Equity accumulators “should be outlawed”

Despite their popularity in the wealth management industry, many structured investment products are still criticised for lacking transparency, to the benefit of the firms issuing or promoting them.

One Hong Kong-based derivatives trader goes as far as to say that certain instruments, such as equity accumulators, should be outlawed or at the very least regulated more stringently, as they saddle the buyer with most of the risk.

Philip York, Hong Kong-based principal at systematic trading firm Alt224, told AsianInvestor: “The industry needs to outlaw any product that creates an asymmetric risk profile between buyer and seller. It is a simple piece of legislation to write that would have saved clients billions over the last 10 years. This is a big industry that needs to be taken down.”

Other industry participants, including a market-maker, have also expressed similar concerns to AsianInvestor.

Under an accumulator contract, the buyer speculates a company will trade in a certain price range within the contract period, and the issuer bets that stock will fall below the strike price.

Accumulators – infamously dubbed “I kill you laters” after investors in Asia sustained big losses on them in 2007-2008 – typically last for a year or less and may terminate early (knock out) if the stock price goes above a threshold.

York stressed that there were many good structured products, such as index-linked exchange-traded funds. “But there are some bad ones,” he said. “These [accumulators] are the worst.”

"Lack of transparency"

Arjen Gaasbeek, Singapore-based managing director at market-making firm Flow Traders, agreed that lack of transparency was a disadvantage for certain structured products. They usually have diverging contract sizes, expiry dates and strike prices, and sometimes carry a knock-out barrier, he noted, meaning they can be hard to understand and evaluate.

It is this lack of transparency that allows some market-making banks “to deliberately obscure the optionality” involved in accumulators, said York.

Accumulators are aggregations of binary, barrier (knock-in/knock-out) and vanilla options, where the investor writes most of the options, but doesn’t get to collect the net option premium, he noted.

“Options are insurance contracts,” said York. “I sell insurance, I collect an insurance premium. I buy insurance, I pay a premium.”

But with accumulators, he said investors are enticed by their wealth manager to buy some calls “for the first month, while sticking you with the bulk of the risk and taking the net insurance premium for the rest of the year”.

“Because the seller gets to dump risk on the customer and also keep the buyer’s insurance premium, the customer has no money to effectively hedge their risk," he added. "This is deceptive conduct, but because it is sold to professional investors there is limited recourse."

Another market-maker speaking to AsianInvestor confirmed that the buyer of the accumulator might sell two puts and buy one call, but would not receive any premium for it.

That is fine as long as the stock stays above the strike price of the puts and call and the investor gets shares into his account against the strike price, he said. “But once the stock drops below the strike price, the investor will be in trouble, since the stock he receives is valued much lower than the price paid.”

Unfair treatment?

It appears that investors may be being unfairly treated, he concluded: “My impression with these structured products is that the investors are at the short end of the stick and that the market-maker, which is typically one of the larger banks, is at an advantage.”

The Singapore head of wealth management product and sales at a large global bank, took a different view: “I don’t think there’s an asymmetric risk between issuers and clients.

“The point about the structured products business in Asia is that it tends to be very one-way,” he noted. “Clients tend to sell small options to generate yield, so from a risk/reward standpoint, it tends to be tilted in that clients win small often, and when they lose, they lose big. But it’s the structure of the market and the structure of the demand.”

The appeal of structured products is based on their ability to deliver yield in a challenging, low-return investment environment, he added – typically 8-9% on flow equity products such as fixed-rate notes linked to a handful of stocks.

While there are no easily available numbers for the size of the Asian structured products market, because these are callable products, the wealth management head said that even a mid-sized bank would be selling $3 billion to $5 billion worth of them a year.

Taking into account all the major global banks and regional players, this stacks up to $50 billion a year of flow products, he noted, with 10% to 20% of that outstanding at any one time.