THE EUROMONEY
INTERNATIONAL DEBT CAPITAL MARKETS HANDBOOK
2013
A global issuer’s perspective on
structured products
by Michael Bennett1, World Bank
The last few years have not been kind to the structured products
industry. The global financial crisis that began in 2008 with the implosion
of the US sub-prime mortgage-backed securities market threw an often
harsh public spotlight on structured products. Ratings downgrades,
steep price declines, defaults and disputes involving various structured
products, from collateralised debt obligations (CDOs) to structured
municipal swaps, all have drawn public and regulatory attention to a
market that previously had attracted little comment and only light
regulatory supervision.2
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Many regulators now consider any complex financial bankruptcy led to losses on these notes, it became evident
product inherently suspect. This reaction is that many of the investors had not adequately appreciated
understandable given the scale of the collapse in some of all of the risks of their investment in minibonds. 3 Incidents
the most complex segments of the structured products
market, in particular sub-prime mortgage-backed CDOs. It
is also a predictable response of regulators who
themselves have come under strong criticism for their
failure to foresee the problems that developed with some
of these products. Because simpler products are simpler to
regulate, it is not surprising that regulators would prefer to
see a general reduction in the complexity of financial
instruments.
Certainly not all criticism of structured products has been
Michael Bennett
unwarranted. Structured products have been sold to
investors that were not able to understand fully the risks. Head of Derivatives and Structured Finance
In Asia, for example, Lehman Brothers, prior to its collapse World Bank
in 2008, distributed through local banks multiple tranches tel: +1 202 458 5099
of complex credit linked notes known as ‘minibonds’ to
fax: +1 202 477 8355
almost 100,000 individual investors in Hong Kong,
email: mbennett1@worldbank.org
Singapore and Taiwan. When the Lehman Brothers’
CHAPTER 4 I EUROMONEY HANDBOOKS
like these, where structured products have been sold of the World Bank’s experience as a frequent issuer of
improperly, have contributed to the regulatory bias in structured notes.
favour of simple financial instruments.
Notwithstanding such incidents, structured products What are structured products?
remain useful and important investment and hedging tools.
Structured products are financial instruments with cash
On the investment side, they permit investors to earn
flows that depend on the value or performance of
enhanced yields and obtain exposure to assets and
underlying assets or embedded derivatives. 5 They are
markets they may not otherwise be able to access. A
customised financial products that permit parties to meet
hedge-fund return-linked structured note, for example,
specific risk-return objectives that cannot be met using
offers investors both the opportunity to earn a higher yield
only traditional instruments, or to hedge exposures that
than they could with a straight bond and exposure to an
cannot be adequately hedged using only plain vanilla
asset class – hedge funds – that is generally accessible
instruments.
only to the wealthiest investors. Likewise, insurance-linked
structured products allow investors to receive insurance In some cases, a structured product is composed of two
premium-type returns by taking exposures that have plain vanilla instruments, such as a zero coupon bond and
traditionally only been accessible to insurance companies. a call option, that could be purchased separately. The
principal benefit of packaging the two elements into a
As a hedging tool, the complexity of structured products
single structured product is convenience for the investor.
reflects the reality that the risks faced by many investors
are themselves complex. Consider, for example, a US
Other types of structured products are more complex.
Some of these products are composed of a complex set of
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investor that holds a euro-denominated bond issued by
risk elements that would be very difficult for an investor to
French company X, and it is the only euro-denominated
compile on its own. Others provide investors exposure to
security in the investor’s portfolio. The investor would like
types of risks or markets that they could not invest in
to enter into a swap to exchange the euro payments it will
directly. There are structured products linked to interest
receive under the bond for US$, but obviously will not
need that swap to continue if company X defaults on the rates, foreign exchange rates, commodities, credit risk,
bond. The investor could enter into a credit-linked, euro- inflation, carbon, insurance, hedge fund returns and many
US$ swap with a dealer that terminates automatically if other underlying variables, as well as hybrid products that
company X defaults on any debt obligation. Although such combine some of these variables into a single product.
