Executive Vice President, Regulatory Policy
Remarks From the SIFMA Complex Product Forum
New York, NY
Thank you, John, for your gracious introduction; to SIFMA for sponsoring this conference; and to the audience for indulging me as I perorate through your coffee and dessert.
Please imagine that you are on vacation in Paris, France. Today you have planned a lavish meal at a famous restaurant named “Chez Jean.” It is owned by Jean Maurello, the most renowned member of a prestigious clan of French chefs.
Your objective is a multicourse dinner that will begin at noon and extend into the evening. Call this the “10-hour repast.”
When you arrive at noon, you discover that Chez Jean offers four menus. All four menus will require you to dine at Chez Jean throughout the afternoon, into the early evening—a 10-hour culinary adventure.
The first menu is “L’Aventure Jean.” It offers a “prix fixe” multicourse meal, including dessert, for 450 Euros. It is well worth it.
The second menu is “L’Aventure Reduit.” It offers the same multicourse meal without dessert, for a fixed price of only 425 Euros. The menu discloses that a separately ordered dessert would cost 35 Euros. This menu permits you to wait until the end of your meal to decide whether you have room for dessert. However, the total cost for the meal is 460 Euros, 10 Euros higher than the first menu.
The next menu is “L’Escapade Maurello.” It offers a fixed price meal, including dessert, for 445 Euros, 5 Euros less than the first menu. “L’Escapade Maurello” reveals an interesting fact about Jean the chef: Jean is price sensitive about the cost of his ingredients. Your meal will begin at noon and extend into the evening, and in Paris, the price of flour has been fluctuating wildly every day. Jean only uses the freshest flour and he is worried that the price of flour will increase between the time that you sit down and when he prepares your dessert, almost 10 hours later.
This menu reflects Jean’s price sensitivity. If you choose it you will pay 445 Euros for a full meal, including dessert. In pricing this meal, Jean assumes that his flour will cost 15 Euros this evening. You must agree to pay Jean for any increase in the cost of his flour above 15 Euros.
The final menu is called “L’Anti-Euro” and it offers a fixed price menu, including dessert, for 455 Euros, 5 Euros more than the first menu. The reason for the higher price is that L’Anti-Euro allows you to hedge the currency payment for your meal. This menu reflects the possibility that you might be currency rate sensitive. Between the moment that you sit down and the time that you pay in Euros, 10 hours later, the value of the U.S. dollar against the Euro might decrease. Chez Jean will agree to charge you according to the exchange rate at the moment that you are seated. If the U.S. dollar depreciates between the moment that you sit down and the time you pay this evening, Jean will discount your bill by the percentage of that depreciation. (You have been told that L’Anti-Euro has been a popular choice among U.S. financiers who are heading back to the States after dining at Chez Jean.)
This is a conference on complex products and you may have anticipated the purpose of my parable. Chez Jean has asked you to choose among four metaphors for a complex financial product.
Let us return to the first menu. “L’Aventure Jean” might serve as a metaphor for a simple equity investment. You are being asked to invest in the entire meal, including dessert, at a price of 450 Euros.
Under the second menu, “L’Aventure Reduit,” you would purchase a culinary unit that costs 425 Euros. This unit consists of an equity interest in a meal and a warrant to purchase dessert, at a “strike price” slightly less than 35 Euros. If the value to you of the dessert this evening equals or exceeds 35 Euros, you will “exercise” your warrant and purchase the dessert. L’Aventure Reduit is available for those who are not sure they will have room for dessert but would like the option to order it.
The third menu, “L’Escapade Maurello,” offers an equity interest in a meal that costs 445 Euros, but requires you to pay for the cost of flour above 15 Euros. Essentially you must agree to insure Chez Jean for an increase in the cost of flour above 15 Euros. This insurance would be equivalent to a call option that you have written to the restaurant, giving the restaurant the right to purchase flour from you for 15 Euros. If you wrote such a call option, and the price of flour rose to 20 Euros, the restaurant could exercise its call option and purchase the flour from you for only 15 Euros. The menu provides a shortcut. Rather than exchanging money for flour, you will simply cover the increase in the cost of flour above 15 Euros. The menu provides the same economic result as if you had written a call option to the restaurant. Chez Jean compensates you for writing the call option by reducing the cost of the meal by 5 Euros.
The fourth menu, “L’Anti-Euro,” consists of a culinary unit that costs 455 Euros. This unit is composed of an equity interest in the meal, including dessert. It also requires the restaurant to cover any decrease in the value of the U.S. dollar. This arrangement is equivalent to writing you a put for U.S. dollars. Under the terms of the put, you are protected from a decline in the value of the U.S. dollar relative to the Euro between the time that you order and the moment that you pay your bill 10 hours later.
