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Challenges faced by bank treasury systems in handling structured products

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Challenges faced by bank treasury systems in handling structured productsStructured products are hybrid financial instruments designed through combination of a Bond/Deposit/Swap with one or more derivatives. They are aimed at providing a customized risk-return investment alternative. The building blocks of a structured product often involve a Bond/Deposit/Swap, which acts as a bearing instrument, often called the “host contract”. The derivatives required for the “structuring” could come from a range of Options - FX OTC, Equity, Commodity, Index etc. The embedded derivatives in the host contracts change the behavior of the hybrid instrument, as the payout of the host contract depends on the payout of the embedded derivative.

A typical example is a range accrual deposit

The Principal Protected Deposit is a very popular product, which offers depositors the potential of earning a higher interest than on a traditional time deposit. The final yield depends on the movement of an underlying exchange rate, and on adverse movement, a minimum interest is paid to the client.

To illustrate numerically:

Date of Deposit : 01-Jan-2012

Principal Amount : EUR 100,000

Period Term : 3 Months

Reference Currencies : EUR/USD

Desired Range : 1.27 to 1.29

Interest Payout if the Reference Rate is in Range : 6%

Interest Payout if the Reference Rate is out of Range : 2%

Day Convention : 30/360

Maturity Date : 31-Mar-2012

Scenario 1: Exchange rate stays in the range of 1.27 to 1.29 during the period

Depositor gets 6% interest for 3 months i.e., EUR 100,000 + EUR 100,000 X 6% X 90 / 360 = EUR 1500

Scenario 2: Exchange rate goes outside the range of 1.27 to 1.29 during the period

Depositor gets 2% interest for 3 months i.e., EUR 100,000 + EUR 100,000 X 2% X 90 / 360 = EUR 500

Benefits to customer and bank

To customers, structured products provide the opportunity to earn higher return on investment with a minimum guaranteed return or principal protection. To banks, they offer an opportunity to attract new customers or strengthen relationships with existing clientele with a wider product range.

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Structured products business and banks

Wish list for banks

The structured products business has rapidly improved since 2008, following a downtrend during the global financial crisis. According to www.structuredretailproducts.com, funds managed under structured products amounted to $1.3 trillion globally during the year 2011, excluding private deals for companies and institutions.

Structured products are usually “buy & hold” instruments with little liquidity. Many issuers overcome this limitation by providing a “repurchase” option or making them available as “Exchange Traded Notes”. Some popular structured products in various markets are:

• Range Accrual Deposit

The treasury systems should possess the following capabilities:

1. Structuring: The treasury system should be capable of constructing the product from the basic building blocks discussed above. Traders usually sense the opportunities in the market and come up with innovative structures. Banks mandate that the defined product go through a cycle of approval by both treasury stakeholders and external regulators before it is offered to a client. Marketing also needs to be timed right to ensure product success. The treasury system should therefore be able to simulate the product and offer it up for approval.

2. Pricing: The treasury system should enable accurate pricing of structured instruments by integrating with providers of market data pertaining to the building blocks of the price. Flexible pricing, for single hybrid instruments or separately for each of the basic building blocks (host contracts and derivatives), is desirable.

• Tower Deposit

• Target Redemption Swap

• Dual Currency Deposits (DCD)

• Equity Linked / Index Linked Deposits

• Exchange Traded Notes

Banks deal in structured products as issuers, distributors and investors. Legacy systems of banks are rarely equipped to handle structured products as these systems do not meet the complex functional requirements of these products.

The objective of this paper is to enumerate and also suggest system requirements for banks to deal in structured products.

3. Marketing: Banks need to communicate clearly the product features along with risks and benefits. A term sheet depicting the best and worst case scenarios can educate prospective clients, both individual and corporate.

4. Distribution: Retail investors worldwide are increasingly evincing interest in structured products, giving banks a large client base to tap into.

Greater flexibility is required to reach the retail segment than to support interbank or corporate segments.

The following additional features would help support the retail segment:

a) Ease of use for wealth managers/ salespersons who will market the products to the retail segment.

b) System support for distribution of products through delivery channels, branches and third party distributors.

