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Structured derivative products markets are very different in size and product types across geographic boundaries. The dominant business model for structured products has been to develop and distribute country-specific products tailored to specific markets (e.g. country indices or stocks) and appetites. The United States is by far the largest market in terms of issuance and complexity of products. In Europe, Germany and Italy have the largest structured derivative products issuances, followed by the United Kingdom. China's structured derivative products business is sizeable in volume but still in its early development stages. Every country has its own market features and product preferences. In the following, we shall summarize some of the key market and product features in the selected countries, to obtain a holistic snapshot of the geographic characteristics.

United States

The US structured product market has evolved for many decades since the 1980s, and is more mature than the others. The majority of the structured products are now issued in the forms of structured notes, structured funds and structured deposits. These products are typically sold over-the-counter, although some may be listed on the exchanges. The annual sales do vary from year to year, and it is estimated to be in the range of USD$55 ~ USD$75 billion.

In terms of product types, US has certainly the most complex structured products in all major underlyings, including equities, interest rates, commodities, credit and currencies. Even in the era of credit crunch and European debt crisis when most of the other countries only having very simple products, one can still find rather complex products in the US across all major asset classes.

The equity-linked products are among the most popular categories, with underlyings in equity indices and single stocks. In the prolonged low volatility environment whereby the structured products pricing is difficult, there are more single stock underlyings as they tend to have larger volatilities than those of equity indices. From time to time, theme-based investment demands also drive the creation of single stock structured products. For example, auto-callable products based on internet single stocks are popular in the aftermath of giant internet company IPOs.

The issuances in currency basket, hybrid basket (e.g. CMS and S&P500), commodity index and long-dated equity for leveraged return products are also frequent. Although the embedded callable or auto-callable features can shorten the durations, in general the products in the US are longer-dated than their European or Asian counterparts.

Compared to other countries, the US market has more retail structured products based on interest rate exotics. For example, products such as callable inverse floater, callable (step-up) fixed-rate note, callable CMS steepener, fixed to floating rate notes are often issued by banks to retail investors. In Europe, these types of interest rate exotic products are deemed as more suitable for professional (institutional or corporate) clients.

European Union

In the European Union, structured product landscapes are very different in different countries. Germany and Italy are the largest in terms of market size and volume, followed by Switzerland, Spain and the UK. In each country, usually only one or two asset classes (e.g. equities and/or interest rate) are the dominant reference underlyings that driving the vast majority of the issuances. In the following, we shall have an overview of Germany, Italy and the UK.

Germany

In Germany, the annual sales of retail structured products are in the order of EUR€40 ~ EUR€50 billion, and the open positions are in the region of EUR€100 billion. Many structured products are listed in exchanges, and the exchange annual turnover is in the order of EUR€45 billion. Public distribution is a very important distribution mechanism in Germany and product demands are often driven by macroeconomics.

The major underlying asset classes are equities and interest rate. Equity-linked products tend to be larger in the number of issuances, although interest rate-linked products can sometimes be larger in volumes. While simple interest rate (EURIBOR or LIBOR) – linked products remain popular, equity-linked structures have been increasing from previous years. The current increase in equity-link products is mainly driven by the capital protection structures that the equity asset class can offer in the low interest rate and low volatility environment. Underlyings that have potentials of delivering higher yield such as blue chip stocks and baskets have been chosen to enable capital protection and attractive pricing.

Sub-dividing the overall structured product volume into investment and leverage product category, interest rate underlying can account for more than 55 % of the volume in the investment product category, while equities account for more than 80 % of the volume in the leverage product category. The other asset classes such as credit, currencies and commodities tend to be rather small in size.

Among the equity-linked products, single index and single stocks are the largest underlyings. Figure 1.1 illustrates the proportions of the two classes of underlyings over a 4-year period. During this particular sample period, the single stock products were becoming more popular, although there was substantial portion in the single index products. The pattern may change over time, but both single index and single stock are key components in the German market.

Figure 1.1 Germany equity underlying (index, stock)

Structured notes and certificates are two popular product wrappers in Germany. The product payoffs are wide-ranging, from capital-protected notes to express and bonus certificates. Reverse convertibles, discount and tracker certificates are also very common. More products are being listed and distributed on the exchanges, partly due to the less stringent requirements of form filling compared to issuing products via bank branches for example. Additionally, leverage products are in demand and they are well suited for exchanges. The exchange-traded warrants and structured mini-bonds, partly due to their leverage nature, are gathering popularity.

Italy

Italy's structured products landscape was severely impacted by the collapse of Lehman Brothers in 2008. Lehman had sold many index-linked products to the Italian insurance sector, which were subsequently distributed to retail policy holders. Theoretically, the end users (retail policy holders) would bear the counterparty risk (the collapse of Lehman). However, for a variety of practical reasons, the insurance companies had to compensate retail policy holders, effectively taking up the Lehman counterparty risk even though they were technically intermediaries. Subsequently, Italy's insurance regulator ISVAP decreed that the insurers would carry the counterparty risks of any products they sell. The viability of distributing prepackaged structured products via insurers is now in question.

