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Retail financial innovation

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by Warren Edwardes, Chief Executive of Delphi Risk Management Limited.

Versions of this article have been published as:

"Financial innovation and derivatives in Housing Finance" June 2001, Housing Finance, Washington DC


"Derivatives: Targeting the retail client" November 2001, FOW, London link

Warren Edwardes is CEO of Delphi Risk Management, the London-based financial product creativity, communication and control consultancy. He is Director of The London School of Banking and Finance and author of inkey financial instruments. understanding and innovating in the world of derivatives - warren edwardesternational best-seller, Key Financial Instruments: understanding and innovating in the world of derivatives" 4 February 2000 Financial Times Prentice Hall ISBN 0273 63300 7 London 


This article updates and forms the basis of chapter 6 of this book by Warren Edwardes

Warren was previously on the board of Charterhouse Bank and has worked in the treasury divisions of Barclays Bank, British Gas and Midland Bank. He first researched into what were later to be called "derivatives" in 1975 and was part of the team that executed one of the world's first currency swaps in 1981. Since then he has devised and transacted numerous structures that form part of the history of derivatives. Edwardes can be contacted via we@dc3.co.uk

Don't focus on derivatives. One of the most dangerous activities of banking is lending. Ernest Patrikis, Federal Reserve Bank of New York


Should new structured financial instruments be sold to the retail client? Of course they should! Product development must be a customer driven approach and the financial markets must be tweaked to fulfil the needs of the retail client. One could say that all wholesale financial products have a retail client as an end user. If an investment bank sells a swap or equity option to a savings bank, that savings bank could use it to structure mortgage or investment products for its clients who are retail clients. Stretching this principle, a foreign exchange transaction with a corporation such as an airline or travel company could help the retail customer facing company to stabilise the prices of its holidays. But I believe that great care must be exercised in selling derivatives and other highly structured products direct to Joe Public. There is always the danger that the investor may claim, truthfully or otherwise, not to have understood the product and declare that it was mis-sold. Even selling structured products through intermediaries can be fraught with difficulty. Banks providing fixed rate mortgages have had problems in demanding the replacement cost when such a mortgage is repaid early.

This chapter looks at some of the issues surrounding retail financial innovation with a few interesting and revealing stories.

Los Chiringuitos financieros

Whilst writing this book in London, I received a telephone cold call. It was not the regular call from a someone trying to sell medical insurance or office stationery. The saleswoman wanted to sell cigarettes in bulk. What intrigued me was that the telephone call was from Spain. I could hear Catalan being spoken in the background and the caller gave me a Barcelona telephone number.

"A very special offer. Cigarettes normally costing 25 Pounds for 15 Pounds. A minimum of 3 cartons. All famous English and American brand names - Marlboro, Camel etc."

It seems that some of the shady financial operators or Chiringuitos financieros have moved on to cigarettes from the futures market! This chapter considers whether futures and options and other derivatives contracts are appropriate for the individual borrower or investor.

The main argument, and a very powerful one at that, against the encouragement of the private investor into the world of derivatives is one of investor protection - not only protection against fraud but also shelter against unsuitably risky investments.

In March 1994, futures fraud surfaced in Catalunya. Several cases illustrated how simply through telephone selling and the allure of untold riches more than 500 investors were relieved of up to 20 million pesetas each. Clients were selected through the business pages of the telephone directories. My sister-in-law, Matilde, was called at her hospital laboratory in Banyoles.

Matilde: "I am not looking for any more investments."

Chiringuito financiero: "Frankly, I am hardly surprised that you don't need any more investments. All the more reason for me to be interested in talking with you, Madam. It is clear to me that you keep yourself well informed. I would just like to inform you of our product which may be of interest to you."

The brochure of the company based in Zug, Switzerland included a photograph of cows grazing in a lush mountain valley. The Tokyo Stock Exchange trading floor featured on the cover, whilst inside were pictures of an oil refinery and glistening gold bars. The text, whilst emphasising the firm's expert capabilities, did not understate the possibility of loss.

"As is explained, stock market speculation is accompanied by significant risk. In the case of options and futures, it is possible to lose one's entire capital. The price analysis and speculation of the highly expert and specialised fund managers are not guaranteed. The markets are subject to a multitude of external influences, in part, unpredictable."

The risks of market loss were thus well outlined. However, those that took the bait were not exposed to market risk - the funds were never ever invested in the futures and options markets, but diverted to Aruba in the Netherlands Antilles! Emphasising the dangers merely served to indicate concern, customer care and professionalism. The silent implication given was «Are you "macho" enough for this investment?»

Derivatives for the Retail Customer

Retail Derivatives have been used for the protection of the individual investor or borrower against a variety of risks.

Derivatives could allow house buyers to lock into the level of house prices whilst saving for a down-payment. Property futures were developed by the London Futures and Options Exchange in the early 1990's but for a variety of reasons did not succeed and, more recently, Real Estate futures have been launched in Chicago.
Borrowers can also protect themselves against rises in mortgage interest costs. Savings banks enter into fixed-floating interest rate swaps or swaptions and offer fixed rate loans to clients.

