Follow-up fundamentals

The quality of after-sales support and restructuring services offered by structured products providers has been open to criticism. But, as more investors embrace derivatives-based investments and the products become ever more exotic, that function is becoming more important than ever

After-sales support and restructuring propositions that structured products providers offer their institutional clients are under increasing scrutiny. While dealers are proactive in the marketing of new structured products, investors often complain that they are less visible when it comes to follow-up services, such as providing secondary market liquidity, performance reviews and advice on profit-taking or restructuring.

Some banks are now looking to fill this void by improving the after-sales service they offer institutional clients. And with so many products available, enabling investors to take views on volatility, correlation and skew, this function is becoming more important than ever.

"I think you must always have a restructuring dialogue with your institutional investors, but it is generally on the basis of a desire to take profit or reduce exposure to a negative position, or on the basis that their view has changed with respect to the underlying or structure," says William Kennedy, head of European equity derivatives sales and structuring at UBS in London. "We're not going out and trying to readjust their book just for the sake of it."

Dealers, therefore, have to tread carefully when encouraging clients to cash out of a product early. And it seems different dealers have very different after-sales support offerings depending on the structure of their trading book and where their strengths lie.

French banks BNP Paribas and Societe Generale, for example, have traditionally been at the forefront of offering structured products to retail and private banking distribution networks. However, this type of business does not necessarily lend itself to restructuring services - contacting thousands of end-user retail or high-net-worth investors to convince them to cash in their exposure in favour of something new is, in practical terms, nearly impossible.

These banks have, however, started to build up the after-sales services they offer their institutional clients.

Last year, for example, SG approached several of its institutional clients with an idea to restructure existing products to take advantage of the dramatic fall in equity market implied volatility. One client had invested in an eight-year capital-guaranteed product in February 2003 linked to a basket of 20 international stocks, the mark-to-market value of which had risen sharply since March of that year as equity volatilities fell. Accounting rules meant the gains could not be realised on its profit and loss account, but SG restructured the product to give the client a fixed 5% annual coupon for seven years, while a new payout was built to take advantage of any future rise in volatility. The client's position was therefore changed from a vega-negative to a vega-positive one (Risk January 2006, pages 34-35).

BNP Paribas is also increasing its restructuring efforts for its institutional clients. "This has really picked up over the past 18 months," says Jean-Eric Pacini, the bank's London-based head of equity derivatives structured product sales. He adds that BNP Paribas monitors the performance of its clients' products and attempts to explain why the product is performing or not. "Clients are more demanding and sophisticated when it comes to understanding product sensitivities and suitability for different market scenarios. And we know we can provide them with a service that adds real value, either in the form of reporting or bespoke advisory," he adds.

Pacini gives the example of a product that BNP Paribas restructured for a client where the initial exposure was a capital-guaranteed coupon-paying investment designed to outperform when equity markets are relatively flat. This structure paid two relatively high fixed annual coupons of 6% for the first two years, but from the third year onwards, paid a coupon linked to the performance of a basket of stocks with individual caps, but no individual floor, that also had lock-in features.

After the first two fixed coupons were paid, Pacini says an expected subsequent pick-up in dispersion could have been detrimental because of the asymmetrical nature of the coupon - with a cap on the upside. "We then proposed to restructure and switch into a stock basket-linked product designed to benefit from a volatility and dispersion pick-up, as the client receives an uncapped participation in the best-performing stocks while maintaining the capital protection," he says.

But surely convincing an investor that has gone to the trouble of buying a capital guarantee to cash in early - capital guarantees only kick in if a product is held until maturity - is always going to be difficult to sell? By selling out of a principal-protected product early, aren't investors paying a premium for insurance that effectively becomes void? "Even if the capital guarantee generally applies at maturity, the behaviour of the product depends on a wide array of parameters throughout its life," says Pacini.

Large flow-trading banks, such as UBS, Deutsche Bank and Credit Suisse, say the after-sales restructuring service they offer their clients is also evolving. Jean-Manuel Dersy, head of equity derivatives sales in Europe at Credit Suisse in London, says providing a secondary market on as many products as possible is especially important. "All clients now, be they institutional, a private banking client or retail network, will require that you provide a very transparent secondary market in your product, and by doing this you enable your client to manage the product much more efficiently," he says, adding that Credit Suisse offers daily liquidity on the bulk of its equity derivatives products.

Dersy has also had success restructuring products where the client initially gains from receiving a high fixed coupon, but where subsequent gains can be eaten away depending on the performance of an underlying basket of equities. "We have bought back and restructured quite a few where the client wanted to go into something more bullish," he says.

"We're seeing much more demand for multi-asset exposure," says UBS' Kennedy. "Institutions are looking to get involved in hedge funds of funds, commodities and property; these are the types of things we're concentrating our time and structuring efforts on," he says.

Jason Good, head of the institutional client group for Europe at Deutsche Bank in London, says any dealer selling structured products to institutional investors these days needs to offer a thorough after-sales service. "Whether it's an insurance company, a pension fund, a fund manager or a hedge fund, they expect active two-way pricing during the life of the product and regular valuations," says Good. "We maintain in excess of 25,000 ongoing prices, so clients can transact in and out of these products on a fairly regular basis."

However, in Good's opinion, mathematical restructuring has peaked. "People are not buying structured products now because of innovative mathematical payouts," he says. "People are buying them - and this is particularly important in the institutional space - because they have an innovative underlying, or there is an innovative engine for generating alpha around the product."

Good says a lot of institutional clients are looking to restructure in favour of making plays on parameters such as correlation, which have effectively become commoditised during the past few years. "I think the correlation market is now at the point the volatility market was at three or four years ago, and I think the institutional market is now more interested in correlation than it is in volatility," he says. "It's not just hedge funds, either. All the large asset managers and pension funds care about correlation - a pension fund farms out maybe 20 or 30 different mandates, and that carries a lot of correlation risk," he says.

An example of the type of correlation strategy a portfolio manager might look to enter into today would be to take a long position in equity-realised correlation, either through a correlation swap or by conducting a dispersion trade, says Good. The popularity of this type of trade ties in with money managers increasingly looking to differentiate the alpha and beta returns they receive. Alpha generally tends to dry up in high-volatility - and especially high-correlation - environments, such as when there is an extreme market move or market crash. This would negatively affect returns, especially for trading strategies that depend on spreads between equities, such as long/short merger arbitrage. A manager could mitigate this risk by going long equity-realised correlation, says Good.

Dealers say their institutional clients are rapidly becoming more sophisticated and more open-minded. That means a big part of how equity derivatives dealers distinguish themselves from their peers will come down to not just how innovative their products are, but how attentive and progressive is their after-sales support.