange ways.

Again, the problem is that regulators have a growing suspicion of proprietary indices, he said, with product intervention and greater transparency more likely.

"The other element is algorithmic trading, which is going to become more difficult and which Mifid 2 will probably regulate to a greater degree," he said.

5. Compliance-based products

The final structured products likely to be popular in 2012 are those designed to comply with the rules of a particular market.

While these products will in essence be simple, interestingly Mifid II will have the effect of classing these products as complex, said Velarde.

Finally, with banks facing pressure on margins, he predicted a move towards e-business and click-to-trade using iPad applications.