Structured Products

Monopolies have long been a thorn in the side of consumers. High prices for a low quality of product or service are a common evil that monopolies engender. From telephone to oil companies, the regulator has broken them one by one over time in order to give the consumer more choices and spur the competition. It has become easy for consumers to compare the prices of every type of product or service, be it credit cards, insurance or flat-screen TVs. While few if any monopolies remain, other forms of captive-client models have emerged. In the private banking industry, a client becomes captive the day he deposits his monies at a bank and entrusts it to his account manager. From that point onwards, the client is usually bombarded with advice to buy this fund or that structured product. Not surprisingly a majority if not all of the proposed investments are in-house products. While in-house products are not fundamentally bad, the account manager often has an interest or been told to recommend the products of his employer in order to maximize the benefits for the bank. In the fund industry this is less of a problem because most of the funds have a similar cost structure and one has a priori no more chances to outperform than another. Hence, an investor might as well purchase the funds of the depositary bank he has chosen, unless their track record is really awful. It is different with structured products, because they often include complex options that every bank prices differently at any given point in time. Most banks also include fees in their products, the level of which may vary considerably. Other banking-related costs, like documentation, funding or trading costs may increase the level of price difference from one bank to another. The difference in pricing may become so great that some banks may not even be able to issue a particular product. This is where the concept of open architecture becomes essential. Let's illustrate this with some examples. In the first one, we ask three banks to construct a capital guaranteed product on the S&P500. In the second one, we require the price of a short term Capped Bonus Certificate on a stock paying a high dividend (E.On, a German utility company with a dividend yield of 8.8%, payable in May). The three banks have a similar rating (ranging between single A to A+ according to S&P's). The two products in detail: 1. Capital guarantee on S&P500 index

• Currency: quanto EUR
• Maturity: 1 year
• Capital guarantee level: 94% of current spot
• Cap Level: 115% of current spot
• Strike price: 100% of current spot
• Issue and reoffer price: 100%
• Participation:

1. Bank A: 56%
2. Bank B: 66%
3. Bank C: 82%

2. Capped Bonus Certificate on E.On

• Currency: EUR
• Maturity: 4 months
• Barrier Level: 78% of spot
• Cap Level: 110% of spot
• Issue and reoffer price: 100%
• Bonus Level:

1. Bank A: can't do
2. Bank B: 107% of spot
3. Bank C: 104% of spot

The above examples show a huge difference in pricing. The performance of the products will vary accordingly. It is known that banks operating in true open architecture will deliver better products on average than those recommending internal products only. While in theory all the banks should operate according to the "best execution" principle, practice shows it is still an advantage to compare prices with various institutes. Some wealthy individuals have reacted to the client-captive kind of advice by splitting their fortunes across three to six banks, also in order to diversify the bank counterparty risk. Thus, the same demand may be addressed to all banks, but only the one with the best pricing will get the deal. The investor may also chose to allocate a mandate to discretionary manage his or her money. In such a case, if the mandate is identical at each bank, one can assess the yearly performance of the portfolio, with the worst bank being eliminated and the funds it managed transferred to the best one. The virtue of open architecture will eventually be reflected in the performance of the portfolio.