Global structured products survey:

trends and issues in the market

Michael Mahlknecht, Director, Consulting, Delta Hedge

As the subprime crisis has recently reminded us, structured finan-

Australia 3 Greece 1 Portugal 2
cial instruments bear multifaceted complex risks, which, at times,
Austria 14 Hungary 2 Singapore 3
even experienced analysts cannot fully grasp. “Reality strikes Belgium 3 Israel 1 Spain 4
back,” stated Jean-Pierre Roth, Chairman of the Governing Board Brazil 2 Italy 5 Slovakia 2
Canada 3 Japan 6 South Africa 2
of the Swiss National Bank, referring to the inadequate methods
China 4 Luxembourg 3 Switzerland 22
for risk management and pricing of structured instruments. These Czech Republic 2 Netherlands 3 Taiwan 2
problems, however, are not specific to the subprime market. In fact, Finland 2 New Zealand 1 U.K. 13
France 4 Norway 2 U.S. 9
structured products — whether they are based on equity, commodi-
Germany 21 Poland 2
ties, credit, or any other asset class — exhibit immanent risks, which
even specialists often have difficulties analyzing and that can be
Figure 1 – Number of participants per country
easily overlooked by less experienced analysts.

Experts in the market have quite differing opinions on the subject.
While some complain about the difficulties in obtaining correct
pricing, others claim that pricing does not present any problem to
structured products managers. While some institutions feel they
are largely pushed by customer enquiries, others have a more
proactive and aggressive attitude towards the market. And while
some pundits state that the highest level of complexity of product
structures has already been achieved, others clearly expect an even
higher level of sophistication in the future.
To a certain degree, of course, all these assessments depend on the
status quo: on the specific niche of the company (i.e., retail versus
corporate customers), on the depth and complexity of its existing
instrument portfolio, and on the regional market it is located in.
In order to gain a truly integrated view of the major issues in the
industry we have carried out a global structured products survey,
the results of which are provided in this article. We find that pricing,
risk management, and system performance are major challenges to
financial institutions.
Methodology and participants
The survey was conducted in two steps. Firstly, 356 institutions
worldwide were approached with a standardized email containing
information on the survey and the four questions posed. For each
question a series of potential answers were provided, among which
the respondents had to choose their responses. 143 institutions
participated in the email survey, most of them (95.8%) providing
feedback to all four questions. The surprisingly high response rate
(40.2%), which is significantly higher than the average for these
types of email surveys, is an indication of the relevance and time-
liness of the questions posed. The response rate is even higher
(73.3%) among the top 30 global players in the field of structured
products, 22 of which have contributed to the survey.
Secondly, personal interviews were conducted with experts from 56
institutions, who were disposed to providing even deeper feedback
after sending back their written answers. To complete the picture,
we also talked to renowned industry experts, as well as to leaders
of various structured products interest groups and associations.
The 143 financial institutions comprised in the survey have their
headquarters located in the 29 countries presented in Figure 1.
As Figure 1 demonstrates, a relatively large proportion of the par-
ticipants came from countries like Germany and Switzerland. This
is simply due to the fact that these countries have highly developed
markets for structured products, while the U.S. and the U.K. are still
some way behind in this space. The same is true (and even more sig-
nificant) for regions like Asia and the CEE countries, where particu-
larly Poland, Hungary, and the Czech Republic are rapidly growing in
this space. The questionnaire comprised the following 4 questions:
1. In which areas do you see the major challenges regarding struc-
tured products management?
a) Precise and transparent pricing of structured products.
b) Fast and simple definition of new instruments in software
systems.
c) Performance and solving current capacity problems in pro-
cessing structured products.
d) Risk management / risk analysis of structured products.
e) The internal communication of risks.
f) Other: (Please specify).
2. Regarding the structured products in your portfolio, do you
expect them:
a) To become more multifaceted (e.g. by adding new underlying
asset classes).
b) To grow in complexity (becoming increasingly complex to
calculate).
c) To grow in number and in volumes.
3. Do you plan to extend your current structured products IT
systems (by third-party or proprietary solutions):
a) Within the next 12 months.
b) Within the next 2 years.
4. What do you think is the main reason for the growing
supply of structured products in the market:
a) Structured products are a major source of revenue for us.
b) Supply is heavily driven by customer inquiries.

