Over the last five years, portfolio managers seeking to enhance returns have increasingly turned to over-the-counter (OTC) structured products. On paper, these products are an excellent way to fine-tune the reward-to-risk payoff. Upon execution, however, trustees and pension fund managers may not realize that the marketplace dealing risks can be incalculable, thereby jeopardizing the expected return.
What is an OTC Structured Product?
Before we examine the nature of this market, we need to understand what an OTC structured product is and why such products were created. OTC products are simply investment products that are not dealt (traded) on a regulated exchange. Asset-backed commercial paper is just one example.
There are a variety of well-defined functional entities that support the creation, distribution and consumption of the product, such as investment banks, investment dealers and brokers, hedge funds and traditional asset managers. Depending on the client, these entities can also play the role of both product wholesaler and retailer. Banks, hedge funds and financial companies can play roles as suppliers and manufacturers, as can clients.
What niche do these products fill in the investment marketplace? Consider the following scenario.
XYZ Bank has $50 million of a certain type of asset (for example, second mortgages), which currently sits on its balance sheet. Due to the higher risk of these assets, they are more expensive to finance and maintain from a regulatory capital perspective (that is, the bank’s margin requirement). There are 25 counterparties associated with this asset type pool, each for a loan amount of about $2 million.
XYZ Bank decides that it no longer wants to have these assets on its balance sheet, nor does it want to create a structured product in the bank’s name, as that would still require direct funding by the bank. Rather, XYZ Bank would prefer to have those assets bundled up, housed and funded by a completely separate entity. The bank can do this through a special purpose vehicle (SPV).
SPVs to the Rescue
An SPV essentially provides a bank (and the banking system) with an option as to how it wishes to house revenue-generating assets. This option is critical as it provides a safety net for the maintenance of balance sheet risk measures—primarily around regulatory capital adequacy—for specific banks. It also provides the flexibility to maintain revenue streams from assets that are originated by a bank, but don’t necessarily fit the bank’s business profile.
While the bank may have a direct ownership interest in the external SPV, the bank is no longer exposed to the vagaries of risk attributes associated with those assets. Therefore, it receives the revenue from those higher risk assets, but not the risk.
At this point, the OTC product has essentially become the financial equivalent of a security, which has capital returns/losses and income returns/losses just like any other security. And even though this new security has been derived from something else, it is now ready to act as the underlying security for other financial instruments, such as indexes and derivatives.
Information Asymmetry
In the OTC marketplace, established professionals who know who the natural buyers and sellers are will profit at the expense of newcomers. A natural buyer would be an entity that typically provides liquidity to the transaction in exchange for the product. A natural seller would be the entity that provides the product to the transaction in exchange for liquidity.
New participants may not realize that, due to information asymmetry, profitable dealing in the OTC market requires dealing in a series of one-way transactions across counterparties to cost-effectively achieve the desired positional outcome.
Those familiar with the markets can interpret market direction, tone and other valuable price-dealing signals at the expense of inexperienced counterparties. Moreover, not only do manufacturers of OTC products create instruments that suit their firm’s wants and needs, they have insight into the overall market through their market-making activities. This aspect of information is sorely missing for those who are new, or relatively inactive, in the OTC structured product market.
Market Meltdown
It would appear that there is a serious disconnect between the act of creating a financial instrument, and the ability to efficiently deal in it—witness the disruptions of certain areas of the OTC market in 2007. Whereas many other financial markets have long been supported by the benefits of a multilateral trading environment, this is not the case for the OTC structured product market.
Massive liquidations of financially engineered securities—which act both as underlying securities and derivatives, and whose intrinsic value is directly connected to the trading and valuation activities in multiple physical marketplaces and multiple marketplace types—were impossibly expected to occur immediately. The market for these securities—securities that may have taken days, if not weeks, to create—was being battered and squeezed by valuations of instruments two or three times removed.
It’s easy to understand, then, why experienced managers working for reputable investment banking operations could not determine the value of these securities. When this seemingly wellestablished inter-bank market for liquidity and credit evaporated, the marketplace broke down, leaving all participants with unaccountable systemic risk that couldn’t be managed effectively through traditional risk measures.
However, while the breakdown has highlighted fundamental flaws in how this market operates, one shouldn’t assume that the products themselves are inherently flawed. The nature of the OTC market is the real issue.
Playing the Game
Some believe that simply participating in the OTC structured product market is part of the risk and have invoked caveat emptor (“buyer beware”) to those who deal in it. But to summarily apply caveat emptor toward the professional conduct of risk in a financial marketplace regulated by federal governments not only denigrates this process and its parties, it also completely eviscerates the original intention of risk management in the first place.
Certain benefits—including the sourcing and sinking of liquidity, the ability to quickly discover prices and the immediate, rapid transfer of risk—naturally flow from the existence of an efficient and transparent, but anonymous, multilateral dealing facility. These benefits simply do not exist in a bilaterally negotiated, cleared and settled OTC market.
The current bilateral dealing model for OTC products is not an efficient model. While many experienced players have built valuable franchises arbitraging inefficiencies on dealing alone, self-preservation and selective dealing can be at odds with the intermediary role expected of these participants by global central banks.
Let’s look at a simple example. If Seller A sells Buyer B a second-hand car, the odds are that he or she doesn’t want the car back. But if Seller A is regulated by the federal government to deal in second-hand cars, Seller A will take the car back…at his or her price. So Seller A makes money on buying and selling used cars, even if the market for them isn’t that liquid. If Seller A can choose which cars to deal, the terms and with whom to deal, it is always in a position of strength compared to Buyer B. Ultimately, this leads to a marketplace imbalance, creating adverse side effects for all buyers.
Nevertheless, until a new model is created, participants must co-exist within the current framework. To reduce the systemic risk for all market participants, new entrants will need to engage resources with the depth of experience to deal with counterparties and the efficiency equal to that of more established market players.
Staying in the Game
With the move in Canada toward active portfolio management, pension funds and money management firms are searching for new investment areas to secure greater non-market correlated returns, and the OTC structured product market is one of them.
Success in this market requires a cohesive, holistic approach across business, operations and technology. All counterparties should have access to the information, dealing, booking, clearing and settlement people, processes and systems needed to participate—and succeed—in OTC structured product deals.
Mark Waugh is director, capital markets and risk, with Stratix Consulting in Toronto. mwaugh@stratix.ca
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