a swap would be relatively complex, it would also better
meet the investor’s specific hedging objectives than any
The World Bank as an issuer of
plain vanilla product could.
structured notes
As a result, and despite the criticisms, there continues to
The World Bank has been issuing bonds in the
be strong institutional and retail investor interest in
international capital markets for more than 60 years to
structured products.4 In fact, given the extent of the losses
fund its activities as a global development organisation,
suffered by investors during the financial crisis, the yield
and in recent years has issued about US$35bn of bonds
enhancement offered by structured products may make
per year.6 It seeks to diversify funding sources by offering
them even more popular in the coming years as investors
bonds in different markets, currencies, maturity structures
seek to rebuild their damaged portfolios.
and formats. As part of that diversification strategy, the
In this article, I examine certain of the key issues with World Bank issues a variety of types of products including
respect to structured products in light of the experience of benchmark bonds, plain vanilla medium-term notes in core
this market during the financial crisis. I also highlight some and emerging market currencies, as well as structured
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notes. The types of structured notes the World Bank issues embedded in the product, the complexity of the structure
range from simple callable notes to more complex may make it difficult for the investor to determine with
structures linked to equity or bond indices or multiple precision how market movements will impact the product’s
currencies. value.
Issuance of structured notes is largely driven by reverse- Given that some investors may not be able to properly
inquiry from dealers and investors, and the terms of the price structured products or fully assess the embedded
notes generally are customised to meet specific investor risks, it is essential that dealers take their investor
needs and preferences. In a typical year, structured note suitability obligations seriously and restrict the sale of
issuance represents roughly 25% of the World Bank’s total these products to investors that do not have such
funding programme. As a frequent issuer of structured limitations. In order to do so, dealers must ensure that
notes and a leading AAA-rated name in the international their sales professionals have sufficient training to
capital markets that understands the franchise value of its understand fully the embedded risks in structured
reputation as a responsible issuer, the World Bank products.8 If salespeople lack the skills to evaluate the
constantly strives to raise standards and promote good price and risk of a structured product, they obviously
practices in the structured products market. cannot make an informed judgment that the product is
suitable for their customers.
Certain key issues with structured Moreover, dealers must carefully evaluate the distribution
20 products chains they use to sell structured products. In many cases,
products are created by one bank but distributed to
Investor suitability
customers through other institutions. 9 Such a distribution
‘Investor suitability’ is the term used to describe the duty
chain is common for structured products, since the ability
of licensed securities dealers to recommend investment
to create these products tends to be concentrated in large,
products that are suitable to their clients, in light of the
international banks while their sale to end customers is
clients’ investment objectives and financial means.
often handled by smaller local or regional dealers. With
Although the precise nature of the investor suitability
such a chain, the salespeople making the investor
standards varies by jurisdiction, some obligation of this
suitability determinations may not even be employed by
type exists in all major securities markets.
the same institution that created the product. As a result,
Structured products pose particular difficulties for dealers that originate these products must be vigilant in
securities dealers seeking to satisfy their investor ensuring that sufficient knowledge about the products
suitability obligations. Because these products generally filters down through the distribution chain to the
include embedded derivatives, at a minimum an investor salespeople who are ultimately facing the end customers.
needs to know how to value options in order to price them.