Exchange rate protection could be available prior to a family holiday in the U.S.. In the late 1980´s Barclays Bank offered low principal currency options through its branches.

All praiseworthy concerns, but the derivatives market is, in general, quite unsuitable for direct use by non high net worth individuals. Most derivatives are, by nature, standardised. Individuals, however, have non-standard needs and risks. Any mismatch (basis risk) may well exceed the client's risk.

Derivatives do, however, have an increasing place in retail banking and insurance. Fixed rate and maximum rate mortgages can be provided by banks and savings institutions, with the financial institution covering its interest rate exposure to a subsequent rise in interest rates through the derivatives market. The client does not deal with derivatives, but is provided with a seamless package. He gets what he wants - a fixed rate mortgage - and the bank manages the risk for itself in the wholesale futures and swaps market. Savings products with "embedded" derivatives are now commonplace. Zero-coupon deposit structures have been offered to the retail market. The interest rate risk for the savings bank is covered through structured zero coupon swaps.

Guaranteed Equity Investments

Since the late 1980's, guaranteed investment schemes have become commonplace from The UK to Ireland to Spain and South Africa. They all rely on derivatives to provide the downside protection promised and they tend to be treated as deposits or insurance policies rather than equity unit trusts.

The earliest and therefore simplest of such guaranteed schemes were as follows: A principal sum was invested with a bank and a guaranteed return was provided at the end of 5 or 7 years. "Double-your-money" schemes were popular at a time of high interest rates. To provide a 100 per cent return in 5 years, a Compound Annual Rate (CAR) of 14.9 per cent is required. To double investments in 7 years, only 10.4 per cent is needed. The principal guarantee under these guaranteed investments was structured through zero coupon interest rate swaps. Often the return was exaggerated through the quoting of simple interest in bold large type in advertisements - 20 per cent per annum in the 5 year case - with the CAR in much smaller type.

A more recent innovation takes the form of stock-market index-linked deposits or bonds offered by banks. The bank provides a deposit investment with the value rising in line with the growth in a stock market index with a guarantee of a return of original capital invested. But there is no interest on the deposit. The effective interest-free deposit allows the bank to protect itself by purchasing or constructing an option on the stock index. The term was typically 5 years. Zero coupon interest rate swaps provided the guarantee.
The investment would be treated in the UK either as a bank deposit or as a single premium insurance policy. Therefore the return being the difference between the deposit and the final maturity value was taxed either as interest or in accordance with the taxation on insurance policies. In most such cases there was no actual equity investment by the retail investor so capital gains treatment did not apply - i.e. there was no capital gains tax free allowance.

There have been many variations under the basic structure depending on the current level of interest rates and market volatility and therefore the pricing of the zero coupon swap and the equity option.
The guarantee was sometimes reduced to less than the principal invested, say 90 per cent of the principal amount to provide more for the equity option. Sometimes there was a guaranteed minimum maturity value of greater than the initial principal invested, say 110 per cent of principal. This reduced the amount available to the bank to purchase equity options.

Under the rationale of providing smoothing of equity markets, instead of providing a return based on the growth over 5 years, the final fixing is now usually the average level of the index over the final year. This effectively reduces the term by half a year. This smoothing operation has been taken further. Not only is the final year's equity index averaged, but so also is the first year's index.

Later, the equity linking was spread to more than one country's stock market index. Nationwide Building Society's "World Guaranteed Equity Bond" provided an investment linked to the average performance of six world markets with a return of capital guaranteed if left for six years. The return was calculated on the difference between the average of the first year and the average of the final sixth year. Maximum returns are linked to twice the investment or 12.25 per cent CAR. All this averaging serves to dampen returns. An investor would be far better off with six separate guaranteed equity bonds guaranteeing return of capital but providing benefits in line with market growth in the individual markets.

Barclays Bank's subsidiary, B2 markets a product providing linking to equity returns through a monthly savings scheme whilst guaranteeing the return of capital invested.

I recommended such an investment with a prime Spanish bank. The index being the Spanish stock market index, the IBEX35, to my sister-in-law in Banyoles. However, I was astonished at the bank's approach of only answering broad questions and only on the telephone. Given the undoubted standing of the institution concerned, a brochure providing full details of the investment in print was surprisingly not forthcoming. If highly structured transactions are sold cheaply over the telephone then financial institutions must ensure that its telephone operating staff are adequately trained to cope with searching questions. Perhaps a contradiction. The internet could prove ideal in that the bank selling the product could even provide a several thousand word explanation of its products at negligible cost. No staff training would be required as customers would be expected to read the literature and understand the product themselves. Questions could be answered not by lowly-paid and hardly-trained telephone-sales staff but via e-mail which would allow a considered answer which would then be posted up on a "frequently asked questions" page ready for the next potential customer.


