F E AT U R E       C A P I TA L    MARKETS

                       UNSTRUCTURED HAZARDS
                       OF STRUCTURED PRODUCTS
                       Treasury personnel should fully appreciate the characteristics and
                       deficiencies of the OTC market for structured products.
                       by Mark Waugh

T   HE C ANADIAN MARKETPLACE has witnessed ongoing advance-
   ments in the creation of various types of structured financial prod-
ucts for short-term investment. Over the counter ( OTC ) or non-
                                                                                             Marketplaces for trading equities,
                                                                                          commodities and their derivatives
                                                                                          operate on well-established mechani-
                                                                                          cal principles. Questions about
exchange-traded structured products have received much attention                          whether or not the actual marketplace
                                                                                          exists or where it’s located would be
from treasurers looking for enhanced returns to cash.                                     viewed as nonsensical.
                                                                                             Certain benefits flow from the exis-
    While there is a tremendous variety        investigate the breakdown of this mar-     tence of a multilateral marketplace to
to the financial attributes of these prod-      ket, concepts associated with games-       all participants. Tangible benefits
ucts, one common feature is the way in         manship may be just as well suited. Suc-   include the sourcing and sinking of liq-
which they are dealt in the market-            cessful professional games have            uidity; the ability to discover prices
place: bilaterally. Although treasury          endured on three fundamental tenets:       through immediate reference points,
personnel may not realize it, expected                                                    and the ability to gauge dealing activi-
return calculations may be jeopardized          1. There is a venue for the game to take  ties against third-party dealing activi-
by certain incalculable risks that arise           place.                                 ties. In addition, all participants can use
from dealing in this marketplace.               2. There are rules that all participants  the marketplace as a way of transferring
    Newcomers in particular need to                endorse and understand, which          risk immediately, rapidly and reliably.
understand how OTC transactions differ             don’t change during the
from exchange-traded products and                  game.
how these differences affect risk/return        3. There are referees to
                                                                                   Dirty players and rule-breakers
expectations. In fact, to say that OTC             monitor the game and,           are ostracized.
transactions occur in a financial mar-             when necessary, inter-
ketplace is somewhat misleading. Most              vene to enforce the rules and penal-      Participants do not enjoy these ben-
financial marketplaces provide the ben-             ize participants who break them.       efits in a bi-laterally negotiated,
efits of multilateral trading to its partici-                                              cleared, and settled OTC market. Fun-
pants. But the OTC market does not.                Even the most unregulated, unstruc- damental flaws in the operation of this
    Institutions have competed for             tured amateur game, such as British marketplace have become apparent in
decades to bring to market financial           Bulldog, follows rules and codes of con- the breakdown in the OTC inter-bank
products that incorporate the latest           duct, possibly laid out by the group just dealing market for credit and liquidity.
theories from the fields of microeco-          before the game begins, by which all          The extensive liquidation of finan-
nomics and finance. Technology plays a          participants abide. Dirty players and cially engineered securities, whose
pivotal role in this financial engineering      rule-breakers are ostracized by the intrinsic value relies on instruments
competition.                                   greater group for undermining the two or three times removed from them
    Given the disruptions in 2007 of cer-      integrity of the game.                     and whose seminal transaction may
tain areas of the OTC market, however, a           Sound gamesmanship principles have taken days, if not weeks, to create
serious discrepancy seems to exist             also exist in some financial markets and put on the books, was expected to
between the creation of a financial            such as equity and commodity occur immediately, an impossible
instrument and the ability to efficiently      exchanges. In these arenas, everyone expectation.
deal in it. The breakdown in the inter-        plays by the same rules. All participants     Exacerbating this pressure were dis-
bank market for credit and liquidity has       understand the nature, quality and senting interpretations of legal lan-
left all participants with unaccountable       meaning of the traded instruments. No guage supporting various flavours of
systemic risk that traditional risk mea-       single participant controls the defini- OTC products. Parochial interpretations
sures cannot readily capture. This mar-        tion of an instrument, and definitions, of legal agreements clearly undermine
ket for liquidity and credit may have          once established, are not open for the integrity of dealing in these prod-
been well-established, but it was far          interpretation. In each of these market- ucts, just as players who change the
from well-functioning.                         places, regulatory referees oversee the rules midway through a game under-
    While a theoretical analysis relying       interests of all those involved in the mine its integrity.
on game theory is probably warranted to        marketplace.                                  Furthermore, according to probabil-