Many dealers respond to the limitations on the ability of
Investors also need to have some understanding of the
salespeople to understand fully all types of structured
correlation among the various elements of a structure in
products and the reality of distribution chains by asking
order to gauge the valuation impact of having these
investors themselves to certify that products are suitable
elements packaged together into a single product. 7
for them. Such a certification generally takes the form of a
In addition, less financially sophisticated investors may fail statement inserted into the product’s sales material which
to appreciate fully the risk of loss they are taking when provides that the investor understands the product and
they purchase structured products. Although the investor has deemed it to be suitable given the investor’s own
may understand in general terms the nature of the risk circumstances.10
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Although obtaining such representations gives some Conflicts of interest
comfort to dealers, the investor suitability obligations Numerous conflicts of interest can arise in the structured
imposed in most major financial markets put the obligation products market. Most of these conflicts stem from the size
on the dealer to make this determination. The rules do not of the dealers that are most active in this market. They
suggest that the dealers can effectively shift this obligation tend to be large, global institutions engaged in many
to the investors themselves by asking the investors to different business lines, from creating structured products
certify that products are suitable for them. It is, after all, to providing investment banking advice and asset
the dealers who are expected to have the professional management services. Given the breadth of their
experience and expertise to evaluate financial products businesses, these dealers are taking thousands of different
and determine their suitability for a particular investor’s positions in various markets every business day. Some of
portfolio.11 Therefore, dealers should consider such these positions may adversely affect the returns on the
representations as an additional form of comfort, but not structured products the dealer has sold to customers.
as a substitute for the dealer making its own determination
Consider, for example, a dealer that creates a credit-linked
about suitability.
note that provides investors with a long position on
As a frequent issuer of structured notes, the World Bank company X. As long as company X does not go bankrupt or
takes investor suitability very seriously. We require each default on any of its outstanding obligations (either of
dealer that underwrites one of our note issues to represent which is defined to be a ‘credit event’), the note will pay a
that it has determined that the investors have the financial high rate of return to the investors. If, however, company X
capacity to bear the risk associated with investment in the
notes and sufficient knowledge and experience to evaluate
does suffer a credit event, the note will redeem early for
less than 100% of the principal amount. Imagine as well
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those risks. Depending on the risk of a structured note, we that the dealer is separately an important lender to
will also set the minimum denomination high enough that company X, and that company X’s business is dependent of
we are comfortable it could only be purchased by investors its ability to keep receiving loans from the dealer. If the
with significant assets. dealer terminates its credit lines to company X, that action
could cause company X to have a credit event and
However, we do not believe that a dealer can rely solely on
consequently for the credit-linked note to be redeemed for
an investor’s asset size in determining investor suitability.
less than its par value, creating a loss for the investors.
When it comes to evaluating the price and risk of
structured products, it is not clear that the size of an A similar result could occur if, rather than being an
investor’s asset base is always a good proxy for knowledge important lender to company X, the dealer’s investment
and expertise.12 banking division was hired by company X as an investment
adviser at a point in time when company X was facing
Even many investors with relatively large portfolios may
extreme financial difficulty. If the dealer, in its capacity as
invest almost entirely in plain vanilla products, such as
investment adviser, reviewed company X’s financial
stocks and fixed rate bonds, and have little or no
situation and advised company X that is best option was to
experience with structured products. Moreover, as
file for bankruptcy protection, the bankruptcy filing would
mentioned earlier, structured products come in an almost
similarly be a credit event that would lead to a loss on the
infinite variety. It would be unrealistic to expect even a
credit linked notes.
large and very knowledgeable investor to have expertise in
all structured product areas. Therefore, dealers must In order to effectively manage and mitigate the impact of
continue to exercise their judgment with regard to investor these sorts of conflicts of interest, dealers that originate
suitability even when selling structured products to large and sell structured products must have processes in place
institutional investors. that allow them to identify the conflicts. 13 Establishing such
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processes is difficult, given the size of the dealers that are investors did so not because of any defect in the
most active in this market. For example, there are practical embedded derivatives or otherwise in the structure, but
limitations on the ability of a structured products division rather because of significant declines in value of the
within a large global institution to know all of the underlying collateral. Many dealers, for example, used
relationships and market positions that are maintained by their own bonds as collateral for the structured products
their institution as a whole. The structured products they originated. When the creditworthiness of the dealers
division may be physically separated from the corporate deteriorated or, in the case of Lehman Brothers, collapsed,
lending and investment banking divisions in a different the market value of the collateral underlying their
building or even a different country, and may also be structured products declined, leading to losses on those
separated by so-called ‘Chinese wall’ regulations from products.
sharing information with those divisions. Therefore,
effective management of conflicts requires oversight at the Given this experience, many dealers are now looking for
highest management level of the dealer where senior safer securities to use as collateral for structured products.
