Structured note markets

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Structured note markets:
products, participants and links to wholesale derivatives markets
David Rule and Adrian Garratt, Sterling Markets Division, and Ole Rummel, Foreign Exchange Division, Bank of England

Hedging and taking risk are the essence of financial markets. A relatively little known mechanism through which this occurs is the market in structured notes, which have embeddedderivatives, some of them very complex. Understanding these instruments can be integral to understanding the underlying derivative markets. In some cases, dealers have used structured notes to bring greater balance to their market risk exposures, by transferring risk elsewhere, including to households, where the risk may be well diversified. But the positions arising from structured notes can sometimesleave dealers ‘the same way around’, potentially giving rise to ‘crowded trades’. In the past that has sometimes been associated with episodes of market stress if the markets proved less liquid than normal when faced with lots of traders exiting at the same time.

FOR CENTRAL BANKS, understanding how the modern financial system fits together is a necessary foundation for making sense of marketdevelopments, for understanding how to interpret changes in asset prices and, therefore, for identifying possible threats to stability and comprehending the dynamics of crises. Derivatives are an integral part of this, used widely for the management of market, credit and other risks. The associated positions and hedging strategies of banks and dealers are an important influence on how marketsrespond to changes in underlying fundamentals. It is perhaps less familiar that derivatives are also used by investors to take market risk in search of additional returns – often via bonds known as structured notes. Some investors purchase such notes in order to obtain initial coupons that exceed market interest rates, receiving upfront premia for, in effect, writing options embedded in the notes. It isperhaps no coincidence that they have been as popular in recent years as they were in the early 1990s, both periods of low short-term interest rates in major currencies when some investors have been ‘searching for yield’.1 In 1994, a number of investors suffered highly publicised losses on holdings of structured notes when US interest rates rose significantly (Box 1).

For issuers, structurednotes can be a way of buying options to hedge risks in their business. Most, however, swap the cash flows due on the notes with a dealer for a more straightforward set of obligations. In economic terms, the dealer then holds the embedded options. Sometimes they may hedge existing exposures taken elsewhere in a dealer’s business. Alternatively, the dealer may seek to hedge by buying or sellingsimilar options in the inter-dealer derivatives markets or through ‘dynamic hedging’ in the underlying cash markets. To a significant extent, so-called ‘exotic’ derivatives markets have developed hand-in-hand with the production and distribution of increasingly complex structured notes as intermediaries compete to offer investors new combinations of risk and return. Potentially, trading of exoticderivatives fills some ‘missing markets’, leading to a more efficient distribution of risk (as well as yielding information that can be valuable to central banks and others). But liquidity in such markets can still be shallow and may dry up in stressed conditions, complicating risk management. After describing the structured note markets and discussing the motivations of investors and issuers, thisarticle analyses the links to wholesale derivatives markets and identifies some issues relating to financial stability.

1: See the ‘Conjuncture and Outlook’ section of this Review for a discussion of the ‘search for yield’.


Financial Stability Review: June 2004 – Structured note markets: products, participants and links to wholesale derivatives markets

Market structure and size...