Tidjane Thiam, CEO of Credit Suisse
The long and largely uneventful life of the XIV – the VelocityShares Daily Inverse VIX Short-Term exchange-traded note (ETN) – and its sudden and fiery end at the start of February amid surging US stock market volatility provides a reminder of how big a business structured notes have quietly become in the years since the financial crisis.
Many banks now issue billions of dollars each year in such notes, tying in dependable intermediate maturity liabilities at low cost and often earning fat fees in the process. Monthly new issue volumes are measured in hundreds of billions of dollars.
Structured Retail Products puts the global market’s outstandings at $2.4 trillion, but it is probably bigger: some sales to accredited investors in the US under 144a are not reported. It could be a $3 trillion market.
Credit Suisse, issuer of the XIV note, has of necessity been playing down its significance since accelerating it after it lost 80% of its value in a single day. The note was a bet on volatility staying low.
At the start of February, with investors growing nervous that the US Federal Reserve has fallen behind the curve on inflation and that rates will rise faster than generally expected, volatility went through the roof. And, poof, the XIV note, first issued in 2010, was gone.
It’s really not material, we can say that very, very strongly. Not material- Tidjane Thiam, Credit Suisse
Credit Suisse has said it suffered no trading losses itself, thank goodness. On its most recent earnings call, chief executive Tidjane Thiam said of the revenue impact of the episode: “It’s really not material, we can say that very, very strongly. Not material.”
Pressed on potential legal exposure to investors who did lose money, Thiam points out that the XIV was a short-term hedging instrument for very sophisticated market participants and that the prospectus made this clear.
“It says things like your ETN has zero long-term value,” he says. “That’s in the prospectus. It says things that like if you invest for more than one day, you are likely to lose all or a substantial portion of your investment.”
Thiam confirms: “It’s a one-day trading tool.”
No doubt compliance officers at Credit Suisse will have been anxiously checking to see if any relationship managers were unwise enough to recommend buying and holding the XIV note to their ultra-high net-worth (UHNW) clients as a way to boost returns by betting on volatility staying low for an extended period.
The XIV note is not, in any case, a good example of how most structured notes, whether exchange traded or privately placed, work. They tend to be buy and hold instruments, not traded ones.
They have become a popular way for banks to issue low-cost funding and for investors, often HNW and UHNW private banking clients, to take exposure to returns from generally rising financial markets while still depending on the bank issuer to pay back their principal.
They’re not deposits. Of course they’re not. No one should ever say that, because bank deposits are their own special class of liability with associated regulation and protections for retail customers. Let’s just say that with volatility low and options cheap, some issuers and buyers have at times treated them almost a bit like deposits, just ones spiced with a bit of added risk and return for the grown-ups.
It was a market that almost died after Lehman went bust, because Lehman itself had been a big issuer of structured notes. It has recovered as quantitative easing boosted most markets and bank issuer risk receded. Big issuers include the likes of Barclays, Credit Suisse, Goldman Sachs, JPMorgan and UBS in the US market; BNP Paribas, Commerzbank, Deutsche, HSBC, Natixis, Société Générale and UBS in Europe.
They and many other banks issue structured notes that their own investors request, and sometimes make these available for other banks to distribute to their clients in turn.
Many structures do allow for loss of principal – as well as zero return – if markets fall below a certain level. Structural complexity has increased with many more reverse convertible notes. However, most consist of a bank issuing a zero-coupon bond – so low-cost finance – while buying and selling a combination of options, usually on stock indices.
The bank hedges its risk of paying this return at the wholesale market rate and passes it onto the buyer at a retail mark-up. The issuer also charges fees. Notes can have caps on returns, floors on downside protection, and all manner of combinations of such collars. A single note can reference several market indices and might not pay out if just one falls 30% or more.
With inflation rising in the US, concerns growing about whether equity valuations can be sustained by strong earnings if interest rates continue to rise and about the recent spike in volatility, the structured note market is already changing.
“Rather than clients asking for notes based on exposure to broad market indices, we are seeing more interest now in risk-managed products such as notes tied to a portfolio of alternative manager returns,” one head of private banking tells Euromoney.
Risk appetite hasn’t entirely disappeared, though. “Of course, if clients want a bit of leverage we can structure those with warrants,” he says. Euromoney is relieved to hear it and delighted the bank is so dedicated to satisfying client needs.
Another private banking head says: “A potential issue for us is that, though they have medium-term maturities, most structured notes have regular call features, often annually. As markets have risen, we have invariably called them, re-set strikes and re-issued at higher terms. Investors have been happy to be bought out from a winning position and then put it back on.”
He doesn’t say it, but his bank has also charged investors repeat fees for this, of course. “It remains to be seen if that rhythm of regular calls will persist now and what the impact may be on treasurers and investors if it doesn’t,” this banker says.