managers have access to information from all of the One option that has been used is World Bank bonds. In the
various divisions. catastrophe bond market, for example, dealers need
collateral that is both safe and easily liquidated in the
When the World Bank works with a dealer to underwrite
event a specified natural disaster occurs. 14 To meet those
and market one of our structured notes, we seek to
requirements, World Bank putable bonds have been
identify upfront all of the actual and potential conflicts of
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utilised for a number of transactions since 2009. A World
interest that dealer may face. To the extent possible, we
Bank putable bond provides the security that comes from
will eliminate conflicts. For example, we may enter into a
the World Bank’s AAA credit rating and also guarantees
swap with the dealer in a connection with a structured note
liquidity through the put option that is provided to the
under which we pay the dealer a floating rate of interest
investor.
and receive from the dealer an amount equal to the coupon
on the note. In such a case, we generally do not permit the
dealer to act also as calculation agent under the notes, Conclusion
since the note calculations will determine what the dealer
owes on the related swap. For other types of conflicts that The global financial crisis has been blamed in part on the
cannot be eliminated, we require full and clear disclosure increasing complexity of financial instruments, and has led
in the note documentation. many regulators to consider ways to curb financial
innovation.15 Complexity, however, is not an inherently evil
Collateral characteristic in a financial instrument. Rather, it is often
Many structured products involve the use of the special just a natural, necessary consequence of tailoring an
purpose vehicles (SPVs) that are required to hold instrument to meet an investor’s specific needs and risk-
collateral. For example, an SPV will issue a note in which return objectives.16 In addition, over the past few decades,
the cash flows that repay the note are generated by the the structured products market has grown to encompass
SPV entering into a swap or other type of underlying products that reference a wide variety of underlying
transaction. The SPV will use the proceeds of the issuance variables, including equity index returns, inflation rates,
to purchase collateral that will act as security for the notes
commodity prices and even mortality statistics. As these
and be the source of the principal repayment.
variables are complex, structured products that reference
The global financial crisis highlighted the importance of them are naturally complex as well. It would be wrong,
the credit quality and liquidity of that collateral. In many therefore, to assume a financial instrument is
cases, structured products that generated losses for inappropriate merely because it is complex.
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Complex products are not appropriate for all investors, notes and nature of the risks associated with investment therein and
that they have sufficient knowledge, experience and access to
however, and the sale of such products places a
professional advisers to make their own legal, tax, accounting and
particularly strong duty on dealers to ensure they treat financial evaluation of the merits and risks of investment in the
their investor suitability and conflicts of interest notes, and that they consider the suitability of such notes as an
investment in the light of their own circumstances and financial
obligations seriously and pay close attention to the quality
condition’.
of collateral that secures the products they sell. Issuers of 11 Asking for such representations may also put the investor in a
structured products must also be vigilant in impressing on difficult position, since professional investors may feel uncomfortable
dealers their expectations regarding investor suitability refusing to attest that they have sufficient expertise to understand a
financial instrument.
and conflicts of interests. Finally, investors must honestly
12 On the issue of ‘sophisticated investor’ exemptions from dealer’s
assess their ability to understand and value structured investor suitability obligations, see, e.g., Gillian Tett, Sophistication
products as part of their investment decision-making debate heats up, Financial Times, May 6, 2010.
17 13 Many dealers use very general disclaimers that attempt to cover
process. If all market participants live up to these
every possible type of conflict of interest that may arise. A typical
obligations, structured products should come to be seen statement of this type, in the context of a credit linked note,
for what they are: valuable investment and hedging tools provides: ‘The dealer may deal with and engage generally in any kind
of commercial or investment banking or other business with regard to
for investors that have the requisite expertise to
the reference entity in the same manner as if any and all notes did
understand them. not exist, regardless of whether any such action might have an
Notes: adverse effect on the reference entity.’ Although such language is
1 The author is the Head of Derivatives and Structured Finance in the broad enough to cover almost any action that a dealer could take in
the market, it is so broad that it arguably does not constitute
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World Bank Treasury. The findings, interpretations and conclusions
expressed herein are those of the author and do not necessarily effective disclosure of any particular action.