14 – The   journal of financial transformation

Main results of the survey
The results of the survey show that financial institutions, inde-
pendent of size, are facing significant challenges when managing
structured products. 56.0% of respondents claimed that pricing is
a major issue for them. Weak liquidity, flawed pricing systems, and
lack of transparency on hedging and transaction costs appear to
be the main reasons for that. 41.3% emphasized having difficulties
with risk management of structured products. A precise modeling
of structures and input parameters, along with dynamic visualiza-
tion tools, can be key for efficient hedging and risk management.
40.9% of global structured products leaders are struggling with
performance and capacity problems. This seems to be associated
with the fact that standard platforms have low performance and
scalability, as well as insufficient real-time capabilities. 31.8% of
global leaders have difficulties defining new structured products
in their current software systems. A modern interface design and
easy product definition features can solve this problem.
The results of the survey also demonstrate that financial institu-
tions, irrespective of geographic location, expend considerable
efforts to enhance their structured products IT infrastructure. In
fact, 4 out of 5 respondents plan to extend their systems within
the next 2 years. 95.2% of the respondents in the top 30 global
leaders category are planning to extend their systems within the
next 24 months. It is interesting to note that the majority of par-
ticipating institutions expect their structured product portfolios to
grow in term of volume and underlying asset classes. Only a quarter
expects a further increase in complexity. Majority of the respon-
dents believe that customer demand will be the main motivation
behind the growing supply of structured products.
Global results in detail
Major challenges in structured products management
The biggest challenge facing financial institutions worldwide is the
correct pricing of the structured products that they have in their
portfolios (56.0%). This is followed by efficient risk management
(41.3%). Performance (21.3%) and the definition of new instruments
in their current software applications (20.0%) appear to be minor
problems for the average institution.
This is due to the fact that the overwhelming majority of participat-
ing companies are local institutions with small portfolios. Those
portfolios are also usually comprised of mostly standard product
structures, which can easily be defined in many software systems.
However, it is interesting to note that irrespective of geographic
location the ranking of the challenges remains constant.
There are many and quite multifaceted reasons underlying these
results, which have been mentioned by the participants. Regarding
pricing as the major challenge, markets for many instruments are
not liquid enough to derive meaningful mark-to-market values or
input parameters, such as efficient volatility surfaces. This may
concern either the instrument itself, or its individual structural con-
stituents, whose prices are not directly observable in the market.
This is true for both complex (often hybrid) structured products as
well as securitized assets, as was the case in the recent subprime
crisis. In such cases, the problem may be solved by using local
approximative market portfolios (as proxies for a non-observable
underlying), or through a fully fledged simulation of all hedging and
transaction costs arising in a trading cycle.
The second reason is that small- and medium-sized price-takers
often do not have comprehensive pricing software systems in
place. For their initial pricing, they rely on approximate estimates
(often, by using simplified theoretical models) or on ‘beauty con-
tests,’ where they ask various issuers for offers and simply select
the best price. In both cases, no transparency on the hedging and
transaction costs implicit in the structure can be achieved. When
structured products are mispriced by their issuers and the market
is lacking liquidity, this can lead to dramatic losses for the naïve
price-takers. Again, employing realistic models (for example, based
on hedging costs simulations or other state-of-the-art approaches)
can significantly improve pricing estimates and transparency on
costs and risks can be dramatically increased.
Finally, many institutions stated that their current software appli-
cations were not capable of adequately calibrating volatility and
correlation surfaces. In fact, sophisticated models (covering, among
others, local and stochastic volatilities as well as various correla-
tion concepts) are essential for the correct evaluation of many
structured products. Moreover, an efficient visualization toolkit can
be helpful in monitoring and calibrating correlations and volatility
surfaces in real-time.
Similar to pricing, the mathematical models used in risk manage-
ment often fail to fully capture the dynamics, risks, and cost struc-
ture of the analyzed instruments. It is well-known that standard
models, like Black-Scholes-Merton, under specific circumstances
produce Greeks or other results that are pretty flawed and lead to
dramatically wrong conclusions. The same is true for the modeling
of volatilities and correlations, which obviously form an essential
component of risk management as well. Since many financial prod-
ucts and their structural components are not actively traded on the
market (and, thus, not observable empirically), risk managers quite
often have to face an undesired “garbage in, garbage out” effect
with regard to input parameters.
