Structured Products
Expert Evidence has specific capability in equity, rates and FX linked products which frequently embed leveraged market positions and are sold to both High Net Worth Individuals and institutional clients without adequate explanation of their liquidity and intrinsic risks. Examples of these products are:
- Equity Linked Notes: Autocallable, Phoenix, Shark, Airbag, Reverse Convertibles;
- Rates Linked Notes: Range Accruals, Constant Maturity Swaps;
- FX Linked Notes: Warrants, complex payout notes; and
- Credit Linked Notes: Single Names, First to Default Baskets.
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Autocallable Notes, Phoenix Notes, Reverse Convertibles
These products typically have a high coupon (interest rate) in return for linking the capital to the performance of an equity price, or index level. The linkage may be to a single equity/index or to the performance of the worst of a basket of equities/indices.
The high coupon is achieved because the investor has sold options to fund it. The strike price of the options may be at a conversion price (for reverse convertibles), or at a lower “knock-in” price in the case of autocallables and phoenix. However, these options which have been sold can mean that the investment product’s price accelerates downwards as the equity/index goes down. Frequently investors do not appreciate the speed of this, or the illiquidity of the investment, resulting in unmanaged capital losses.
Furthermore, if a portfolio of structured notes has been used to secure finance, the lending bank may consider a margin call if the market goes distressed. The margin call will be calculated on the bank’s risk systems, something the investor does not have visibility of, and can result in a forced sale of assets at the bottom of the market.
Cases have been initiated because the full scope and management of the accelerating downside has not been expected, or the bank’s margin call decision is in dispute. Return to top of page.
Shark Notes, Airbags
Shark Notes link the investor’s capital to the performance of an underlying reference equity/index/commodity. In a bullish Shark Note, performance is leveraged until hit hits a trigger level. The payout then reverts to a fixed rebate.
An Airbag gives upside exposure, but downside exposure to the capital is triggered if the underlying goes through a lower barrier level. Return to top of page.
Callable Range Accruals
These capital protected notes provide an above market interest rate in return for taking the view that the reference interest rate remains between an upper and lower band. Risk here is that the shape of the forward interest rate curve, off which they have been priced, has not been disclosed. This makes the product riskier than expected and increases the possibility of a portfolio producing zero income. Furthermore, because the products are seen as less risky, higher loan-to-value borrowing levels are used. Coupons going to zero imply that the prices go down, triggering a margin call. Return to top of page.
Credit Linked Notes
In these investments, a higher coupon is paid in return for linking the capital to the credit performance of a reference entity. If the reference entity defaults then the Credit Linked Note price will drop rapidly. A first to default basket has the same characteristics, except that it pays a higher coupon because it is linked to the first to default of a number of reference credits.
Expert Evidence is able to offer portfolio analysis, determining the suitability of the product, a review of post-trade performance and if the liquidity offered matched pre-trade marketing.
Reviews can also cover higher-risk products such as Contracts For Difference (‘CFDs‘) offered on numerous offshore trading platforms. Return to top of page.
Secured Financing Transactions (SFTs): Securities Lending and Repurchase Transactions (Repo)
Secured Financing Transactions (‘SFTs‘), including securities lending and repurchase agreements (‘repos‘), came under increased regulatory scrutiny following the Global Financial Crisis (‘GFC‘). During the crisis, trust among financial institutions deteriorated, causing the unsecured wholesale deposit markets to cease functioning effectively. In contrast, the SFT markets (including securities lending and repo) continued to function, as the market participants had collateral allocated against their cash liquidity to protect themselves in the event of a customer default.
However, the GFC exposed several vulnerabilities within the SFT market. Disputes arose over the rationale for exercising default notices on clients (banks legal teams), roles and responsibilities of intermediaries such as Central Securities Depositories (‘CSDs‘), and questions on the interpretation of legal frameworks, including the ICMA Global Master Repurchase Agreement (‘GMRA‘), particularly regarding the valuation of collateral securities. One notable legal dispute post GFC involved Lehman Brothers International Europe (‘LBIE‘) and ExxonMobil Financial Services B.V.’s (‘EMFS‘), concerning close-out valuations on a triparty repo transaction.
Pricing of Asset-Backed Securities (‘ABS‘) by financing desks across jurisdictions during the height of the crisis and implementation of various pricing mechanisms led to significant disputes. These issues were further magnified due to client default enforcements and the subsequent fire-sale liquidations of assets.
As the marketplace expands and new jurisdictions grow their capital markets footprint – the requirement for liquidity to be generated and placed within these expanding domestic and international markets has heightened the relevance of secured financing transactions. The Securities Lending market is overseen by the International Securities Lending Association (‘ISLA‘), currently covering 68 jurisdictions and each having nuances to their area of coverage. The International Capital Markets Association (‘ICMA‘) covers approximately 71 jurisdictions, and similarly there are different rules and peculiarities to these various markets. Both ISLA and ICMA support the development of a safe and efficient framework for the industry, by playing a vital role in promoting market best practices, standardization, and legal certainty.
Alongside market growth, there are multiple vendors involved across the entire SFT industry, including IT vendors, agent lenders (often large banks), inter-dealer brokers, and other intermediaries. These agents can act on behalf of clients, leading to disputes over liability when defaults occur. For example, when an inter-dealer broker has intermediated repo transactions between two financial institutions, one of whom has subsequently defaulted, legal questions arise regarding the agent’s responsibilities and to what extent their involvement and lack of transparency contributed to the financial losses.
In recent years, there have been investigations regarding the transparency of the securities lending market and perceived opaqueness of the activities in that market. Both U.S. and European markets are seeing intensified scrutiny on the need for greater transparency in securities lending. The U.S. Securities and Exchange Commission (‘SEC‘), for instance, had its authority to regulate securities lending recently upheld by a U.S. appeals court. Ongoing legal actions and policy debates continue to focus on the efficiency of the current over-the-counter (‘OTC‘) market structure, with calls for central electronic marketplaces. Additionally, the rise of tokenized securities is introducing new regulatory complexities and is expected to prompt further court action and legal challenges. For further context, see: Stock Loan Antitrust Litigation by Cohen Milstein top of page.
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Thomas Walford
Andrew Wise
