Manufacturing and Managing Customer-Driven Derivatives. Qu Dong

documents are listed in Table 2.4.

Table 2.4 Key quantitative documents

Table 2.5 and Table 2.6 show examples of the model technical and testing documentation templates respectively. These tables are given to illustrate the scopes and details required for achieving a high documentation standard.

Table 2.5 Technical documentation template

Table 2.6 Model testing documentation template

      Model technical and testing documents also serve as the audit trail of the quantitative works done during the model/product development. These works are essential to pursue the highest possible quality for the model and the quant library as a whole.

      Product Issuance and Wrappers

      This section explains the typical mechanism of product issuance and hedge, and product wrappers with their characteristics.

      Issuance and Hedge

When a structured derivative product is issued, it typically involves three parties: investors, an issuer and a derivative desk. The investors buy the product (e.g. a structured note) from the issuer, who subsequently hedges the derivative risks with a derivative desk. The flow is illustrated in Figure 2.4 and described in Table 2.7.

Figure 2.4 Flow of product issuance and hedge

Table 2.7 Flow description

      Notes:

      ¹ Issuer's position can be booked as a floating rate note (with coupon L_f) plus a swap. Net-net this is equivalent to a zero coupon bond plus an option.

      ² Issuer's total funding level (L_f) includes issuer-specific credit spread (s₁). L_f is an important factor in derivatives pricing given it is included in the swap hedge.

      ³ If the structured note is callable or autocallable, the swap and funding leg are also callable or autocallable. One needs to assess or value the associated callable effects.

      From investors' perspective, in addition to the market risks, the counterparty (issuer) risks in the structured products must be taken into account when they make investment decisions. The pricing of the products must include the counterparty (issuer) risks and it is typically manifested in issuer's funding spread.

      Wrapper Categories

      Structured products are distributed to investors via different channels in various wrappers. Different wrappers have different features and benefits. In a nutshell, a wrapper specifies what the product will be issued as (e.g. a security or bank saving account), and their subsequent tax and financial protection treatment. Naturally, different jurisdictions have different preferences in terms of meeting investors' needs.

Table 2.8 lists some of the key structured product wrappers and their features.

Table 2.8 Key structured product wrappers

      SPVs for Collateral

      Banks sometimes set up special purpose vehicles (SPVs) to issue structured products. SPVs can be used to hold collateral, among other tax and rating conveniences. After the SPV issuing a note, it will enter a swap transaction to completely hedge the product payoff. The SPV can then use the proceeds of the issuance to purchase collateral as security for the note principal repayment, for example. If dealers use their own bonds as collateral for the structured products they originated, then when they collapse, as in the case of Lehman Brothers, the value of collateral will also collapse. In such cases, the losses on the structured products are due to the significant decline in the collateral value, even if the derivatives embedded in the products may perform well.

      A SPV with good collateral management will substantially reduce investors' counterparty risks. It is therefore very important for SPVs to seek high-quality and safer collateral for structured products.

      Product Distribution

      Derivative product distribution is not simply selling products. There is a comprehensive set of principles and rules one must follow to the word and in spirit, in particular relating to the retail customers.

      Organization

      In retail structured derivative business, organizationally there is a clear distinction between the manufacturing and distribution functions. The two functions have very different policies, processes as well as regulatory requirements. Product providers (manufacturers) and distribution functions need to agree and have distinct responsibilities towards investors. The product providers should interact with intermediaries who are the direct client-facing functions. In broad terms, intermediaries include private banks, independent financial advisors, and various modern distribution platforms that are subject to very strict regulation and compliance rules as client-facing functions.

      As client-facing functions, investors' suitability and products suitability are extremely important topics that need to be included in the distribution process. In the context of product transparency, the marketing materials need to be clearly articulated to enable investors evaluating the products from the perspective of risk/reward and their specific investment objectives. One should make sure the materials are clear and not misleading, and it is also important to make proper risk disclosure, including market risks, credit risks, liquidity/unwinding costs, tax consideration. The fees and costs need to be disclosed clearly. The overall documentation standard must remain very high in stating products accurately, fairly and explaining the risks clearly and accurately.

      While managing the relationship between investors and distribution functions is a key task, distribution functions also need to fully understand the new products themselves. Distribution functions should review and understand the products, whether they are developed by themselves or by a third-party provider. There should be an internal review process, taking into account the nature of the products, target investors, their risk appetite and assess the appropriateness for the intended target markets. The overarching rules in the structured products distribution should be KYC (know your customers), KYD (know your distributors) and KYPP (know your product providers).

      It is also extremely important for the business and distribution functions to analyse and manage conflicts of interests around retail structured products. For example, some of the investment and debt products are indeed complex and linked to issuer's proprietary index. For firms that issuing structured products linked to their own or their affiliate's indices, addressing embedded conflicts is critical in order to avoid serious problems of favour issuers over investors. Some proprietary indices based on complicated algorithms and strategies may potentially harm investors' economic interests. Selling callable products to investors who adopt a buy-and-hold strategy could have a negative impact on investors. The firms have responsibilities to customers and managing conflicts of interest is a very important aspect of the structured derivatives business.

      Due to increasingly strict regulatory rules on distributing “complex” derivative products to retail customers, banks are increasingly exploring the option to outsource certain distribution functions to third-party specialist research/marketing/servicing companies.

      Documentation

      In