CANADIAN Treasurer                                                                                          FEBRUARY / MARCH 2008 15
ity theory, conducting deals based on                               have brought in-house operations and                chises, if the model functions on
who is involved rather than what is                                 technologies that are completely for-               anonymity. A means test in advance of
involved jeopardizes the factor inde-                               eign to their existing business.                    admission to the facility should perma-
pendence necessary for a risk-efficient                                 In such a context, established pro-             nently remove the counterparty give-
system.                                                             fessionals in the OTC market, who know              up requirement. Moreover, security
    Finally, since banks act as agents of                           the natural buyers and sellers, profit at            deconstruction and pricing must be
private enterprise and government pol-                              the expense of the newcomers. Market                readily and electronically available
icy, their dual role exacerbates the neg-                           direction, tone and other valuable price            within the facility for efficient examina-
ative effect of a systemic failure on the                           dealing signals are gained at the                   tion of tier composition across respec-
rest of the economy.                                                expense of inexperienced counterpar-                tive securities.
    Some say these factors in the OTC                               ties. Newcomers don’t necessarily real-                 Until a new model is created, partic-
game are part of the risk in dealing in                             ize that profitable dealing in the OTC              ipants must co-exist within the existing
structured products. They say the buyer                             market essentially requires dealing in a            framework. To reduce the systemic risk
should beware when dealing in OTC                                   series of one-way transactions across               for all market participants new entrants
transactions. This advice may apply to                              counterparties to achieve the desired               to this market will require counterparty
personal, private transactions involving                            positional outcome.                                 dealing depth and efficiency equal to
second-hand cars in flea markets, but it                                 Not only do manufacturers of OTC                that of established market players.
has no place in the professional con-                               products create instruments that suit                   Success in this market requires a
duct of risk-management strategies in a                             their respective needs (based on their              cohesive, holistic approach across the
financial marketplace regulated by a                                own firms’ desired position), they also             disciplines of business, operations and
federal government.                                                 have insight into the overall marketplace           technology. Therefore, information,
    Instead of transferring well-defined                            through their market-making activities.             dealing, booking, clearing and settle-
and understood risk profiles and                                    Those who are new or relatively inactive            ment people, processes and systems
assuming a more desirable risk profile,                              in this market do not have access to this           should be expected to exist, equally,
parties who repudiate the rules                                     aspect of information.                              amongst counterparties to a deal.
through selective interpretation, after                                 The current bi-lateral dealing model                If these conditions do not apply,
the game is in play, turn the exercise                              for OTC products is not efficient. While            then, as in poker, a cursory look around
into a fiasco. Counterparties who have                               many experienced players have built                 the table will identify who should prob-
followed the original rules are left                                valuable franchises arbitraging ineffi-             ably not be in the game; or at least,
unfairly and unethically with deterio-                              ciencies on dealing alone, self-preser-             won’t be for long.
rating risk profiles.                                                vation and selective dealing are often at
    The move in Canada toward active                                odds with the role of intermediary that             Mark Waugh is Director of Capital Mar-
portfolio management has sent pen-                                  that global central banks expect these              kets & Risk at Stratix Consulting in
sion funds and money management                                     participants to play.                               Toronto (www.stratix.ca), co-host of the
firms searching for new books of busi-                                  The creation of a multilateral deal-            4th Annual FPL Canadian Electronic
ness to secure greater, non-market-cor-                             ing facility does not necessarily have to           Trading Conference in Toronto in May
related returns. As a result, many firms                             compromise the value of these fran-                 (www.etradingcanada.ca).

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16 CANADIAN Treasurer                                                                                                                             FEBRUARY / MARCH 2008

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