Your menu choice will depend upon many factors, including the following:
- the probability that you will have an appetite for dessert;
- the value to you of waiting to purchase the dessert;
- the utility to you of that dessert;
- the probability that the cost of flour will increase above 15 Euros by more than the meal discount of 5 Euros;
- the probability that the U.S. dollar will depreciate by more than 1 percent [5/450] during the course of your meal;
- your price sensitivity to currency fluctuations; and
- the value of your time to consider all of these choices.
We can draw fundamental lessons from my parable of Chez Jean. First, a large array of choices can hinder a person’s ability to make a rational decision. Perhaps this lesson is not surprising. Behavioral economists have coined the term “choice overload” to describe this impairment of a person’s ability to make a rational decision.
Imagine if the Chez Jean waiter handed you four menus. Your first response would be to ask the waiter to guide you through the menus and to recommend one that is most likely to meet your culinary goals and objectives. Your waiter would become your adviser.
The complexity of choices also can hinder the ability of a person to make a rational decision. What makes a product “complex”? In 2012, FINRA released Regulatory Notice 12-03, our Notice on complex products. Although our Notice did not attempt to define the term “complex product,” we did list examples of complex products, such as:
- products that are secured by a pool of collateral;
- products with an embedded derivative;
- products with “worst of features;”
- products tied to the performance of a market index that is not well understood; and, most important,
- products with contingencies.
I appreciate that this added complexity may protect investors against specific risks. Regulatory Notice 12-03 recognized that “the complexity of some products may arise from features that seek to reduce the probability of investment losses in particular situations.” Nevertheless, the complexity of a product makes its analysis more difficult.
If I were to summarize the defining feature of many complex products, I would say that the expected return or payoff of a complex product is typically contingent upon a feature of the product itself. The contingency complicates choice selection.
If we compare the simpler two menus at Chez Jean, the one for the full meal with dessert, and the one in which dessert is not included, we immediately appreciate the complications of a contingency. The second menu has a contingency that depends upon whether you will want dessert 10 hours later. In order to evaluate the second menu you would have to compare the value of dessert-choice deferral to the fact that you will pay more for the dessert. The evaluation of this contingency will take time as you peruse the menus. You could avoid this time consuming analysis by selecting the first menu that has no dessert contingency—even if it is not the more “rational” choice given the probability that you will order dessert. In other words, because of the dessert contingency, you might need your waiter’s advice even to compare the first two menus.
An option is a common form of contingency embedded in complex products. Regulatory Notice 12-03 suggested that a financial adviser should be competent to develop a payoff diagram of an embedded option. I was surprised that the industry was more alarmed by this statement than any other in the Notice. An embedded option often makes a product complex, even if it protects the investor against losses. It does not seem too much to ask that the financial adviser recommending the product be competent to describe the option payoff according to price assumptions about the underlying asset.
I have argued that the ability to make a rational investment decision can be complicated by a large number of choices or by the presence of a contingency within any of those choices. Choice selection can be further complicated if you are asked to compare contingencies. In my parable, how do you compare the last two menus, one with a written flour call and the other offering a currency put? The first of these menus is cheaper because the customer writes the call, but the second allows the customer to hedge a currency risk.
We might assume that the customer will care only about either the cost of the meal or the currency risk, but not both. Of course, the assumption that customers have a singular objective is normally false. Most customers have multiple objectives. In order to recommend either of the last two menus, the waiter must understand the importance of each contingency to the customer, the probability that the contingency will be exercised, and the cost or discount to the customer associated with that contingency.
Some complex products carry multiple contingencies. Range accrual notes typically offer an attractive fixed rate for a defined period, such as one year, followed by a floating rate that depends on the extent to which the performance of one or more reference assets stays within a pre-specified range. For example, a floating coupon rate could be 10 percent per year, times the fraction of time during the quarter that LIBOR is below 400 basis points and the S&P 500 is above 1,600. The analysis of a product with multiple contingencies can be especially difficult.
A contingency might further complicate a decision when it is unrelated to the product’s essential features. Choosing between the first two menus requires effort, but it is relatively easy because the dessert question is closely associated with the essential product, the 10-hour meal. Whether you might have an appetite for dessert requires consideration of how much you will eat before dessert.
But consider the other two menus. Neither the price of flour nor the currency rate is relevant to your decision to dine at Chez Jean. The two menus with contingencies about the price of flour or the US dollar are the most difficult to analyze because they are unrelated to your reason for dining at Chez Jean. That is, they are unrelated to your appetite.
One might think of this question as one about information costs. If a financial adviser has analyzed a common stock, then evaluating a call on that stock is relatively easy. The marginal costs of obtaining information about the call are not too high. However, imagine a financial adviser who has analyzed a simple note (with a given credit quality, interest rate, and tenor). Now the adviser is asked to analyze a comparable note (from the same issuer and with the same maturity) with a contingency related to the S&P 500, a commodity index, or an index linked to a volatility strategy. The marginal costs to the adviser of obtaining the information to evaluate this contingency could be high.
