Structured deposits in China have always involved a delicate balancing act between offering low risk and beating deposit interest rates.
Over the years, this exercise proved increasingly problematic, and after the 2015 equity peak and with the stock market rout, Chinese banks had to find a solution to this problem. The answer was gold.
The precious metal, which is a traditional safe haven asset for investors, especially during choppy markets, attracted Chinese investors. The trend permeated into the structured products market allowing physical gold to be delivered to investors in an investment with a defined payoff.
The logic was that binary options, more commonly known as digital payoffs, are an easy way to beat deposit rates. As long as gold continued to rally, investors would get a slightly higher return, so if gold increased in one year or less above a certain threshold, clients would get a fixed coupon, beating their benchmark.
The simplicity of the payoff attracted Chinese investors and with an average volatility of around 20% in 2015 and 2016, these products delivered interesting coupons. But the environment became harsher, as volatility around the price of gold contracted, reaching an all-time low of seven percent.
Since 2016, Chinese banks had to find a new solution to continue offering capital protection and, at the same time, beat deposits rates.
They found one in the form of the USD three-month Libor - the new golden child of underlyings - which has reached an astonishing 90% of the total notional sold in structured products in China.
However, digital options on interest rates didn’t provide sufficient returns. Knowing they had to show Chinese investors how important a potential fixed coupon is, compared with participation in an underlying, banks had to find a different payoff, which came in the form of the range accrual.
This payoff offers investors the potential to earn above average returns of the underlying stays within a defined range. The investor is essentially selling digital options that pay out if the US Libor breaches the range strikes, allowing for the extra return.
As uncertainty around the USA-China trade war lingers, range accruals have replaced digital structured products as the product that defines the Chinese market. Why?
Because it still provides higher returns and delivers what the Chinese investor needs: capital preservation with a golden coupon.
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