Aug 3, 2015

Part II: The Role & Market Impact of Risk Ratings for Structured Products

In this Part II video blog, PRIIPs Methodologies in Focus, Tim Mortimer, Managing Director for Future Value Consultants and Keith Styrcula, Chairman and Founder of the Structured Products Association join Jim Jockle, CMO of Numerix to continue their discussion and debate around around the proposed PRIIPs methodologies. They discuss industry impact of risk rating for structured products going forward, issues it may impose or unforeseen issues that could result, and the biggest concerns from a US and European perspective. Lastly, Tim and Keith offer their thoughts on which way the regulators might swing.

Weigh in and continue the conversation on Twitter @nxanalytics, LinkedIn, or in the comments section.

Video Transcript:

Jim Jockle (Host): One thing that we haven’t really discussed or broadly addressed is that markets change. To have a risk rating at the time of issuance, is that creating some sort of statement removing the element of market transitions? So Keith, let me ask you in that regard, you know what kind of potential liability does this introduce into a product? If I’m an investor I sit here and say ‘you know the risk on this is B. I feel good about it’ but yet you know tomorrow perhaps I put too much faith in that risk ranking you know the VIX blows out to 26 and S&P is down 600bps. I’m coming up to my call date and now you know I don’t get my return on my investment. How does that fit into market dynamics?

Keith Styrcula (Guest): Jim it’s a great point, if we talk about one size fits all ratings, there is a risk that we’ve over simplified on a quantitative basis how the product is supposed to work, so if it doesn’t take into account certain markets / market disruption events, you could add a principal protected notes from Lehman Brothers for example and that would probably have gotten the most conserved risk rating and most of those trades blew up and that became a big liability for lots of distributors of those notes…so what happens is it takes into account credit rating and how meaningful is it at the end of the day if the product doesn’t perform as the investor was expecting?

Jim Jockle: And yet also,  as it relates to some of the KID documentation and the prospectus how is that going to be used, as a retail investor you know, is this creating documents that I can point to if the transaction didn’t go my way?

Keith Styrcula: It could very well be a lightning rod as again as we were talking about earlier, the KID documentation it has a very limited amount of space to describe a product so if a product has certain complexities can you get all of that into the KID document? So that’s one concern , the other concern would be that when an investor loses money it always easy to look over your shoulder and say well he didn’t disclose this he didn’t tell me the FX market could go this way, we didn’t properly disclose this and it becomes a lightning rod. My reading of some of the proposed infrastructure for PRIIPs does suggest that could become a document that the investor could use and create enhanced liability for the manufacturers that they otherwise wouldn’t have.

Jim Jockle: So, Tim let me ask you a question. You’ve been in this market for years, to the extent of these four options is there do you think one of them is going to win out at this point in time? Or let me ask what is your preference in terms of methodology and why?

Tim Mortimer (Guest): It’s hard to call really. I think the 2 quantitative methods which is options 2 and 3 on the list are my favorites and I personally think it is likely to come from one of those 2. I think any qualitative method is fraught with difficulty to keep a consistent and wide-ranging enough.

Jim Jockle: So let me ask you one other question in that regard, so coming back to the market dynamics and elements changing there is also been a lot of questions about the use of projections over the life. Where do you see, looking at future potential performance as part of this disclosure bringing greater transparency in understanding other products to investors?

Tim Mortimer:  That’s another question that regulators in the UK and the rest of Europe have been grappling within the last year or so. Everyone broadly or most people broadly say that investor projections i.e. some kind of understanding of what the product might realistically return are a good thing and the question is how you get there. So if you rely on historical data in some way, that’s clearly very dependent on what actually happened in the past. If you go for forward looking simulations/ projections which is probably a more reliable way to go forward, then of course the question is what parameters do you use, what volatility levels and also what missed premium, if any, what market uplift? And it’s very important that if the industry goes down that road that if two distributors bring out identical products on the same day, they have got to be using the same methodology, because they should get the same results. Otherwise you would get an investor pick up two brochures of what are essentially identical products and might get misled by the fact that the two distributors have used two different, although perhaps intrinsically reasonable methods on their own but have come up with different numbers-so consistency is key in this regard.

Keith Styrcula: Well it sounds to me as if there should be some third party, not just the manufacturer but that something like when you go to get a CUSIP for an example. When you get that from S&P is there some sort of separate body, where you could go to them and so yet the two manufacturers with similar products getting the same risk rating from a third party. To me that’s sounds as if that’s something that should be looked into.