For the structured products as a whole, Italy's securities market regulator CONSOB stipulates that product distributors have to formally distinguish between “liquid” and “illiquid” products. For “illiquid” products, which include OTC derivative products, strict documentation, pricing and reporting standards are required. If a distributor wishes to sell an “illiquid” product, including a structured product, it has to have an internal independent price evaluation models and provide investors with regular reports on the product's performance. Typically, separate Monte Carlo pricing and statistical analysis is needed for every product issuance, in order to meet CONSOB's prospectus requirements.

CONSOB pays a great deal of attention to the products considered as “complex” and/or “dangerous” in the retail market. To limit retail customers' risks to such products, CONSOB compiled a list of “complex financial products” (including asset-backed securities, convertible, structured and credit-linked products, etc.) and recommended intermediaries not to offer them to retail investors. The intermediaries are expected to maintain the coherence between the products offered and customers' profiles, at the distribution stage as well as the product design stage. CONSOB also requires structured products providers to abstain from offering and placing certain “very highly complex financial instruments” to retail investors.

Annual sales of retail structured products in Italy is in the region of EUR€35 ~ EUR€45bn. Overall the volume of issuance with equities as underlyings is broadly similar to those with interest rates as underlyings. The issuances of certificates linked to equity underlyings are on the rise in the low interest rate and low inflation environment.

For the equity-linked products, single index and single stocks are the two key categories of underlyings. Figure 1.2 illustrates the proportions of the two classes of underlyings over a 4-year period. During this particular sample period, the volumes of single stock products had increased relative to the single index. The rise of single stock products was mainly driven by the demand for higher coupons and more interesting payoffs. The pattern may fluctuate over time, and a substantial portion of the equity-linked products was still referencing a single index.

Figure 1.2 Italy equity underlying (index, stock)

Structured certificates and fund-linked products have a range of payoffs, including protected tracker, capped or uncapped call, reverse convertibles, digital and callable. As all listed products are automatically classified as “liquid” under CONSOB's rules, there is a strong incentive to get products listed on the Borsa Italiana. Listed products tend to be the simple payoff types. Leverage products are also in demand and they are well suited to listing on the exchange. Certificates designed to suit the specific financial environment can sell well in Italy. For example, in 2014/2015, when the markets were steadily positive and moving sideways, autocallable (express) certificates and capital-protected certificates were popular with investors. These short-term (e.g. 3-year) certificates have indeed generated good returns for investors.

United Kingdom

In terms of the market size, UK structured products annual sales are in the order of GBP£10 ~ GBP£15 billion. The total outstanding client positions are in the region of GBP£60 billion. The vast majority of the retail structured products are equity-linked, and there is little in the way of FX, commodity or interest rate-linked products in the retail space.

The typical product wrappers are:

• Investment plans: These plans are typically offered via intermediaries, such as Independent Financial Advisers (IFAs). They are administrated either by a third party or the issuer. The plans are often targeted to the NISAs and SIPP investors who have no tax liability on the returns. The plans are also marketed as tax-efficient investments (within the limit) as, for the direct investors who pay UK tax, the returns of the plans will be treated as capital gain instead of income.

• Structured deposits: These are offered by banks and building societies as fixed-term deposit/saving accounts. The returns will be treated as interest income and subject to income tax, unless it is wrapped in a NISA. The deposit/saving with authorized firms is protected by the Financial Services Compensation Scheme (FSCS).

• Exchange-traded structures: These are typically issued as certificates, and are listed on the London Stock Exchange as full tradable securities. The listed securities have the benefit of transparency and liquidity. The exchange-traded structures are quoted throughout the trading day.

For the equity-linked products, single index is very dominant in the UK as shown in Figure 1.3. FTSE-100 is the most popular index followed by EURO STOXX 50 and S&P 500. Basket of indices is often used, but there is very little in single stocks.

Figure 1.3 UK equity underlying (index, basket)

Apart from underlying liquidity and investors' risk appetite and familiarity with the indices, UK's stamp duty on share transactions may have depressed the single stock-based product offering. It is conceivable that financial transaction tax on stocks, which makes hedging single stock-based products very expensive, can skew the markets and product offerings.

Over the years, the mainstream structured product payoffs in the UK have been fluctuating among capped or uncapped call, digital, reverse convertible and kickout (auto-callable). In the low interest rate and low volatility environment, kickout products are very popular and they constitute a very large portion of the business. Basket underlying is sometimes used in the kickout products to enhance the headline rate.

China

China's financial systems are still evolving. Its structured products markets are very different from the western counterparts in both framework and contents. The overall picture therefore seems to be more complex from a western perspective.

Markets and Drivers

In China, commercial banks including city commercial banks, rural commercial bank and rural credit cooperatives, can issue structured products to attract short-term deposits. Trust products, private equity limited partnership products and increasingly the internet products are the other main forms of structured (fixed income) products in the market. The so-called “shadow banking” encompasses segments including trust companies, wealth management and private lending among individuals. Structured products are typically categorized as part of wealth management products (WMPs) family, as illustrated in Table 1.6.

Table 1.6 WMPs and structured products

One of main issuers of WMPs is the trust companies. The investment trust industry is one of the main players in WMPs. The trust companies are usually selling the trust products through the wealth management divisions of commercial banks. The products distributed by banks are perceived as having “implicit guarantees”, meaning that the distributing 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.