With the growing complexity of structured products, the likelihood
of hidden risks not being detected early enough is increasing. This
may include impending gamma bombs, difficult-to-quantify prepay-
ment risks, credit and counterparty risks, and many others. In order
to gain a clearer picture of hidden risks, extensive visualization
15
 tools have been proved to be very helpful. Interactive computer
graphics, for example, allow the firm to perform complete visual
what-if analyses, graphical simulations, and to execute dynamic
hedging transactions. The behavior of structured products, funds,
or portfolios can be viewed in the form of a movie, showing, for
example, concurrent simulations of values, Greeks, and other risk
measures. Such visual tools can also support the internal reporting
and the communication of risks across a financial institution.
Unfortunately, current off-the-shelf risk management systems are
usually unable to support all structured products adequately. To
overcome this problem institutions can choose only between time-
consuming workarounds or dangerous simplifications. While there
is clearly no substitute for a detailed analysis of product and port-
folio structures, in practice transparency on their constituents is, in
many cases, relatively low; at least for price-takers. Consequently,
some institutions (as well as structured product associations) plan
to create transparent and dynamic risk measures, which should
be able to facilitate communication in the market. Being an issue
mainly for the major financial institutions, performance problems
and the definition of new products in the system will be looked at
more closely next.
Future development of structured product portfolios
The majority of the participating institutions (70.3%) expect their
structured product portfolios to grow in number and volumes, while
63.5% stated structured products will become more multifaceted,
especially in terms of underlying asset classes. In general, credit-
linked structures, weather derivatives, volatility products, as well as
structured funds and structures based on alternative investments
(such as private equity) can be expected to further gain in impor-
tance in the market in the future. On the other hand, many smaller
institutions trying to catch up have plans to broaden their portfolios,
by, for example, covering hybrid and equity derivatives, as well as
interest-rate and FX derivatives. Only 25.7% of the participants
expect their products under management to grow in complexity.
In fact, many experts have stated that the peak of complexity had
already been reached. This is obviously not the case for companies
that to date have managed only rather simple structures, typically
low-volume price-takers planning to extend their structured prod-
ucts businesses within the next few years.
Planned extensions of IT systems
Almost 3 out of 5 financial institutions plan to extend their IT sys-
tems to manage structured products within the next 12 months.
This group consists of large-sized institutions that are continuously
extending their software infrastructure through both third-party
and proprietary applications and various local and regional players
that claim that after working with simple Excel solutions for a long
time they plan to extend their systems with front-to-end off-the-
shelf solutions.
16 – The   journal of financial transformation
It is further interesting to note that, in interviews, many major
financial institutions stated that they were looking for a seamless
combination of in-house and commercial systems. While in the
past purely proprietary solutions had often been preferred, some
experts suggested that this reasoning was heavily due to the limited
interoperability of many of the off-the-shelf systems. Now that the
service-oriented architectures (SOA) principle is entering the world
of finance, software suppliers that have strengths in specific areas
are able to deliver significant added value, provided that their sys-
tems meet the modern integration standards and are able to build
a flexible and open framework of real-time solutions. Only 18.6% of
the institutions questioned said they were satisfied with their existing
software. 24.3% of the participants plan to extend their systems in
the next 2 years.
Main reasons for growing supply of structured products
57.1% of the respondents identified customer demand as the major
driver behind an increasing supply of structured products. 42.9%
said that they had entered the structured products business pro-
actively, since it became a major source of revenue for them. One-
sixth of the respondents chose both options, simply because they are
so interrelated that at a certain point it can be difficult to differenti-
ate between them.
In fact, this issue emerged from the many discussions we had held
with medium-sized financial institutions in relatively mature mar-
kets. Several of those institutions did not yet have the necessary
systems in place to analyze all of their structured products, but
claimed that they had to offer structured products to their clients
simply because there were so many client inquiries. One manager
said, “Our clients are offered all these structured products by the
larger banks and ask us whether we were also able to deliver these
to them. So we have to react.” It is interesting to note that two
banks, which gave us similar responses a year earlier, have in the
meantime established powerful structured products teams and
departments, and now view structured products as one of their
most important sources of revenue.
