The structured products learning curve

Earlier this year, ASIC promised to direct most of its efforts to scrutinising areas such as advice related to structured products. Janine Mace examines the implications of such close scrutiny.

Since the global financial crisis (GFC), calling a financial product ‘complex’ has taken on a whole new meaning.

Rather than clever or innovative, it now conjures up images of risk and capital loss.

It is also likely to be a great way to generate some extra attention from nervous regulators.

As Standard & Poor’s director fund services Rodney Lay notes: “Regulators are taking a very cautious approach given the GFC. The emphasis as an financial adviser is to make sure you understand the product.”

In March, the Australian Securities and Investments Commission (ASIC) announced it planned to direct most of its efforts this year to scrutinising several key areas, one of which included advice relating to structured products.

“In the last 18 months we have seen a proliferation of complex products. A number of these products are highly risky and unsuitable for many consumers. While we will be looking at complex products across the board, we will be focusing in particular on capital guaranteed products.”

The regulator went on to note: “These products are often very complex and generally no two are the same.

If an financial adviser recommends these products to clients, it is vital the adviser fully understands how the products work and carefully considers whether they are appropriate to the client’s circumstances and investment goals.

The financial adviser should also be in a position to explain to the client the risks associated with the product and quantify the potential for loss.”

ASIC also noted it planned to conduct a health check on structured capital protected and guaranteed products, particularly where the client borrowed up to 100 per cent of the investment amount via a non-recourse loan. 

The regulator has acted on its warnings and in July it imposed licence conditions on JB Global following concerns about the advice provided on a number of capital protected products and structured products generally.

ASIC also obtained corrective disclosures from JBG Structured Investments in relation to its JB Global Income & Equity Accelerator Units Series 12, 14 and 15 Product Disclosure Statements (PDSs).

ASIC went on to release its ‘Review of disclosure for capital protected products and retail structured or derivative products’ which looked at the level of disclosure in 64 products in this area.

The report recommended issuers improve their level of disclosure, particularly in relation to explaining counterparty risk, the likelihood of early terminator or other significant limitations, and about the break costs for early termination or redemption.

This close interest by the regulator is unlikely to evaporate, according to HSBC head of sales in global markets Ian Collins.

“Regulators have always been concerned about structured products and that has led HSBC to structure our products at the more conservative end of the spectrum,” he notes.

“However, we may find the rules may be more strictly applied in the future in the face of this concern.”

Synthetic ETFs – bad or just misunderstood?

Although structured products have long been viewed as complex, regulators are also considering applying the tag to certain types of exchange traded funds (ETFs).

In fact, some experts argue the line between structured products and ETFs is blurring. They believe synthetic ETFs (some of which include aspects of ‘financial engineering’) are now more like structured products than the traditional index-based ETF. 

In September, Bloomberg reported European regulators were becoming increasingly concerned that retail investors were buying more complex ETFs in search of higher returns. Anxiety was further highlighted when the $2.3 billion trading loss by a ‘rogue trader’ at UBS AG was linked to ETF trading. 

Steven Maijoor, chairman of the European Securities and Markets Authority, said the demand by consumers for higher returns was seeing the emergence of “all kinds of structured products” in response. “We can see that more and more complex products end up in the hands of retail investors. That’s a concern for us.”

He said new ETF varieties were more complex and the risks for investors and financial stability needed to be analysed. The UK’s Financial Services Authority and the Bank of England Financial Policy Committee have also expressed concerns about the potential impact of these products. 

In Australia, ASIC has added information to its website to help consumers understand the different types of ETFs and their risks.

In launching the guidance, ASIC chairman Greg Medcraft, pointed to the differences between ‘physical’ ETFs which invest in the underlying investments they are designed to track and ‘synthetic’ ETFs which use derivatives such as swap agreements to achieve similar outcomes. 

“While conventional ETFs are often relatively straightforward, there are complexities and risks to be aware of. Furthermore, the use of derivatives by synthetic ETFs creates separate additional issues for investors to understand,” Medcraft noted.

“ASIC is monitoring this area closely and will review thoroughly the introduction of any new types of ETFs in Australia, as some of these can be complex investments that may not be suitable for many retail investors.”

Despite the regulatory concern, Lay believes ETFs are not structured products and points out there are three different types of ETFs: traditional ETFs, exchange traded commodities (ETCs) and exchange traded notes (ETNs).

“I would not consider them structured products. The more standard ETFs and ETNs over gold are not structured products,” he says. 

“The ETNs we will see coming to this market in the foreseeable future will not be considered structured products.”

Path Independent managing director Geoff Watkins takes a slightly different view. 

“ETFs and synthetic ETFs are put together by the same people who put together structured products. The same desk in the investment banks are developing ETFs and structured products. As soon as they are synthetic they are structured,” he argues.

Although regulators may be concerned, Watkins believes there is little to be worried about here. “Australia is relatively safe, but complexity will be looked at more carefully by regulators in the future.”

However, he does sound a warning note. “Regulators need to be careful they do not stop innovation, or confuse complexity with risk.”