Simplicity versus complexity: What are the limits of structured financial products?

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Cheuk Hin Anthony Yu's picture

Structured financial products are now infamous among ordinary citizens. It is an odd phenomenon when we know that it is just a portfolio which may contain ordinary financial instruments like bonds and call options. Therefore, in this essay, we shall look into structured financial products deeply, on why they have such a bad reputation, and whether this reputation is justified.

Structured products became popular among both individual and corporate investors after the dotcom bust in 2000 because of the need to limit risks1, but it gained bad reputation after the Lehman crisis in 2008. Almost all critics blamed structured product as the major cause, and we shall look at their arguments one by one.

First, a common claim is that when compared to other financial products, structured products are less transparent and therefore are dangerous to hold in turbulent times2. However, these products are not really less transparent – they have a certain payout in different situations, which can be clearly stated. What is not transparent is the seller, usually banks, who does not explain every possible situation to investors, for example the case where the counterparty goes bankrupt. This has led to disputes over minibond in Hong Kong after Lehman collapsed. Banks sales claimed to customers that minibonds are high-return substitutes to bonds, while remaining low-risk3. As a result, citizens who are not professional investors bought these risky bonds. These incidents resulted in the bad reputation for structured products, and even resulted in a belief that people who promote structured products must be undercover marketing by banks4. but the product itself has nothing to be blamed for. It is the bank’s fault in causing such disasters.

Some commenters did not make this mistake of hitting the straw man, and correctly point out that since there is a profit ceiling specified when a structured product is designed, these products give less profits than equities in good times5, and less profits than savings accounts in bad times6. Therefore one should invest in equities or savings accounts instead of structured products. This claim is a fallacy of composition. While what the commenter points out is true, it ignores the other side of the story – that structured products give more profits than equities in bad times, and more profits than savings account in good times. Therefore, it is incorrect to state that equities or savings accounts are superior to structured products. In fact, structured products are superior to them in terms of customizability. For example, in times with low volatility, investing in equities or bonds does not give large return. But one can design an index-tracking structured product which can amplify the performance of the index7. Although with higher risk (amplifying the performance means downside risk is also amplified), it is a useful instrument for day-traders of very short-term investments8, who usually cannot do much without a sufficiently large volatility.

Others say the major problem of structured products is its complexity which makes it prohibiting to investors, and sometimes even for financial advisors and regulators. It is true that one may easily overlook the risks of structured products, even for regulatory organizations. However, it is still within the scope of due diligence9, and sometimes financial advisors do not recommend them simply because of their bitter experience in the past10. These products can even be considered simple in terms of their outcome, when compared to equities which may have unpredictable ups and downs11. For example, the outcome of minibonds seems to be ‘unpredictable’ when Lehman collapsed, but it is just the sales who has to be blamed for – they sold the minibonds as if they were guaranteed income bonds. Had the investors not just listening to the sales’ words, but also their financial advisor’s, they would have been able to understand their whole array of choices (and probably would buy low-risk products because they bought minibonds when they were misled to believe that those are low-risk high-return products).

There is even an argument that says large investment banks only sell structured financial products, but never buy them, so they are necessarily bad choices. This is logically wrong12. Moreover, the wide variety of structured products implies that every diversified portfolio held by banks very likely contain structured products, while the components are not explicitly tied.

After looking into the arguments attributed to structured financial products, we can see that they are either incorrect, or are not really attributed to structured products. In fact, most of the scandals related to structured products originate from dishonest selling strategy. Therefore, what we can conclude is the adverse commentary on structured financial products comes from its complexity, which allowed sellers to deceive customers by not telling the whole picture. This was true last decade, and regulators often overlooked these problems until some kind of crisis occurs and the problem emerges. However, seeing the potential problems, regulators like FSA made it mandatory for structured product sellers to disclose the counterparty13 (because structured products lose their value if the counterparty goes bankrupt), and implemented various measures to raise the level of due diligence regarding structured financial products. In Hong Kong, banks began to keep audio records of their sales’ explanation of financial products to customers as reference in case of disputes. This movement towards stricter regulations reduces the risk of receiving insufficient information regarding the product. Therefore, it is anticipated that the reputation of structured products among informed investors will gradually improve.

Bibliography

  1. Baht, Shrikant (2009). Taking stock of structured products. The Business Times. Retrieved 17 November 2012, from: http://business.asiaone.com/
  2. Currie, Maike (2009). How safe are structured products? Investors Chronicle. Retrieved 17 November 2012, from: http://www.investorschronicle.co.uk/2011/11/11/tips-and-ideas/trading-ideas/how-safe-are-structured-products-GKiqSd0F1Zn1ime0AFRpzK/article.html
  3. Wikipedia (2010). 雷曼兄弟迷你債券事件. Wikipedia. Retrieved 17 November 2012, from: http://zh.wikipedia.org/wiki/
  4. An example of this belief can be seen in the comment by Harry Katz under the article ‘Adviser “dogma” has limited take up of structured products, says analyst’: http://www.ifaonline.co.uk/ifaonline/news/2185526/uk-advisers-dogmatic-structured-products-analyst
  5. Currie, Maike (2009). How safe are structured products? Investors Chronicle. Retrieved 17 November 2012, from: http://www.investorschronicle.co.uk/2011/11/11/tips-and-ideas/trading-ideas/how-safe-are-structured-products-GKiqSd0F1Zn1ime0AFRpzK/article.html
  6. Gibbs, Daniel (2012). A Critique of Structured Product Critics. AdvancEquities. Retrieved 17 November 2012, from: http://advancequities.com/en/the-latest-news/headlines/88-headlines/291-structured-products.html
  7. Collins, Hannah (2012). Leveraged products see steep declines in Europe. Risk.net. Retrieved 17 November 2012, from: http://www.risk.net/structured-products/news/2216646/leveraged-products-see-steep-declines-in-europe
  8. Collins, Hannah (2012). Leveraged products see steep declines in Europe. Risk.net. Retrieved 17 November 2012, from: http://www.risk.net/structured-products/news/2216646/leveraged-products-see-steep-declines-in-europe
  9. Gibbs, Daniel (2012). A Critique of Structured Product Critics. AdvancEquities. Retrieved 17 November 2012, from: http://advancequities.com/en/the-latest-news/headlines/88-headlines/291-structured-products.html
  10. Brittain, Nicola (2012). Adviser 'dogma' has limited take up of structured products, says analyst. IFAonline. Retrieved 17 November 2012, from: http://www.ifaonline.co.uk/ifaonline/news/2185526/uk-advisers-dogmatic-structured-products-analyst
  11. Brittain, Nicola (2012). Adviser 'dogma' has limited take up of structured products, says analyst. IFAonline. Retrieved 17 November 2012, from: http://www.ifaonline.co.uk/ifaonline/news/2185526/uk-advisers-dogmatic-structured-products-analys
  12. Chu, Kris (2012). 「我只賣我會買的東西」. 哲學哲學雞蛋糕. Retrieved 17 November 2012, from: http://phiphicake.blogspot.com/2012/10/blog-post_10.html
  13. Financial Services Authority (2010). Quality of advice on structured investment products. Financial Services Authority. Retrieved 17 November 2012, from: http://www.fsa.gov.uk/pubs/other/qa_structured.pdf