Counterparty risk: lesson learned?

Following the demise of Lehman Brothers in late 2008, counterparty risk quickly became the hot topic. This time last year, the majority of articles written on structured products were either focused on, or at least mentioning, counterparty risk. The move of counterparty risk to the headlines quickly prompted providers like ourselves to not only provide greater transparency to the market, but to develop lower counterparty risk solutions for concerned investors. Just one year on, the structured product landscape has changed dramatically. Providers have really stepped up to the mark, not only giving greater transparency on the level of counterparty risk in their products, but also providing better tools and explanations to help investors to understand counterparty risk. Some, ourselves included, proactively developed new products with counterparty risk mitigation features. Of course, there will always be counterparty risk in structured products (as it is with all investments, from corporate bonds to equity shares). However, changes made in the industry have meant greater choice for investors and more information available to help them make the best decisions. In this article we reflect on some of the changes that have been made, and contemplate where the market could move from here. Greater Transparency has been Key Prior to Lehman’s bankruptcy, few structured product investors had concerns about the safety of their investment. Instead, investment decisions were mostly driven by the return potential and level of capital protection built into a payout. Post Lehman, this changed. As well as the features of the product and the advertised payout, investors started looking at how that payout was provided – what entity was responsible for paying the return. In particular, when a product was advertised as ‘capital protected’, how secure would that protection be? Providers were immediately aware of a need to provide more information: in particular, greater transparency on the risk associated with that counterparty and in which circumstances the capital protection would not be valid. Some providers also produced supplementary materials explaining how they selected counterparties to use for their products, as well as how common measures of credit quality such as credit ratings and credit spreads worked. This additional information was well received by the market. Investors were much more informed about the investment risks and, as a result, were more confident that they were making better-informed investment decisions. A Wider Choice of Solutions For some investors, it was not enough simply to understand counterparty risk. Instead, these investors were looking for solutions with lower risk. Providers were very quick to meet this demand, with solutions ranging from using very highly rated assets (eg, AAA-rated Government bonds) to secure capital protection, collateralising the entire returns, or, within the UK, structuring products as deposits to allow retail investors to benefit from FSCS protection if needed. A good example of one of these solutions was our ‘gilt-backed’ wrapper, first launched in the UK discretionary wealth market in December 2008. Not only was the capital protection provided by UK government bonds, but the growth return was also collateralised so that investors had no counterparty exposure to Morgan Stanley. This ended up being one of our most popular products to date, reinforcing the view that demand was strong for lower counterparty risk solutions. Of course, with the range of counterparty risk solutions available to investors growing, investment decisions inevitably become more complex. Investors now have a series of new questions they needed to ask before investing. For example, if a product is collateralised, they may wish to consider the following questions:

• Which elements of the payout are collateralised? The return, the capital repayment, or both?
• Which assets are being held as collateral, and what is their credit-quality?
• How frequently is the collateral being topped up if the value of the product increases?

It is now therefore more important than ever that product providers give clear information to investors and advisers, not just on what risk had been mitigated, but exactly how this had been achieved. The Cost of Reducing Counterparty Risk Perhaps one of the most important considerations faced by investors is what they give up when they chose a produce with a lower counterparty risk. In general, the lower the credit risk in a structured product, the less attractive its payout will look. For example, the economic terms available on a structured product backed by AAA-rated government bonds will be less attractive than the terms on a product backed by an A-rated financial institution. In exchange for additional security over the repayment of capital, investors might receive a lower participation rate in any upside, a reduced opportunity for the full return of capital, or their potential returns might be capped at a certain level. This is because AAA-rated assets typically have a lower yield than A-rated assets, giving the provider less to spend on the derivative contract that provides the growth or income return. For many investors, it may not be a straightforward decision to select the product with the lowest counterparty risk. Instead they may decide what level of counterparty risk they are happy to take, and then look for the best terms across all products that meet that standard. Where Next? Today, the market is generally much better informed about what counterparty risk is. One could even argue that, now the dust is settling after the turmoil of the last 18 months, more investors are once again getting comfortable taking on counterparty risk of financial institutions. Of course, this has been helped by the fact that more and more products are reaching maturity, and delivering the returns that were promised at the outset. However, there will always be a need for providers to deliver new solutions. Just like the market needs a choice of different return profiles, and different capital protection levels, it also needs a range of counterparty risk options. Collateralised structures, products backed by highly rated assets and structured deposits will continue to sit alongside the more traditional financial institution issued products, but what else can providers offer? One solution we expect to take off in 2010 is the structured fund. This is where a provider will issue a structured payout in a Ucits III wrapper. At Morgan Stanley, we have already launched two funds successfully into the UK discretionary wealth market using our Irish Open Ended Investment Company (OEIC), and intend to offer similar funds to retail investors as soon as possible. Not only does the Ucits III wrapper offer reduced counterparty risk through the use of collateralisation with high credit quality assets, but there are additional benefits for investors: the fund is highly regulated, has no fixed end date (so no need to crystallise gains after the set investment period) and offers decent liquidity. Of course, offering a structured payout in a fund wrapper will be more expensive than the more traditional structured products. The provider needs to set up a separate entity with ringfenced assets and a Trustee. However, offering this solution will increase the choice available to investors even further. What has become clear over the past eighteen months is the impact that counterparty risk has had on the industry. From financial advisers, product providers, regulators and even the individual investors themselves, everyone has had a role in shaping how we consider counterparty risk – in particular, how we explain it, understand it and how we can try to manage it. Counterparty risk, together with payout features, is now firmly a part of the investment decision process, as it should always have been. Investors now have the right tools to help them not only determine the right level of risk they want to take, but to find the solution that will achieve that for them. The views expressed in this article are those of its author and do not necessarily represent those of the company he represents. This article is issued and approved by Morgan Stanley & Co. International plc. (“Morgan Stanley”), authorised and regulated in the United Kingdom by the Financial Services Authority. It does not constitute investment research and is not a product of Morgan Stanley’s Research Department. This is for informational purposes only and is not an offer to buy or sell any financial instrument or participate in any trading strategy.

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