Risks of Structured Products
8 January 2016
When you take out a structured investment it’s not usually the issuing bank or insurance company that promises to return your capital or pay the promised returns; instead it buys complex underlying investments from one or more other institutions, often referred to as ‘counterparties’.
If a counterparty were to fail, its agreement is with the issuer, so you have no direct claim on the counterparty and no recourse to compensation.
Banks selling structured products often talk about ‘capital protection’ – but this doesn’t necessarily mean that your money’s completely safe. There are two common types of protection:
- Full protection – also described as ‘100% capital protection’, ‘capital security’ or a ‘capital guarantee’, this means that the minimum that you receive on maturity should be at least equal to the amount originally invested.
- Partial protection – how much of your original money you get back depends on the performance of the index your product is based on and only a proportion – say 90% – is protected by the capital ‘guarantee’.
Structured products are defined as ‘complex instruments’ because of the rules that dictates how each one behaves, and it is important that you fully understand how a particular product is structured before you tie your money up for a not inconsiderable amount of time.
In addition to ‘counterparty risk’ – that the bank or financial institution underwriting the product fails to return your money – there is also ‘market risk’, the danger that a collapse in the market could wipe out your capital.
‘‘counterparty risk’ – that the bank or financial institution underwriting the product fails to return your money’
There has been greater awareness of counterparty risk since the almost unthinkable happened and Lehman Brothers collapsed in 2008; this event more than any other threatened to bring down the entire banking system and holders of structured products backed by the bank lost money.
Whilst structured investments offer varying levels of capital protection, seismic events such as this and the meltdown in markets left investors out of pocket with many claiming to have been miss-sold products by advisers.
‘‘market risk’, the danger that a collapse in the market could wipe out your capital’
One attraction of structured products was the capital protection and limited losses they were believed to offer, but when it did hit the fan, the products couldn’t offer protection enough; lucky investors could prove that they had not been supplied enough information about the risk to which they were exposed, but others had to take their turn with the bank’s administrators.
On such occasions does the small print come to the fore – Lehman’s ‘capital guaranteed’ products were just that – as long as the bank remained solvent; a harsh lesson and a big tick in the box for pedantry and a sharp reminder to make sure you understand exactly what you are buying.
As a result general levels of information and transparency from issuers has greatly improved but as recently as 2012 Santander was fined £1.5 million for selling ‘guaranteed’ structured products in the UK without making it clear that people wouldn’t be fully covered if the firms the bank had chosen to provide the underlying investments failed.
When considering counterparty risk, a useful place to start could be its S&P or Fitch credit rating – AAA indicates that the counterparty is least likely to default and anything above a BBB is considered ‘investment-grade’; in reality it is unlikely that sub-investment grade companies will be underpinning structured products, but it is good practice to check.
Some issuers such as Société Générale spread the counterparty risk around on certain products between Aviva, Barclays, Lloyds TSB and RBS – all rated A or A- by Standard and Poors.
It can only be hoped that the lessons that were learned after 2008 make the possibility of a repeat all the more remote but even if the catastrophic failure of banking institutions can be avoided, there remains a very real that markets could meltdown; the global financial village comes with a very real risk of contagion.
‘the global financial village comes with a very real risk of contagion’
Many structured investments will protect your capital to the point where the index reaches 50% of its value at its inception – this is called its ‘barrier’ – and whilst not common, such falls in the FTSE 100 are not unheard of.
During the financial crisis in 2008, the index fell by just under 48%, whereas in the dotcom crash either side of the millennium, the market fell a whopping 53% making the 36% ‘slump’ of the late 80s look like a minor correction – albeit that it did not feel it at the time.
Another thing to look for is the precise nature of the barrier that exists on a particular products – issuers either apply an ‘American’, or a ‘European’ barrier; although the threshold is usually the same at 50% of the index, the American is considered to have been breached if the underlying index falls below that level at any point during the investment term, whereas the ‘European’ is only broken if the index is below the barrier level at the end of the term.
No doubt that the European is the one to have but Lehmans’ demise has taught financial markets to never say never, and anyone considering investing in structured investments must ensure that they are fully apprised of the risks and understand where the rewards kick in.
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