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Challenging the case against structured products - Counterparty risk - 13/12/2023

A criticism of structured products almost always at the forefront of the discussion is the exposure to potential counterparty failure. Structured products essentially function as a contract between the investor and the counterparty bank, facilitated by the product provider. In exchange for effectively lending the bank their capital for the term of the investment, the bank offers pre-defined terms for certain market outcomes detailed in the contract / product. Whilst potential for failure of a major bank or issuing institution is remote, history has proven that systemic events are possible and can shake the financial system. The collapse of Lehman Brothers demonstrated this back in 2008 and whilst catastrophic at the time, once the dust eventually settled the pain realised wasn’t as bad as many initially thought.

Should the counterparty bank default on its obligations, investors could theoretically be facing a total loss on their investment, however this is by no means a foregone conclusion. With Lehman’s investors were left to the mercy of the liquidator who had the task of selling the bank’s assets to repay debts. On the day of Lehman’s collapse the implied recovery rate for Lehman’s senior bonds was 30% but as it was for UK retail FTSE linked autocall investors the ultimate recovery rate was between 76.53% and 97.48% albeit over an eleven-year period. As such, no investor should have suffered a total loss but that should not belittle the risk where no matter how strong the institution may appear, the risk of collapse is always a possibility. Less than 1% of all structured products in the UK retail market at that time of the collapse were backed by Lehman Brothers. The other 99% that represented the wider market was unaffected.

More recently Credit Suisse, a counterparty to a small number of UK retail structures got into difficulty and was acquired by rival UBS, coordinated by the Swiss government and Swiss regulators. Whilst the outcome for $17 billion of Credit Suisse additional tier 1 bonds would be written down to zero, the senior secured credit backed structured products were unaffected and they continued to perform as defined in their product literature.

A key principle of sensible investing is of course diversification to the extent that no investor should have been substantially exposed solely to the risk of a single bank failure. Today’s UK retail structured products sector utilises ten globally systemically important banks providing ample opportunity to diversify counterparty risk. Details of each institution are included in the product literature, together with the ratings of perceived strength from credit rating agencies such as Standard & Poor’s, Moody’s and Fitch who typically rate these banks to have a strong capacity to meet their financial obligations.

Additionally, where the product is a structured deposit investors can potentially benefit from the protection provided by the FSCS which will pay up to £85,000 per person, per failed deposit-taker.

All investing involves risk in one form or another and with structured products, counterparty risk is almost always ‘baked in’. The ultimate acceptance is that risk plays a part in facilitating the defined returns of structured products, which with very few exceptions have delivered positive results.

Structured investments put capital at risk.

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