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c) Various lifecycle events like sale, repurchase, periodic interest, maturity processing made available through delivery channels.

d) Integration of the product life cycle pay-in/pay-outs with retail savings/current accounts, payments processing (to receive subscriptions and pay out the proceeds of maturity, interest) etc.

e) Processing of fees paid to third party distributors/wealth managers through the system.

f ) Adherence to MiFID, KYC and other consumer identification and protection guidelines.

5. Deal capture: The system should enable hassle-free deal capture facilitated through a flexible, reusable template which can capture all information about the structure, along with the conditions, across multiple clients. The system should be able to auto default many of the fields based on pre-configured rules.

Issuing banks would usually have two sets of deals, with the deals for building blocks on one side. In the case of an equity-linked product combining a deposit with an equity option, the customer would be buying an equity option by foregoing a portion of the interest receivable. The bank needs to buy a back-to-back option in the market to square off the option position arising out of selling the option to the client. The deals that the bank needs to go into are as follows:

1. Deposit deal with the client as part of the structured product

2. Sell deal for an equity option to the client as part of the structured product and

3. Buy deal for an equity option from the market

Typically, the first and second deals are clubbed together; however, it is more important to logically link this combination with the third deal, as having a back-to-back option deal for each structured product can happen only in an ideal case. In reality, the entire option position arising out of the

distribution of structured products to multiple clients is usually squared through a limited set of options with some residual open position.

6. Back office operations: These include confirmations and settlements. Only a single confirmation needs to be sent to the clients even if the product comprises multiple instruments. There also needs to be a single settlement, giving the combined effect of host contract and embedded derivatives. In case of retail markets, the pay-in and pay-out often happens directly into the customer accounts.

7. Risk perspective: Since the product bears risk arising from the host contract and the embedded derivatives, risk managers must monitor the limits associated with each separately. The system should support the risk manager by reporting the exposures arising from each contract in the respective credit and market risk buckets. Blotters/ Views/Reports should be available to the risk managers monitoring the risks so that they can control and mitigate them.

8. Accounting: Accounting standards direct bankers to bifurcate the structured product into the host contract and the embedded derivatives wherever the derivative is identifiable and independent of the host contract.

IAS 39 of International Accounting Standards Board (IASB) defines the accounting of structured products with embedded derivatives. IAS 39.11 requires that the embedded derivative be separate from the host contract if three conditions are met:

a. The economic characteristics and risks of the embedded derivative are not closely related to those of the host contract.

b. A separate instrument with the same terms as the embedded derivative would meet the definition of a derivative.

c. The hybrid instrument is not measured at fair value with changes in the fair value recognized in the Profit & Loss account.

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The above case discussed in #5 of “Equity Option Linked Deposit” has to be divided into deposit and embedded derivative of equity options as

i) The economic characteristics of deposit and equity option are not closely related.

ii) A separate instrument, such as equity option would meet the definition of a derivative.

iii) The hybrid instrument is treated as a deposit and not usually measured at fair value.

The above principles must be applied in each case and the product bifurcated based on applicability.

Treasury systems should provide the option of bifurcation and be able to identify it separately for accounting, which should include the fair value of the option and the host contract separately to reflect the current economic state of the hybrid instrument.

9. Compliance: Regulators across the globe have put in stringent guidelines for reporting of structured products due to the risks they pose to both banks and investors.

Compliance requirements usually include:

• Compliance with accounting and reporting standards like IAS 39, IFRS7, US GAAP

• Risk disclosure statements with details about market/liquidity/credit/options risks etc.

• Scenario analysis statements giving best and worst case scenarios

• Compliance with consumer protection guidelines like MiFID

The system should be flexible enough to handle various kinds of reporting as mandated by the regulatory bodies.

ConclusionMost treasury systems available will not be able to support many of the features in the wish list. While there is no exhaustive list to choose the ‘must have’ features from, it helps to have basic features like splitting of the derivative and the host contract, ability to reach retail segments and ability to provide the reports required for compliance.

Banks need to make an informed judgment of the system to buy based on long-term business objectives, customer needs, expected volumes and compliance requirements.

Raja Sekharam ChagantyPrincipal consultant, Finacle, Infosys

Finacle from Infosys partners with banks to transform process, product and customer experience, arming them with ‘accelerated innovation’ that is key to building tomorrow’s bank.

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