32 CAPITAL Business Magazine
com
Regional Business
Dangerous innovations
Structured finance
instruments in the UAE
Innovation in the finance industry: ability of large gain
structured finance products - Products implying a one -to-one tracking of an asset, a bas-
Structured products are investment vehicles whose value is
derived from, or based on, a reference-underlying asset, a mar-
ket measure or an investment strategy. They generally have
varying terms, payout and risk profiles. Some have a princi-
pal guarantee function, some pay interest and some do both.
Those having “principal guarantee” function offer protection
of the principal investment if held until maturity. The returns,
if any, are typically payable at maturity and depend on the
performance of an underlying set of commodities, equities or
indexes. Those paying interest relate the volume of interest to
market performance of a complex mix of “underlying” assets”.
A “structured” way of viewing structured
products could lead to the following segmentation:
- Products with high probability of small gain + low prob-
ability of large loss
- Products with high probability of small loss + low prob-
ket of assets, or the correlation between assets
- Products that combine all features and best labeled as “hy-
brid structure”.
Structured products were created to meet specific needs that
cannot be met by available standardized financial instru-
ments. Their greatest advantage is, probably, the potential for
enhanced risk-adjusted returns.
Structured products are usually issued by investment banks or
affiliates thereof. They have fixed maturities. They are mostly
made of two components: a note and a derivative which is
often an option. The note provides for periodic interest pay-
ments to the investor at a predetermined rate, and the deriva-
tive provides for the payment at maturity.
Risks associated with structured products are many. The most
threatening is the risk of loss of principal, which is real if the
market value of the underlying asset or assets oscillates, nega-
tively, or the investor’s demand for liquidity induces an early
www.capital-me.
33
By Professor El Namaki
To innovate is to add value. That could be producer value, end user value or supply chain value. The uniqueness
of the process delivers windfall gains and measurable synergies. It is a Multi-stage process whereby organizations
transform ideas into new, improved products, services or processes, in order to advance, compete and differenti-
ate themselves successfully in their marketplace. Yet innovation does not always carry that aura of effectiveness.
Recent history of innovation in the finance industry reveals a strikingly negative outcome. Structured finance prod-
ucts have lead, in widely publicized cases, to asset loss, investment institution collapse, massive government inter-
vention and, last but not least, consumer pain . It is innovation gone berserk! The UAE Government has introduced
restrictions on trading in structured products as of August 2009 unless approved by the Central Bank. Why?
pre-maturity termination of the investment. The market val- • Credit risk. Structured products are unsecured debt from an
ue of structured products is, moreover, influenced by unpre- investment bank. Risk measurement methodologies for trading
dictable factors that may include, but are not limited to, the these products were heavily focused on VaR (Value at Risk) (b),
price or level of the underlying asset (or market measure), especially for market risks and related techniques for counter-
the volatility of the underlying asset (or market measure), in- party credit risks. Generally risks were measured using separate
terest rates, dividend rates, the issuer’s creditworthiness, the methodologies and “risk engines” for different types of risks, e.g.,
time remaining to maturity and geopolitical conditions. market risk or credit risk. Some risk measurement methodologies
The regulatory framework of structured products, in the required simplifying factors in their risk estimation, rather than a
United States in the first place and Europe in the second, is full revaluation of the individual positions. Simplification, how-
hazy at best. It seems, to all appearances, that ffinancial regu- ever, often tended to underestimate exposures, as specific risks re-
lation has lagged behind financial innovation. US regulatory sulting from unique product features may not have been captured.
regime regulates deposit-taking financial in- • Complexity. Structured products are com-
stitutions and conventional financial prod- A structural product plex investments and complex investments
ucts with obvious externalities and seems to was defined, for the could have concealed risks that are not read-
have largely ignored non-bank entities with Central Bank’s purpos- ily apparent to the unsuspecting investor. The
their myriad of novel and unconventional es, as a ‘pre-packaged slicing and dicing of mortgages lead, for ex-
instruments. investment strategy’ ample, to intricate products that investors,
with ‘embedded op- credit rating agencies and even brokerage
Where did structured tions’ in respect of an- firms failed, at times, to comprehend. Mort-
finance products go wrong? other financial product gage-backed securities (MBS), asset-backed
Incidents of structural product failure are or products. securities (ABS), collateralized mortgage
more frequent than not. The scope and scale obligations (CMO) and collateralized debt
are well known given the involvement of in- obligation (CDO) are examples. The hetero-
vestment banks, funding agencies and countries in the pro- geneity of asset base, the derived nature of returns and the very
cess. Those cases have pointed out to several prime sources of wide variety of the product specifications all lead to a difficult to
malfunction: understand instrument even for the specialized.