To summarize these points, the complexity of a financial adviser’s investment selection often will depend upon the answer to three questions:
- How many approved investment choices is the adviser expected to consider?
- How many of these investment choices have one or more embedded options?
- How many of these embedded options refer to reference assets that are unrelated to the essential features of the product?
As we stated in Regulatory Notice 12-03, consideration of complex products with embedded options require additional training and heightened supervision of financial advisers. A well trained and qualified financial adviser can make use of structured notes and other complex products to provide customized advice that reflects the investment objectives of a client. In providing guidance on complex products we have not questioned the utility of these products. Rather, we have emphasized the need for heightened training and supervision.
Since I have focused on structured products, which often have embedded options, I’ll talk a little about what we have observed in that market, recognizing that there are many other complex products out there. According to a widely cited data source, the total dollar amount of new issues of U.S. structured retail products has not increased significantly since 2010. In that year, the total dollar amount of new issues was about $56 billion. We understand that this increase largely consisted of products offering full principal protection. In the five years since 2010, the total dollar amount of new issues has remained flat and has never eclipsed the 2010 amount. If we were to annualize the total dollar amount of new issues based on the first five months of this year, total sales for 2016 would be about $42 billion. This amount, $42 billion, would be about 25 percent lower than total dollar amount of new issues last year.*
Perhaps one explanation for the decline in new issues is the current market environment. Suppressed market volatility, for example, reduces the perceived need for products that are designed to hedge against volatility. Another possible explanation is the effect of regulation. For example, some have commented on the possible effects of a Federal Reserve Board proposal concerning the calculation of total loss absorbing capacity, or TLAC. Another possible regulatory complication for the future sale of all complex products is the Department of Labor’s fiduciary rule.
I am not an ERISA attorney, but one can assume that the DOL rule will discourage the sale of commission-sold products through the retirement channel. The rule presents several questions that are pertinent to all commission-sold products:
- How will broker-dealers restructure their operations and their compensation structures to enable them to sell commission-sold products through the retirement channel, consistent with the DOL rule?
- To what extent will broker-dealers similarly restructure their non-retirement operations?
- Perhaps most important for this conference, how will the manufacturers of commission-sold products restructure those products to allow them to be distributed in the retirement channel?
The DOL fiduciary rule will raise similar questions for the sale of complex products, particularly complex products that are proprietary to the broker-dealer or its affiliate.
I urge you to be especially sensitive to the possibility that a financial services company might be issuing complex products to retail investors in order to manage its own risk. Some commenters have asserted that structured notes may be used as a mechanism to shift particular risks to retail investors. Such activity could present serious regulatory issues.
We are seeing more frequent issuance of structured notes that put principal at risk, in particular for product types that in the past typically offered full principal protection. We also have seen more products that are using multiple reference assets, often in a “worst-of” structure.
We have seen more range accrual notes with principal at risk, whereas up until a few years ago these usually offered full principal protection. More recent examples now often have the added contingency that the payout at maturity will depend on the level of an equity index. In addition to the contingency associated with the variable coupon rates as I have described, an investor now also has to worry about whether an equity index will fall below some barrier level like 50 percent, at the maturity date. If that contingency is met, the investor could forfeit principal.
Another example of an exotic product that caught our attention recently was a structured note with a so-called “shark-fin payoff.” We have not seen a note like this in the U.S. for a number of years. The shark-fin payoff gets its name from the distinctive shape of its payoff diagram, which resembles the dorsal fin of a shark breaking the water’s surface.
In this particular case, however, the product offered a novel twist to the more generic shark-fin structure. For the sake of my presentation, I’ve made some simplifications to the actual product, but the basic idea is the same.
- The note has a maturity of one year and has no call provision.
- The holder is promised a payoff at maturity based upon the performance of the worse performing of the S&P 500 or Russell 2000 indices.
- The maximum potential payoff to the note holder is a return of principal plus 20 percent and the maximum potential loss is 80 percent (meaning an investor could recover only 20 percent of principal).
- The note provides a 20 percent buffer if the lesser-performing index has a negative return, so an investor could lose up to 80 percent of principal in the unlikely event one of the indices goes to zero.
- If the lesser-performing index returns between –20 percent and 0 percent, the note pays a (linear) return of between 0 percent and 20 percent.
- If the lesser-performing index return is between 0 percent and +20 percent, the note pays a fixed return of 20 percent.
- If the lesser-performing index return is greater than 20 percent, the investor loses 60 percent.
I am confident that the industry will continue to launch products with interesting features and creative structures. We can also be sure that the principles that we articulated in Regulatory Notice 12-03, such as ensuring that the financial advisers who sell them are properly trained and supervised—will continue to be guiding regulatory principles for the complex product industry.
Thank you again for the opportunity to address you today and best of luck with all of your fine dining decisions.
* See structuredretailproducts.com.