Liquidity has fast become one of the key issues on the international agenda. We ask participants to comment on the current situation and future prospects.
The founder of the US Structured Products Association knows something we don't: "Stay tuned," says Keith Styrcula, knowingly, when asked whether banks in the US generally quote prices on each others' products (they do not at present). "To borrow an apt, but time-worn phrase, 'necessity is the mother of invention'," he says. Secondary market liquidity has become the number one issue in the US market, particularly after the 'Bear Stearns scenario' of last month.
When 'liquidity' is provided solely by the issuer, the crisis that causes it to disappear can be confined to a single institution, as witnessed when troubled Bear Stearns stopped quoting secondary market prices on its online system while it waited for suitor JPMorgan to confer its credit rating on the bank's products. (Providers confirm that Bear Stearns was quoting over the phone during that period, but at unattractive prices.)
Widening spreads are common in distressed markets confirms one Belgian banker, while DZ Bank's Heiko Paul adds, "In shock situations liquidity is pulled out of the market - after the shock, the rise in volatility reverses this trend for structured products."
As another banker in Germany points out, even in this listed market, "There were shortcomings in providing liquidity when markets became really volatile." The capacity constraints of the technology employed by issuers caused the problems, he explained.
Styrcula, long an advocate of exchange listing, agrees but says it is really the dissemination of pricing that needs to be addressed in the US market. "This lack of electronic pricing for the majority of the 7,000-plus structured products issued each year in the US is a major frustration for many on the distribution side, who rightfully say, 'My retail investor doesn't have a Bloomberg terminal'," he says. "I'm aware of several initiatives intended to address this."
Third party quotes are rare - even a listed market relies on quotes from the issuer, notes one banker - and Styrcula agrees we are at least two to three years away from being able to take a liquid secondary market for granted. The firms are so proficient at creating new issues on a cost-effective basis, that there is little interest in making active secondary markets for existing structures, he says. "As you noted, the solution will come from an incentivised third party." He will not say who, but the external systems used to make prices available are Bloomberg, Reuters, and now BondDesk, Numerix and others.
Meanwhile, the major investment banks have been busy developing in-house e-commerce platforms for their own products. Whether Barcap's BarX or Deutsche Bank's Xavex, the platforms are local variations on a single concept: a multi-asset-class platform with educational and marketing bells and whistles, and usually online trading in real time.
The market standard size limit, if there is one, depends on the liquidity of the underlying instrument, but in continental Europe appears to be around €100,000 (larger could cause price adjustments), rising to €250,000. Larger orders tend to be taken by telephone. One bank that asked not to be named said there was no limit if the investor made direct contact, but a limit of around €250,000 would apply via the exchange, where most of its products are listed.
Again, there appears to be a geographical bias in terms of the use of valuations versus actual dealing prices, which often reflects the existence or not of an exchange traded market. Macquarie Bank in Asia, for example, uses daily valuations (it provides daily liquidity for the majority of its non-flow products) and executes via telephone or email. Many make their quotes available on Bloomberg and Reuters, or Telekurs in Germany, as well as in-house web systems.
Banks increasingly show performance statistics against the underlying as well as on a standalone basis. One Belgian bank, however, said clients can perform their own analysis from Reuters or Bloomberg prices.
An impediment in the US to offering this information, says Styrcula, "is that the industry prefers to market structured products based on cool jargon and acronyms, rather than the performance of the products issued. In this regard we could certainly use a page from our brethren in the mutual fund industry."
Back on the high street, among the local banks and mutuals, of course, daily liquidity is less common, and often accompanied by onerous exit penalties. Here, JPMorgan's Tim Hailes, who is also chair of the joint trade associations committee on retail structured products (JAC), says, it is really a question of making sure that the clients know what they are getting. "Are people investing on a buy to hold basis? What's the client expectation? These are the questions that issuers need to think of when selling [at this level]."
Drivers and driven
There are multiple drivers towards increasing liquidity. The most obvious factor is the investor ("If you don't deliver you're out of the market," notes one Belgian banker) in a list that extends from the best execution requirement posed by Europe's Mifid directive, through to open architecture in general, competition and self-regulatory attempts by industry players and bodies. Eric Wasescha, Geschäftsführer at the Schweizerischer Verband für Strukturierte Produkte, says, in a statement echoed by SPA's Styrcula, "We believe that a healthy competition is the best guarantee for a liquid market."
Demand for liquidity is greatest in the private banking community, where it is considered part of the positive cycle of growth. Wealthy investors will even pressure distributors and issuers into providing liquidity where it does not exist, as recently proved by IIB's Irish clients who had borrowed to invest in a hedge fund-linked product and seen the value of their investment eroded by rising interest rates. Liquidity was provided.
A recent Barclays Capital survey of 91 Asian managers highlighted the focus of wealthy individuals, who listed the most important product features over the next two years as, in descending order, growth, liquidity, diversification and capital protection.
Morgan Stanley's Marc Chamberlain says, "...In the private banking world [liquidity] is a two-way process, with people looking to buy and sell on the secondary market. Daily pricing and intra day is necessary to be able to give the manager the same liquidity they have with shares of a fund. Mandated managers can't be caught in a situation where you're liquidating a portfolio and just the structured product is waiting."
The trickle to retail, where structured products are sold on a buy and hold basis, is slow, but even here financial advisers are increasingly asking the question, and providers increasingly consider it their duty to provide a secondary market. One UK provider says, "We see three or four orders for returns every week and generally the spread is around 1%, which is pretty good really." But as the sophistication declines so does the liquidity:" [In pure retail] we offer a window every two weeks and we don't really see a demand for more," says Chamberlain.
A French (mostly retail) asset manager calls liquidity provision 'one of our key jobs': "We impose our demands and expectations for this facility clearly within the swap agreement with the counterparty we choose. We always insist on a daily Nav and clients can exit the funds when they wish at this level for no extra cost," he says. On the other hand, the house charges a 'preventative' 5% fee for investors to buy funds on the secondary market because for retail funds with original structures "the spreads are too big for us to consider them attractive for our clients".
Funds investing in SPs and the active management of mandates are another likely push towards, and perhaps provider of, liquidity. Not long ago, such funds could be counted on a single hand. Now they include among others, Barings Asset Management and Lombard Odier Darier Hentsch, which is aiming to raise €1bn across Europe for its fund of structured products.
Sometimes banks are liquidity drivers themselves, as they push to differentiate themselves by their service, sometimes because they see an opportunity in the market. A year ago, in Italy, for example, Morgan Stanley offered around €41bn for 250 structured products listed on the Italian stock exchange, planning to buy listed products with a small secondary market and repackage them into bonds paying a variable coupon. The plan was not a success and these days nobody wants to talk about it.
Back on solid ground, Macquarie's Singapore-based Harry Krkalo says the bank's offer of daily redemption "in most cases exceeds our clients' expectations, and in some cases the client's own back office capabilities." Nevertheless, he says, "...Investment banks will ultimately need to provide distributors with an efficient information delivery model as well as be able to back up pricing requests with a fair secondary market."
So what holds back liquidity? DZ Bank's Heiko Paul, says liquidity is a victim of the rapid growth in the market. This means, among other things, as another German banker explains, "Technology has to be scalable at the issuer level in order to maintain the ability to quote and trade all products... the only solution is to increase the capacity of quoting systems and risk management systems."
"The market is already quite liquid, taking into account the complexity of the products," says a Belgian banker. "To get real liquidity, where different banks quote for the same product, you would need a lot of standardisation, which is difficult given the nature of the products." That and whatever Styrcula is not prepared to reveal.