From this perspective, one might be tempted to interpret the degree
to which market participants take on such a proactive attitude as an
indication of the maturity of a market. However, the logic also flows
in the other direction. A number of global issuers have explained
that in the past, overly complex and nontransparent structures had
been introduced to the market that were sophisticatedly designed to
deliver high returns, but were not able to arouse investors’ interest.
Most of these global players have since taken on a much more cus-
tomer-oriented attitude. Those that have not, were sometimes hit by
major losses in the markets.
Global top 30 players’ results
We approached the global top 30 players in the area of structured
products and received responses from 22 of them. Their responses,
along with feedback from the interviews that have been conducted
with experts and specialists from these companies (as well as with
structured products associations, which in many instances are
representing larger institutions), should serve as a representation
of the perspective of the worldwide market leaders, and in specific
that of the global structured products players.
Major challenges in structured products management
In contrast to the global average, pricing is not the single biggest
challenge for the major global players. In fact, 40.9% mentioned
performance and capacity problems as the major issues, closely
followed by risk management (36.4%), pricing, and the definition
of new structured products in their current software systems (both
31.8%). Again, this ranking remains astonishingly stable, almost
independent of geographical location. In part, these results stem
from the sheer size of the participating companies. Obviously, per-
formance problems are much more likely to impact financial insti-
tutions that manage larger volumes. Similarly, risk management is
much trickier for the global financial issuers, which have to monitor
and hedge considerably more complex structures on a daily basis.
Again, there are multifaceted explanations for these results, which
have been put forward by participants. The problems with pricing
and risk management have already been pointed out in the previ-
ous section, so the focus here is on performance and the definition
of new instruments in software systems. One of the main reasons
for performance and capacity problems is that most of the existing
standard software platforms are rather weak. On the one hand, this
is due to the chosen software languages: software systems entirely
written, for example, in Java can hardly be expected to support
stable and supreme performance at the highest level (compared,
especially, to C++). On the other hand, modern concepts like grid
computing or real-time SOA are not yet implemented in most of the
standard platforms. Grid computing essentially means distributing
complex calculations across a grid of servers. Some major financial
institutions, after introducing solutions based on end-to-end grid
computing, reported time savings of 70% or more. Making use of
advanced numerical engines and the power and scalability features
of modern operating systems and multi-CPU machines, even highly
complex and large books can be managed and calculated with
supreme performance.
As many existing software platforms are highly monolithic by their
very nature, they do not offer enough flexibility and scalability
to be on par with the growing requirements and volumes. As a
consequence, it is not surprising that even global structured prod-
ucts issuers, as well as derivatives exchanges, have experienced
embarrassing IT breakdowns during trading hours. Powerful system
architectures, which are based on standards such as CORBA, and
a component-oriented development design help to overcome such
problems. Most off-the-shelf software solutions are not designed
or implemented as true real-time solutions. However, a real-time
service-oriented architecture (RT-SOA) is crucial for ensuring the
biggest possible performance.
Regarding the definition of new structured products in the soft-
ware, the design of new structured products is problematic with
most software platforms. This can result in significant further
scripting or coding effort, or even lead to a situation where a spe-
cific product cannot be managed adequately. Beside the additional
ongoing costs arising from such efforts, this may lead to valuable
loss of time (especially when coding must be outsourced to the soft-
ware provider), which is crucial for risk managers and traders. An
efficient software solution should feature a strongly simplified cod-
ing language (i.e., similar to VBA), which makes it possible to define
every instrument easily and within a very short period of time. Even
more intuitive is a visual building-block approach, which allows trad-
ers and risk managers to define every desired new instrument on
their own, simply by using graphical templates, assembling them
via mouse click, and editing the remaining properties and payoff
functions in a simple code.
Furthermore, most standard system providers have integrated
external mathematical libraries (such as NumeriX or FinCAD) in their
software. However, usually only part of the mathematical methods
provided in the libraries are available to the end-user. This is again
due to the monolithic character of most off-the-shelf platforms; open
interfaces, which makes it difficult, costly, and excessively time-con-
suming to integrate new methods (or new libraries) with them. An
efficient solution offers modern, open interfaces (i.e., CORBA/COM
interfaces), which allows for a rapid integration of the software
with other (third-party or proprietary) products, irrespective of the
language in which they have been written, be it C++, Java, Matlab,
Mathematica, Python, or any other standard language.
