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'Demystifying' Derivatives

Banks can use a few simple principles to educate investors.

By ALVIN LEE | <CITE>From today's Wall Street Journal Asia</CITE>

Hong Kong's legislature recently began an investigation into retail sales of complex credit derivatives linked to Lehman Brothers. Small investors in Hong Kong have lost potentially millions of dollars on these products, known as "minibonds," and many claim they were misled about the risks involved. These events highlight serious potential shortcomings in investor education, risk transparency and suitability of retail structured-product investments. It's time for market participants to address these gaps.

Retail structured products have become popular investments in Asia and Europe, with total issuance in 2007-08 estimated at about $100 billion in Asia and $300 billion in Europe. They're also gaining popularity in the United States. Some products offer principal protection, while others can offer retail investors a way into higher risks and higher returns that would otherwise require prohibitive minimum investments. As long as investors understand the risks, these products can be a useful part of a diversified portfolio.

But they can also decline in value in falling markets. In Asia, credit-linked notes dependent on Lehman Brothers as either underwriter or reference counterparty were especially popular. In markets like Hong Kong, Singapore and Taiwan, issuance of these Lehman-linked retail products topped $3 billion. Lehman's bankruptcy filing two months ago threatened the value of many of these products, prompting large public protests against the banks that sold them. Issuance of so-called equity accumulators, another popular structured product, exceeded that figure and has also led to well-publicized losses as equities slid this year.

The story exposes the complications for small investors. Investors in Lehman minibonds did receive product descriptions and risk disclosures, and in Hong Kong and Singapore these documents had been prepared in accordance with local securities regulations. But the products can be quite complex, and the supporting documentation similarly so. Because of the wide variety of such products, no standardized format for risk assessment currently exists.

Some have also questioned whether bank staff themselves fully understood all the risks of products they were selling, suggesting they might not have been prepared to answer investor questions.

Fostering a culture of well-informed and educated investors is essential if the industry is to continue innovating investment products. So what should be done?

First, banks should ensure widespread understanding of product risks by their investment specialists and relationship managers, and ensure the risk and return profile of a structured product matches an investor's risk appetite. This could be done by scoring both a product's overall risk and the investor's risk appetite, and ensuring the two match. It also will require additional training of sales staff to make sure they can both understand complex products themselves and explain those products to others in easy-to-understand language.

Second, banks should supplement a product's prospectus with a succinct summary or "top sheet" of all the key risks inherent in the product to enable investors to make fair assessments. Top sheets could indicate whether principal is protected; note call features, price volatility estimates and potential investment returns under a range of market conditions; and offer a clear outline of any counterparty-related risks. If the product does carry a counterparty risk, an objective assessment of the counterparty creditworthiness should be supplied.

Third, banks should model the financial characteristics of each product and provide investors with a way to check periodically whether changing market conditions have altered the product's risk profile. Structured-product originators in some European markets are already investigating the collection of product details for this purpose.

Fourth, banks should encourage investors to understand the risk of their portfolios as a whole before they invest in new products. A number of banks provide periodic portfolio risk analyses to their clients, including for structured products, and clients almost universally respond positively to such efforts.

As investors and financial institutions emerge out of this crisis, product innovation will resume and industry participants need to be ready. These principles outline one way to regain retail investor confidence by demystifying the complexities of structured products. If investors fail to gain better insight into the risks of products in their portfolios, they are bound to repeat the same kinds of mistakes that led to the concentrated exposures and losses of the last several months.

Mr. Lee is head of business operations in Asia-Pacific for