I had a problem with the lack of transparency in the market and the fact that it was available only to the very wealthiest families. It is also very inefficient, very manual intensive- Jason Barsema, Halo Investing
It’s not a transparent market. Jason Barsema, a former Credit Suisse private banker, is trying to change that with a multi-issuer platform called Halo Investing for trade execution that now curates up to 6,000 structured note ideas referencing hundreds of underlyings, including indices, stocks and exchange-traded funds.
Barsema, co-founder and president of Halo, set up the platform because he had seen at Credit Suisse the benefit to his wealthy investors from structured notes, but also the complexity in dealing in them and the limits on price discovery and secondary liquidity.
“At Credit Suisse, my team was a large buyer of the bank’s structured notes from March 2009 onwards,” he says, recalling: “We were long a lot of cash. There was a feeling that if the markets fell another 40% then we were all toast anyway. And structured notes offered a big bullet coupon and big upside if they rose.”
After his first purchase, he became a convert to defined outcome investing.
“It doesn’t much matter what the documents a bank signs with ultra-high net-worth investors actually say, their typical verbal instructions are: ‘Make me 5% to 7% a year, and don’t lose my money’,” Barsema says. “Investors can currently get a 9-plus% yield on structured notes linked to major indices, subject to the issuer remaining solvent, with no losses even if the markets fell 35%.”
While Barsema agrees with asset allocators who suggest most long-term savings should be in stock index and total return bond funds, he sees room for maybe 20% or so in instruments such as structured notes.
However, he says: “I had a problem with the lack of transparency in the market and the fact that it was available only to the very wealthiest families. It is also very inefficient, very manual intensive. And that is what makes the fees so high; to compensate for the issuing banks’ high cost of production.
“In addition, the products lack liquidity. The treasurer of a big bank doesn’t want to buy back $50,000 of some note just because one of its wealthy clients needs cash, but there is no truly efficient secondary market. And issuer risk is rather concentrated.”
He insists: “The good news is that all of these market structure problems can be solved with technology.”
Barsema says it can cost up to $7,500 per instance for a US bank to issue a structured note off its registered shelf documentation because it has to get outside legal and tax opinion on each offering and also compensate a transfer agent for custody and clearing. His platform aims to automate the process and drive down those costs sharply.
“Right now, if a UHNW client wants a structured note, he tells his relationship manager or registered investment adviser (RIA), who contacts the bank, which then contacts the bank’s treasury, and trading, and legal, and compliance and risk. We can automate that process, consolidate it, while pricing structures in milliseconds.
“We believe we can cut banks’ issuance costs by 80%, and we want those savings to go to the end-customer.”
However, there’s upside for issuers too.
Barsema says: “To the benefit of banks, we think we can take orders from prospective buyers in smaller amounts where it’s worth a bank issuing for $100,000 or less, ultimately significantly increasing their flow. Most important, we can bring these products to people who need them the most, which is the retail and mass affluent investor.”
Halo has 10 US issuers using its platform that receive alerts as to the structures potential buyers are enquiring for.
Barsema says: “Today investors might be able to see a handful of issuers and compare their terms. Our platform allows a more dynamic process whereby issuers can real-time improve terms to bid for investor participation.
“We did a big note recently for a registered investment adviser structured on a multiple of the return on two underlyings, which started with potential issuers offering 210% uncapped, and on which investors were able to walk away in the end with a note paying 300% of the underlying. That RIA now has a client for life.”
Halo is not a distributor, but rather a financial technology platform that might eventually become an alternative trading system. It does take some responsibility for suitability, even though issuers and RIAs that source notes for clients through the platform can apply their own suitability screens.
While Barsema believes the whole structured note market is one that should be democratized and opened up to more issuers and investors, what is he seeing that causes concern?
“We could process any structure, but Halo limits the ones we handle,” he says. “We’re seeing more proprietary indices as underlyings, which concerns me. We’d also begun seeing more exotic structures when volatility and rates were low, but with technology advances, investors can still get very attractive terms without all the complexity.”
Barsema has other concerns though.
“We won’t be doing levered ETNs or any structures that rely on being able to roll over futures which may become so expensive that even if the index moves in the investors’ favour they still don’t make money,” he says.
“We’re seeing more complex features being added, like contingent coupons where you can get knocked out if the underlying falls below a certain level at any point, even intra-day, rather than on the coupon date. We won’t have those, nor structures that apply multiples of the loss below the level of downside protection.”
Rather, Barsema says: “We’re concentrating on simple income and growth structures with participation in the upside and some downside protection.”
If Halo delivers, it might benefit bank issuers and also become a platform they might want to provide to their HNW investors in structured notes on a white-label basis. European banks are already looking at this. It could become a marketplace for banks to trade each other’s structured notes, which doesn’t much happen today.
And Barsema also has his eye on another group.
“We believe we have developed an efficient process for non-bank issuers also to sell structured notes,” he says. “More details will be coming on this throughout 2018.”
Why shouldn’t large, well-rated corporates benefit from their brand name recognition and borrow more through structured notes?
It’s a good question, but it sounds like the key lesson from a fan of the structured note market is that buyers should still beware. Always.