Future development of structured product portfolios
For obvious reasons, even the more global players expect their
structured product portfolios to grow in terms of volumes, underly-
ing assets, and complexity. It is, however, quite interesting to note
how similar the proportions of their responses are to the results for
the worldwide average. The majority of the respondents (85.7%)
expect their structured product portfolios to grow in number and
volumes, 71.4% stated structured products will become more mul-
tifaceted, and only 23.8% expect their products to grow in terms
of complexity.
Planned extensions of IT systems
76.2% of the top 30 global players plan to extend their structured
products IT systems within the next 12 months. Although in several
17
 cases only small and ongoing enhancements may be added to the
systems, this surprisingly high percentage number shows the enor-
mous IT challenge facing the structured products departments of
major financial institutions. Only 4.8% of this group of respondents
stated that they were satisfied with their existing software. 19%
plan to extend their systems within the next 2 years. Thus, alto-
gether 95.2% of the addressed global financial institutions plan to
extend their system within the next 24 months.
Main reasons for growing supply of structured products
71.4% of the respondents said customer demand is the major driver
behind the growing supply of structured products. 28.6% said they
had entered the structured products business proactively, since it
formed a major source of revenue to them. Although almost one-
fifth of the participants have chosen both options (simply because
those are so interrelated with each other that it can be difficult
to differentiate between them), this result seems to prove what
has already been pointed out in the previous section, that while in
the past overly complex and nontransparent structures had been
introduced to the market, which had difficulty generating investor
attention, most players have now taken a more customer-oriented
attitude.
Outlook
In addition to the results of this, conducted between August 2007
and January 2008, further important trends and upcoming future
issues can be expected for the global structured products markets.
A particularly interesting class of structured products emerging
in the market now is the Islamic (or Sharia-compliant) structured
products, which are increasingly being issued by global financial
institutions especially for customers in Southeast Asia and the
Middle East. In order to be Sharia-compliant, these structured prod-
ucts have to be based on well-accepted Islamic laws and financing
modes and can be constructed by, for example, using roll-over
Murabaha, combinations of Murabaha and Arbun (similar to con-
ventional bond + call investment strategies), total return swaps
based on “Wa’d” (promises), CPPI structures, or other innovative
methods. In this way, almost all conventional structured products
can be replicated in a Sharia-compliant way, ranging from range
accruals, capital-guaranteed products and hedge fund-linked deriv-
atives, up to double-chance win-win certificates, and other complex
instruments.
18 – The   journal of financial transformation
It is still highly speculative to state whether (and when) the struc-
tured credit market is going to fully recover and to once again
reach the size and growth rates that were observed prior to the
recent subprime crisis. However, one can anticipate that the regula-
tory environment will become stricter in this space, putting further
pressure on financial institutions to implement comprehensive and
efficient processes and systems for the management of complex
financial products. This may be especially true for the U.S., but can
also be extended to the E.U. and other regions, and cover all exist-
ing types of structured products.
A highly important issue that is often overlooked in structured
products management, although explicitly required by guidelines
such as Basel II, is counterparty credit risk. A careful analysis is
relevant. It is important for investors in structured products to be
aware of their counterparty’s credit risks, even though issuers are
typically AA or better rated. Secondly, structured product issuers
are taking on all performance obligations resulting from the individ-
ual transactions underlying a product structure, and are thus pro-
viding a counterparty credit enhancement to their customers. This
has to be reflected in product pricing. Most industry practitioners
still resort to relatively rough Basel II capital adequacy calculations
when pricing counterparty credit risk. Finally, issuers themselves
are facing counterparty risks within their hedging transactions,
especially when they are transacting in illiquid markets.
The volume of equity-linked structured products is increasing at a
fast pace, and this trend can be expected to continue. One of the
reasons for this development is that the U.S. structured products
market is rapidly catching up in this area. While equity-linked prod-
ucts have historically been more popular in Europe (for instance,
with the issuance of complex structured retail products like the
“mountain range” created by BNP Paribas), the structured products
market in the U.S. is rapidly evolving now. Another important rea-
son is the growing need for exchange-traded options for hedging
purposes, which can currently be observed in the market.
All these developments will pose major challenges for practitioners,
and further complicate the pricing and risk management of struc-
tured products.