In March 1999, Nationwide, the UK's largest Building Society launched a mortgage Euro rate mortgage in the UK. In itself this was nothing new as a number of UK banks including Barclays and Abbey National had already offered such mortgages soon after the introduction of the Euro. But what was different was that while being linked to the interest rate environment in Europe, the European Tracker Mortgage operated entirely in Sterling. As far as the borrower was concerned, there would be no exchange rate risk on the interest payments or on the repayment of principal.

Nationwide's chief executive, Brian Davis said: "For those who are keen to link their mortgage to European interest rates, it is the first mortgage available in the UK to provide that opportunity with all payments required in sterling." To me, this mortgage is a curious hybrid as it appears to serve the needs of interest rate speculators rather than hedgers. It is not a natural hedge for those with Euro income or assets nor is it a natural liability for purely UK based borrowers. But it serves those who wish to benefit from lower current Euro interest rates. Given the higher margin over market rates it is a bet on Sterling remaining outside the Euro and having higher interest rates.

The Nationwide product involved a ten year variable rate mortgage with rates set at 1.75% above the European Central Bank (ECB) base rate, with a discount of 1% in the first year. During the first 10 years the interest rate will continue to be set at 1.75% above ECB base rate and will reflect changes. At the end of the 10-year period the rate will revert to Nationwide's standard variable rate. This compared with true Euro mortgage rates of 1.5 per cent above Euribor.

The pricing of the mortgage includes very stiff redemption fees. Early redemption fees will be payable if all or part of the mortgage is repaid, or transferred to another product, during the first 10 years, as follows: Years 1 to 5 - 9 months gross interest; Years 6 to 8 - 6 months gross interest; Years 9 and 10 - 3 months gross interest.
In a falling interest rate environment, the ECB rate should lag Euribor and in a stable environment the ECB rate should be about 0.25% above Euribor.

So how did the Nationwide hedge its bets? It did not run the exchange rate risk as reported in the press but involved the Nationwide buying a Quanto swaption. It bought a two-month option to enter into a 10-year interest rate swap to pay 3 month Euribor and receive Sterling 3 month LIBOR. Both interest related amounts are determined using a Sterling principal. What is worth noting in such a swap is that the natural day basis is different between the two currencies. Sterling is quoted on a 365 day basis whilst Euribor is quoted on a 360 day basis. This makes a small difference of 7 basis points at interest rates of 5% or so but will be significantly higher if such a structure was applied to currencies with higher interest rates. At rates of 15% seen in the UK a decade ago the difference would be 21 basis points.

How was the Quanto hedged by the bank providing the hedge? Probably by finding someone the other side. Quantos were first seen linked to dual currency notes where the interest was linked to one currency's benchmark but denominated and indeed payable in another currency. Perhaps the Nationwide could have cut out the middleman investment bank by creating its own deposit structure with interest rates linked to the ECB? Or issue a Quanto bond or note structure to appeal to investors.

And finally, …

I believe that raw financial derivatives should not be actively marketed to individuals. However, financial institutions should make use of the variety of options, futures and swaps available to satisfy their customers' investment and financing requirements. It is incumbent on these institutions, however, to ensure that their customers have absolutely no doubt as to what they are entering into and the risks inherent - including in the case of fixed rate mortgages, any early repayment penalties or with respect to investments, premature encashment terms.

In the mid-1990's the UK's Britannia Building Society launched inflation-indexed deposits. I am not aware of how Britannia hedged the inflation-risk in its liabilities but I do not believe that they used internal asset/liability management. No inflation-linked mortgage product was publicised by Britannia at the time. The key to successfully managed financial instruments is to create structured asset or liability instruments. But then instead of going into the market to hedge such structures, savings banks should engineer liability or asset structures that have equal and opposite properties. This not only increases the margins but enhances liquidity.

And many of the most successful retail financial products have not used derivatives at all. Paying interest on current accounts was deemed to be revolutionary not so long ago. And being prepared to provide flexible "one accounts", combining current accounts and mortgages with monthly salary income being used to temporarily reduce the client's mortgage, was deemed to be uneconomic. Now such flexible mortgages are commonplace. And some retail banks have introduced cash prizes in lieu of interest or "cash back" on taking out loans. These structures do not require derivatives. The most successful products are those that can be explained in a 30-second television sound-bite. These have the inherent difficulty of being easy to replicate by competitors. Anything much more complicated could lead to complaints years down the line over mis-selling and misrepresentation.

IF.com, Halifax Bank of the UK's internet banking standalone subsidiary, has attempted to patent its flexible mortgage structures. I would be surprised if this proves to be successful as there seems to be little different in IF.com's structure to what has been available elsewhere for several years. However, the very process of attempting a patent has provided the impression of innovation and it has generated favourable publicity. Even if an innovative product proves to be unsuccessful, the market need not become aware of the lack of success. The publicity generated during the launch in the media will probably more than cover the development costs. In any case the innovative reputation of the firm will be enhanced and the publicity will generate normal business as it will be seen to be an institution that cared for its customers' needs.

Delphi Risk Management: Delphi creativity Delphi communication & Delphi control are the Innovation, Communication & Risk Management arms of Delphi Risk Management Limited 

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