reflect the views of the World Bank or its affiliated organizations. 14 A catastrophe bond is a natural disaster related insurance-linked
security. In a typical catastrophe bond structure, a sponsor enters
Portions of this article are included in the author’s article Complexity
into an insurance contract with an SPV that issues bonds to capital
and its Discontents: Recurring Legal Concerns with Structured
markets investors. The SPV invests the proceeds of the bonds in
Products, NYU Journal of Law & Business, Vol. 7:811 (2011).
collateral and transfers the return on the collateral, along with the
2 See, e.g., Jason Paez, Defusing financial weapons of mass
insurance premiums paid by the sponsor under the insurance
destruction, Huffington Post (February 15, 2010).
contract, to the bond investors as the periodic coupon on the bonds.
3 For a more complete description of Lehman Brothers minibonds, see
If a specified natural disaster occurs during the term of the bonds,
Freshfield Bruckhaus Deringer, Briefing: An Overview of the Lehman
the SPV liquidates the collateral and uses the proceeds to make a
Brothers Minibonds Saga (December 16, 2008).
payment to the sponsor in accordance with the terms of the
4 On the growth of the structured products market following the
insurance contract. In such a case, the investors suffer a loss of their
financial crisis, see John F. Wasik, An Investment for the Experienced ,
principal.
New York Times, October 20, 2010, at F8.
15 Many of the regulatory changes that were introduced in the wake of
5 The UK Financial Services Authority defines a ‘structured investment
the financial crisis will make it difficult for dealers to create complex
product’, in part, as one in which the return ‘is linked by a pre-set
structured products. For example, new derivatives regulations in both
formula to the performance of an index, a combination of indices, a
the US and Europe will impose higher capital charges on dealers with
basket of selected stocks or other factors or combination of factors’. respect to their derivatives transactions that cannot be settled
6 During its 2012 fiscal year (July 1, 2011 to June 30, 2012), the World through a central counterparty. Since many types of complex
Bank raised over US$39bn through 296 separate bond issues structured products involve embedded derivatives that will not be
denominated in 23 different currencies. clearable with a central counterparty, these rules will add to the
7 On the price transparency of structured products, see, e.g., Aline van costs of such products, and may make some types of structured
Duyn, Derivatives Transparency is Key Battleground , Financial Times products prohibitively expensive. For an overview of relevant
(March 11, 2010). regulatory changes that were introduced after the financial crisis,
8 See, e.g., Quality of Advice on Structured Investment Products, UK see, e.g., The impact of financial regulatory reform on structured
Financial Service Authority, October 2009. products, Morrison & Foerster News Bulletin, June 29, 2010.
9 For example, before its collapse in September 2008, Lehman Brothers 16 It should also be noted that a simple structure does not guarantee
distributed its structured products through more than 600 third-party that a financial instrument will be a good investment, as plain vanilla
distributors (US Structured Notes Update, MTN-I, August 29, 2008). products are capable of causing losses as great as complex ones. For
10 A typical certification of this type provides: ‘prospective purchasers example, as many investors lost money on the relatively easy to
of the notes should ensure they understand the characteristics of the understand plain vanilla equity and bonds of financial institutions
CHAPTER 4 I EUROMONEY HANDBOOKS
that were involved in the sub-prime mortgage business in the US as
lost money on complex sub-prime mortgage-backed CDOs. Contact us:
17 For an institutional investor looking to purchase a new type of
World Bank
structured product, many different people within the investor’s
organisation will need time to be educated about the structure, from 1225 Connecticut Avenue NW, Washington,
the portfolio manager who makes the investment decision, to the
DC 20433 USA
back office staff that need to know how to book the product in the
firm’s systems to the accounting staff that must understand how to web: debtsecurities@worldbank.org
account for it.
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CHAPTER 4 I EUROMONEY HANDBOOKS