• Market pricing and liquidity. Structured products pricing • Regulation: Structured products are instruments made and
is matrix based rather than net asset value based. Matrix prices rated by an unregulated segment of the finance industry: in-
are based on quoted prices for securities with similar coupons, vestment banks and rating agencies. A combination of an
ratings, and maturities, rather than on specific bids and offers AAA rating by rating agencies and a reduced capital require-
for the designated security. The name “matrix price” comes ment (for this type of asset) by Basel II, enhanced their ap-
from the practice of interpolating among values for similar peal. Their very AAA credit rating had a profound impact on
instruments arranged in a matrix format. the acquisition behavior of institutional investors as pension
It is important to stress here that securitized and structured finance funds, insurance companies and mutual funds.
markets are dealer markets. Price and market quote information is • Initial pricing. Prices of complex structured finance prod-
ultimately derived and verified through dealers based on the deal- ucts were often too low and did not reflect their true risk ex-
ers’ market making and liquidity providing function. By virtue of posure. One of those risks , systemic risk, emerged when
their size and market presence, large institutional investors can in- difficulties arose in asset-backed commercial papers and in-
fluence price discovery and formation based on their trading and terest shifted, by money market operators, to the Treasury
portfolio positions, according to The Bond Market Association. bill market, inducing an increase in their price and a decline
34 CAPITAL Business Magazine
Regional Business
in their yield, according to George Dionne, in his paper
“Structured finance, risk management and the recent finan-
cial crisis” presented at HEC Montreal in 2009.
Enter the UAE
The UAE’s bur going wealth management industry made
structured products a common feature in domestic investment
portfolios. The ominous winds that blew from afar exposed,
however, the lurking threat and drew attention to an urgent
need for a defence mechanism. The Central Bank’s move, in
late Sept 2009, to impose a near ban on retailing of those prod-
ucts was a step in that direction. The instructions were stern
with sanctions and penalties going as far as striking the respec-
tive bank’s name from the register of banks of the Emirates.
A structural product was defined, for the Central Bank’s pur-
poses, as a ‘pre-packaged investment strategy’ with ‘embedded
options’ in respect of another financial product or products.
These are products where, according to the Central Bank again,
underlying assets were layered in a way that obscured risk and
undermined transparency. And that is especially the case if the
emerging murky blend goes beyond the comprehension of a
typical retail investor. As to the buyer or the investor, he was
recognized by the Central Bank as a high net worth individual,
a term equated, in the United States, to individuals with a net
worth in excess of one million US dollars. The term could also
cover individuals with a high level of financial expertise (e.g. a
company licensed to provide financial services).
External events should have had a profound impact on the
Central Bank’s decision. Damage inflicted in the US and Eu-
rope was measurable and audible! Lehman brothers collapse
created a strong wave whose ripples reached far away shores!
There is also the probability that the quantitative dimension
of the damage, within a UAE context, was profound with a
potential for measurable societal impact.
Lessons to be learned
Events surrounding structural products have called in the US and
Europe, for regulation. Regulation of the products, the issuers (in-
vestment banks), the rating agencies and the retailing process. Gov-
ernments are currently spending a lot of time and energy setting the
parameters of this regulation. What is certain is that regulation will
play an increasing role in the fortunes of the sector. The European
Commission, for example, is attempting to bring coherence to a raft
of already existing regulation so as to establish an effective regu-
latory framework for packaged retail investment products (Prips).
The UK’s Financial Services Authority put the squeeze on firms
marketing structured products to retail investors and three went
About the Author
Professor El Namaki is president, Drucker Society for Gulf States based in Dubai. He was dean of Maastricht School of
Management and The Netherlands.
He can be contacted at dr_el_namaki@drucker-gulf.org
www.capital-me.com
into administration. “It is tightening controls and will undertake
follow-up assessments during 2010 to ensure firms are meeting its
advice standards and are designing and marketing products in an
appropriate way,” the Financial Times reported in May 2010.
Balancing innovation and risk is essential for innovation to
add value, on the other hand. Did structured finance products
do that? “In some respects financial innovation makes risk
management easier. Risk can now be sliced and diced, moved
off the balance sheet, and hedged by derivative instruments,”
Ben. S Bernanke said at the Financial Markets Conference in
Sea Island, Georgia in 2007.
It is very likely, and advisable that the Central Bank of the UAE
follows the near ban of retailing of these products with a regu-
latory move similar to those initiated in the USA, the EU and
Britain. The difference may be a matter of emphasis. Protecting
the investor may feature far more heavily in the case of the UAE
than protecting the investment banks or their quasi institutions,
as is the case in the USA and, to a certain extent, Europe.
Summary and conclusions
To innovate is to add value. That could be producer value,
end user value or supply chain value. Yet innovation does
not always carry that aura of effectiveness. Recent histories
of innovation in the finance industry reveal a strikingly nega-
tive outcome. Structured finance products have lead, in widely
publicized cases, to asset loss, investment institution collapse,
massive government intervention and, last but not least, con-
sumer pain . It is innovation gone berserk! Marketing price,
short term illiquidity, credit risk, complexity, lack of regula-
tion and low initial pricing have all contributed to a combina-
tion of mal practice and mal performance.
Events seem to have induced the Central Bank of the UAE
to introduce retail trading restrictions on those products. The
UAE has a large wealth management industry and structured
products are a common feature of domestic investment port-
folios. Yet instructions were given to all banks operating with
in the Emirates to cease the selling and trading in those prod-
ucts unless explicitly allowed by the Central Bank. Penalties
for breaching this prohibition went as far as the striking of
the bank from the register of banks.
It is very likely, and advisable that the Central Bank of the UAE
follows the near ban of retailing of these products with a regu-
latory move similar to those initiated in the USA, the EU and
Britain. The difference may be a matter of emphasis. Protecting
the investor may feature far more heavily in the case of the UAE
than protecting the investment banks or their quasi institutions.