Jim Jockle: Well could this be finally the catalyst to an active secondary market?

Keith Styrcula:  You’ve got many steps in-between a secondary market, but that would be one step towards that. I would agree with you.

Jim Jockle: So Keith, one final question and then were going to come to a close. Tim, my question for you in just a minute is going to be what haven’t we talked about, what keeps you up at night? I’ll let you think about that just for a second, but Keith you know SEC clearly took a leadership as it’s, compared with European colleagues on EIV, but you can argue that we are probably two years away from a version of PRIIPs coming to the US. What are the US manufacturers going to be looking at during this time frame and how are they going to be thinking about preparing?

Keith Styrcula: I think at this point in time Jim, many of the issuers are already grappling right now with enhanced regulation in the wake of ’07 market break. So there’s a lot they’re already dealing with, with FINRA, so I don’t think they’re forward looking about what going to happen , it’s going to be a wait and see approach to see how it works. But, as we know, the European market is far more developed that the US market in terms of the issuance of structured notes and the widespread acceptance among retail investors. I’d say there’s probably a three or four year lead time that Europe has over the US, so we’ll get there I would say probably about two or three years, we’ll start to see/we’ll have the opportunity to see how PRIIPs has worked in the EU and the SEC typically goes to adopt successful programs that successful and hopefully discard the other parts that are not.

Jim Jockle: And arguably we’ll start seeing interest rates come back globally across the board…

Keith Styrcula: Theoretically.

Jim Jockle: All those boons that will help facilitate issuance, but with better more transparent products. So…

Keith Styrcula:  That would be the goal and of course we at the structured products association fully support greater transparency. Hopefully transparency that does not provide complexity to either the investor or the issuer being able to comply with those regulations.

Jim Jockle: So, Tim back to your nightmares. What’s keeping you up?

Tim Mortimer: Well I guess the question of how the industries in both the UK, Europe and the US can grow and what role our company can play in that in terms of providing risk ratings, projections, costs and estimates and analysis…the whole thing. Structured products are a very interesting asset class, investment class, as I’m sure we all agree .The thing about them is that they sit in two camps in my view. On the one hand, they are quite simple. A contract between and issuer and an investor. ‘I’m looking for these cash loans and these profiles at a certain point in time. On the other hand, they naturally can lend themselves to some type of quantitative, fund-like analysis, so the risk ratings and cost analysis, that kind of thing as well.  It’s important that the message stays clear and the investors don’t get confused by exactly what these products are all about. If the industry as a whole gets that right it, it should be possible to grow the market and provide solutions for more people than is currently being done.

Jim Jockle: Thank you Tim and now Keith any final thoughts?

Keith Styrcula: No. I think Tim has done an excellent job in what’s been going on in Europe. We’re taking that wait and see approach here in the US, and so we will be watching things very carefully going forward.

Jim Jockle:  Well gentleman. I want to thank you so much for your time today and your insights and thoughts and of course as we get to the August 17th date and we get some more clarity I would love to have you both back on to be able to discuss kind of where the next steps are as well. As we see what options are finally on the table. Thanks you so much. I’m your host Jim Jockle.

On the Numerix Video blog it’s our goal to examine the topics that you want to talk about. Keep the conversation going on LinkedIn, and on Twitter @nxanalytics. Thanks for joining.

On the Numerix Video blog it’s our goal to examine the topics that you want to talk about. Keep the conversation going on LinkedIn, and on Twitter @nxanalytics. Thanks for joining. - See more at: https://www.numerix.com/part-i-explanation-priips-methodologies-structured-products#sthash.jESGlHCM.dpuf
On the Numerix Video blog it’s our goal to examine the topics that you want to talk about. Keep the conversation going on LinkedIn, and on Twitter @nxanalytics. Thanks for joining. - See more at: https://www.numerix.com/part-i-explanation-priips-methodologies-structured-products#sthash.jESGlHCM.dpuf
On the Numerix Video blog it’s our goal to examine the topics that you want to talk about. Keep the conversation going on LinkedIn, and on Twitter @nxanalytics. Thanks for joining. - See more at: https://www.numerix.com/part-i-explanation-priips-methodologies-structured-products#sthash.jESGlHCM.dpuf
Blog Post - Jan 23, 2012

Improving Transparency in the US Retail Structured Products Market

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