Manufacturing and Managing Customer-Driven Derivatives. Qu Dong

Europe, the regulation on Key Information Documents (KIDs) for Packaged Retail and Insurance-based Investment Products (PRIIPs) has been adopted by the European Council (EC). It will be deployed by end of 2016, and it is aimed at increasing market transparency for retail investors. PRIIPs covers investment funds, structured deposits and life insurance policies with investment elements. Retail investors will be provided with compulsory information on all products intended for them, and KIDs will be required to explain clearly all the risks associated with the investment products. KIDs must contain risk and performance scenarios and cost disclosures. The risk matrix and risk scenarios need to be shown and explained very clearly to investors.

      The new mandatory KIDs for PRIIPs must comply with a set of uniform rules on the format as well as content, to enable better understanding by retail investors. It will include the features of the product, including whether the capital is at risk, cost and risk profile and relevant performance information. The format, presentation and content of KIDs should be calibrated to maximize retail investors' understanding and to allow them to compare different PRIIPs. As a pre-contractual information document, KIDs will be required before retail investors buy an investment product offered by a bank, an insurance company or an investment fund. KIDs will have to indicate what the product invests in, what its risks and potential rewards are and what total costs will be during the product's life cycle. It will cover a wide range of investment products that retail investors can buy through banks, financial intermediaries and on the internet. KID is designed to offer better disclosures about the features, risks and costs of products. Its more standardized information can facilitate easier comparability among investment products.

      EC has made exemptions, and the new regulation on KIDs will not be applicable to the following product categories:

      • deposits (only structured deposits and securities will be subject to KIDs);

      • non-life insurance products;

      • life insurance contracts whose benefits are only payable upon death or in the event of incapacity due to injury, sickness or infirmity;

      • pension schemes that are officially recognized;

      • pension products whose primary purpose is to provide investors retirement incomes;

      • individual pension products whereby an employer contribution is required.

      Distribution Channels

      Traditional and modern distribution channels include bank branches, financial advisers, money managers, public distribution on exchanges and e-platforms. The often observed trend is that the volume per product becomes lower, but there are many more small tickets. This, together with the fact that we are in the internet age, have made e-platforms an essential part of the modern distribution mechanism. Single issuer e-platforms have automated production and distribution process and substantially reduced costs. Also emerging are the independent multi-issuer platforms, which either supplement or compete with in-house e-platforms, providing investors a single marketplace.

      Each distribution channel has its own purposes and features. Through intermediary, it is typically supply-driven, rather than explicit demands from end-consumers. The end-consumers are increasingly bypassing the intermediaries to buy directly from banks and retail distributors. Public distribution for listed products, including covered warrants are mainly for vanilla products. However, the trend is a more homogenous distribution channels with increased share of e-platform. Multi-issuer platforms have become a trendy subject, and both sell-side and buy-side institutions are increasing the infrastructure investment in the field.

      In line with the natural evolution of financial e-commerce, practitioners need to position themselves to capitalize on the internet- and technology-driven distribution landscape. Financial e-commerce platforms can enhance transparency, choices and convenience for customers. It will become a core part of the modern integrated wealth management service and distribution model.

      Chapter 3

      Financial Risk Management, Basel III and Beyond

      Needless to say, derivatives business is not just about pricing and trading. Financial risk management and the banking global rule book Basel III play essential and overarching roles. Executives must manage the derivatives business in line with the economic and regulatory capital requirements, and seek to optimize risk-adjusted overall business performance.

      Risk Measures and Financial Rule Books

Risk measurement and economic and regulatory capital management are crucial parts of the business. Apart from risk sensitivities for hedging, such as Delta Gamma Vega, a range of other risk measures and quantities are also the essential ingredients of day-to-day risk management activities. Table 3.1 itemizes some of such essential risk measures and quantities:

Table 3.1 Essential risk measures and quantities

      The activities on these risk measures and quantities are not only driven by best practices, but also financial regulations including tighter capital adequacy rules and stricter collateral requirements for un-cleared derivative trades. Financial rules and regulations have become key elements in the derivatives business, and they are gaining increasing importance. They are among the key drivers for risk management modernization and more efficient and reliable risk infrastructures. It is therefore vital to understand the relevant regulations and their implications on the derivative business, with a view to optimizing capital usage and risk/return.

      Basel III

      Basel III (Basel 2010, Basel 2013) is a comprehensive set of reform measures that are designed to strengthen the regulation, supervision and risk management of the banking sector. It was developed by the Basel Committee on Banking Supervision as the global banking rule book, and endorsed by G20 countries. While Basel III sets the international standards and rules, they need to be adopted and implemented by individual countries or jurisdictions. In Europe, Basel III is implemented through the legislative package Capital Requirements Directive IV (CRD IV), and the associated Capital Requirements Regulation (CRR).

      Basel III has profound business and quantitative impacts on a number of frontiers:

      • Capital: Laying down stricter capital rules for the financial firms, with detailed requirements on the quality of capital, capital loss absorption and minimum capital ratios and buffers. The capital ratio is defined as:

      where RWA is a risk-based capital measure and its calculation involves risk models and methodologies designed to capture all key risks. RWAs include credit risk as well as market risk RWAs, linking the capital treatments directly to the financial risks including derivative risks. Operational risks also contribute to RWAs.

      • Leverage: Setting prudent leverage ratio limit to avoid excessive leverage in financial institutions and in financial systems. The leverage ratio is defined as:

      where Total Assets include on- and off-balance sheet assets, and they are not risk-weighted. Setting a floor to the leverage ratio will force financial institutions to optimize assets and capital, in conjunction with RWAs.

      • Liquidity: Setting adequate liquidity standards and defining the important liquidity measures, including short-term Liquidity Coverage Ratio (LCR) and long-term Net Stable Funding Ratio (NSFR).

      • Systemic risks: Addressing systemic risks within the financial systems and proposing some regulatory incentives to mitigate them. It covers the topics of counterparty credit risk (CCR), provision of capital incentives for using Central Counterparties (CCP), higher capital requirements for systemic derivative instruments, usage of contingent capital, collateral, trading book, securitization, reputation and operational risks, etc.

      • Management and supervision: Addressing management principles and policies, firm-wide governance, supervisory policies and practices, market discipline including transparency and disclosure, and remuneration policy.

      Solvency