Structured Products - Knowing your provider

by Professional Paraplanner
Structured Products - Knowing your provider
Over the years, two of the questions most frequently asked of us by advisers and paraplanners are: ‘What is the best framework for assessing structured products for our clients?’ and ‘What should we look out for before recommending a structured product?’ There are a number of areas I think paraplanners need to consider when undertaking due diligence on structured products. 

Changing regulatory emphasis

The regulator has published two reviews on structured products since the global financial crisis. The first review published in 2009 brought people’s attention to counterparty risk. In addition to credit rating, many advisers and their paraplanners are now asking product providers to provide information on, for example, credit default swap levels on the counterparty bank. Some have gone even further, asking providers for other metrics on their balance sheet. The second review published by the regulator in 2015 highlighted the importance of product governance for structured product providers. The regulator wanted to see providers considering the target market in their product development process. The regulator emphasised that the providers must understand how the product would perform under different market scenarios, and explain these to potential investors and their advisers. An emphasis in product governance is one of the key changes that will come into play when MiFID II becomes a reality in 2018. A clearer explanation on possible performance will be required for many investment products when PRIIPS comes into play at the same time. Structured product providers in the UK have started implementing these principles two years ahead of other investments. These developments highlight that paraplanners need to keep evolving the way they assess structured products. Whilst it is still important to consider counterparty bank risk, the focus is moving onto providers. In particular, on whether providers know what they are doing.

Know your provider

Advisers and paraplanners are familiar with the concept of ‘know your clients’. They also have been using different research tools to perform a ‘know your manager’ as part of due diligence on investment funds. A ‘know your provider’ assessment on structured product providers would make logical sense, whether the provider is a bank or an independent plan manager. In the past, some structured product providers told paraplanners that assessing providers was unnecessary. The product’s performance relies on the counterparty bank delivering its contractual promise. So looking at counterparty bank risk is of prime importance. Then one should look at the product terms and how they work. On the provider itself, most people only look at the costs and the level of service from the provider. Looking back, most of the incidents that occurred in the structured product market, which then coloured investors’ perceptions of the asset class itself, had nothing to do with counterparty bank risk (except in the case of the collapse of Lehman Brothers). On the contrary, they often related to the product providers. One can even argue that issues on underperforming products were due to product providers not paying attention to governance in the product development process, something that was picked up in the thematic review by the FCA in 2015

Here is the good news: the structured product industry has moved on. Providers will no longer shy away from going through a ‘know your provider’ process. The industry has also adapted the recommendations from the thematic review, strengthening the product governance process. Still, it doesn’t mean advisers and paraplanners can ignore ‘know your provider’. Here are three suggested areas to which one should pay attention.

1. Technical expertise and credentials

One of the issues raised in the FCA thematic review was providers’ overreliance on third parties in performing some of the more technically demanding tasks. Examples include modelling how a product was likely to perform under different future scenarios (often called ‘stress tests’). The regulator was not questioning outsourcing but reminded providers that they also need to understand the more technical aspects, in particular how they should be utilised in product development and identifying the target market for the products. The challenge for providers is to demonstrate that they have the people with ‘know how’ throughout the product development process, understanding how the product could perform under different scenarios, and work closely with advisers / paraplanners on the more technical areas in using structured products in client portfolios. The technical requirement goes beyond such quantitative modelling and analysis. Clients also need the product to be held safely and securely. That is the responsibility of the custodian and administrator. Some providers outsource this area to other parties. But here is another area where issues can occur, especially on segregation of client money from corporate funds (big financial institutions have been fined on this in recent years). So don’t ignore the technical expertise required in this area. 

2. Business model

Different providers obviously have different business models. How their business models perform will be reflected in their financials. It is not just to check whether their firm has been making money. One should also look at how much profit gets reinvested in the business, whether there are any other sources of income to the firm, and how the business performed during different market cycles. These factors will affect the longevity of the firm. No one wants a provider to stop delivering the service to a client in the middle of his six-year investment term.

3. Product governance

The industry has embraced the product governance changes recommended by the regulator. Providers will be able to explain how their process works. In particular, the process should result in a clear articulation of the target market that the product is designed for, which in turn will help advisers and paraplanners in identifying the right type of clients for the investment. This should be evident when one talks to representatives of the providers or looks at their marketing materials. A focus on delivering the best client outcome should be embedded in the firm’s culture. To sum up, just like any investment product provider, a structured product provider should give comfort to paraplanners that the firm knows what it is doing. Different providers could demonstrate this in different ways, but all should be willing to demonstrate this to you. So engage them – know your provider better!

Source: (April 2017 edition)