Manufacturing and Managing Customer-Driven Derivatives. Qu Dong

banks may compensate investors if products default. Whether the “implicit guarantee” holds when default happens or it is simply a misunderstanding on the investors' part, can only be decided when a real default case sets a precedent. Nonetheless, when the credit-risky fixed coupon products paying much higher yields are perceived as guaranteed by banks, investors will go for those products rather than banks' deposits of similar maturities.

      Another main wrapper for structured products is structured deposits. These are aimed at Chinese domestic savers and investors. Providers can also issue through the QDII (qualified domestic institutional investors) scheme, which allows Chinese institutional investors to invest abroad. Through QDII, these investors can be introduced to some of the best-selling structures abroad.

      Both customers' investment needs and banks' desire for alternative funding drive the rise of the issuance of WMPs. It is true that some investors are looking at the return side of the high-yielding WMPs without paying adequate attention to the associated risks. They are drawn by the expected return rate and the implicit capital guarantee, while the risks in products are often overlooked. However, investors' increasing awareness of credit risks in the fixed coupon products will shift their attention to the structured products in the WMPs family.

      The liquidity needs can encourage banks to raise cash through the issuance of WMPs targeted at deposit-rich companies and households. China regulatory framework is also evolving, and it can have significant impact on the product issuance. For example, the introduction of the asset management plan pilot scheme by the regulator triggers a volume increase of alternative funding products via the structured product channel.

      Overall, the biggest demand for structured products is from the retail investors, accounting for about 70 % of the total notional. Institutional investors have a market share of around 20 %. The remaining gap is filled by private banking customers etc. Insurance companies have become a potential driving force for structured products, following the introduction of new relaxed rules by the China Insurance Regulatory Commission (CIRC) over the use of derivatives for hedging purposes by insurers. Insurance companies can now use OTC options and swaps to hedge market risks on their equity holdings or lock-in profits from winning open positions.

      Regulatory Development

      China Securities Regulatory Commission (CSRC) in 2012 gave the green light to banks and securities firm to issue structured products, provided it is risk-neutral, namely they are collateralized and have no risks on issuers' books.

      In order to better control the risks associated with alternative funding through WMPs, the regulator recently introduced the use of asset management plans (AMPs) among domestic banks. AMPs will not be able to assign expected returns to their offerings and providers of such products are required to regularly publish net asset values, and disclose the underlying assets backing the products. Specifically, under the AMPs scheme:

      • banks can sell asset management plans directly to customers, instead of via other local banks;

      • an implicit guarantee of principal and yield by WMPs in the form of expected return is removed;

      • banks earn an explicit management fee simply by issuing asset management products to customers, instead of implicit fees from the spread between the actual return and the cap promised to investors;

      • banks no longer have to use third-party intermediaries to structure off-balance products. As publicly-traded instruments, the asset management schemes provide enhanced transparency to investors.

      Key Products and Trend

      The payoffs of structured products in China are much simpler than their counterparts in the West. Vast majority of the issuances are capital-protected vanilla products, and typical embedded options are call, digital, up-and-out call (shark fin), etc. The popular underlyings are gold, FX, interest rates (Shibor-linked) and some equities. Most of the products are typically very short-dated (3 months or 6 months). Investors had preferred short-dated products because of their higher flexibility and liquidity. However, there are severe limitations on short-dated products in terms of market exposures and potential higher returns. As the structured products market becomes more mature and investors have a better understanding of the products, the dominance of short-dated products is being contested by a gradual trend for longer-dated (more than 1 year) products. Longer-dated products allow investors not only higher expected returns, but also exposures to more underlyings including commodities, domestic and overseas equities.

      Chinese investors tend to pay more attention to yield than the underlying. Up to now the global product offerings involve underlyings that are mostly overseas assets. The choice of domestic stocks as suitable underlyings for the structured products is limited but expanding. Since the introduction of future contracts on the SSE (Shanghai Stock Exchange) Composite Index, the stock market underlying has become a reality, again mostly for short-dated products ranging from a few days to two years. In February 2015, China introduced its first exchange-listed option on Exchange Traded Fund (ETF). The option underlying Huaxia SSE 50 ETF tracks the performance of the SSE 50 index, which consists of 50 blue chip stocks. The introduction of ETF listed options is an important step forward in the development of China's listed and OTC derivative markets. It facilitates hedging, price finding and market transparency, allowing practitioners to build more reliable implied volatility surfaces for example. It is expected that after ETF options, stock index options and single stock options will be introduced in due course on SSE and SZSE (Shenzhen Stock Exchange). Structured products based on blue chip stocks will be boosted as a result.

      China's OTC Shibor-linked derivatives market is also expanding. Standardized Shibor-linked vanilla derivatives have also been rolling out. Standardized Shibor-linked derivatives can be used as interest rate hedging tools, and will facilitate interest rate liberalization in the country through enhanced market transparency. Some of the latest examples include 1-month OIS based on the overnight Shibor rate, 3-month swap based on the one-week Shibor rate, 3-month swap based on the seven-day repurchase rate and 3-month Shibor FRA. These provide standardized points of reference, catering for the growing demand for more efficient trading and hedging of interest rate risks from practitioners, including structured products issuers.

      It is clear that structured products based on local currency and local underlyings will become popular in the future, when domestic market hedging capabilities are built up. As China is also undergoing interest rate liberalization, high-yield fixed income products may gradually lose their attraction. Sensibly designed structured products can be viable replacements in the long term.

      China's financial markets are still evolving with its economic development and social needs. One example is how the country should handle its demographic situation and look after older people financially. There have been numerous discussions on the topic and new policies are emerging along the line of “utilizing houses to look after pensioners”. It is conceivable that equity release (reversion) products will be manufactured and distributed by the insurance companies. As these types of products often have embedded real estate derivatives, it is vital for the Chinese customers to understand the benefits as well as the risks in those products.

      Chapter 2

      Pillars in Structured Derivative Business

      Structured derivative business encompasses exotic derivatives, in addition to vanillas. The key elements to understand in structured derivatives are Models, Risks, Applications and Hedges (MRAH). Given the risky nature of the structured derivatives, failing to understand MRAH, structured derivatives can backlash and HARM you. Grasping MRAH requires an effective and 201Csimpler” business value chain, with an efficient and well-functioning product development and distribution processes.

      Derivative Business Value Chain

Structured derivatives business is not a stand-alone trading or stand-alone sales business. It is an integrated risk management business. A coherent and consistent risk management business value chain consists of the key pillars in Figure 2.1.