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 embedded derivatives, 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 sometimes leave 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 market developments, 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 markets respond 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 is