F E AT U R E C A P I TA L MARKETS
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).
MAXIMIZE YOUR SKILLS AS A TREASURY PROFESSIONAL !
Please start my personal subscription to Canadian Treasurer magazine!
1 Year Subscription — $45.00 +GST, $47.25 Cdn t Quebec Residents $50.79 t Atlantic Provinces Residents* $50.85 t
2 Year Subscription — $75.00 +GST, $78.75 Cdn t Quebec Residents $84.66 t Atlantic Provinces Residents* $84.75 t
GST Registration #R121368393; QST Registration #1017357391) *PEI Residents $47.25/$78.75
Payment enclosed t (Please make cheque payable to Treasury Mgmt.Assoc. of Canada)
MasterCard t Visa t Amex t
Card #: Expiry Date:
Authorizing Signature: Bill me t
PLEASE SEND ME INFORMATION ABOUT TMAC t
COMPANY: PHONE #: FAX #:
FULL MAILING ADDRESS:
Please return this form to: Canadian Treasurer, 8 King Street East Suite 1010 Toronto, Ontario M5C 1B5 Canada
Fax: (416) 367-3240 Phone #: (416) 367-8500 1-800-449-8622 or e-mail above information to: firstname.lastname@example.org
16 CANADIAN Treasurer FEBRUARY / MARCH 2008