Bells and Whistles in Structured Notes and OTC Derivatives

Banks can add extra stuff called “bells and whistles” to structured notes and over-the-counter derivatives. These added features let the banks match up the way the investment makes money and the amount of risk it has with what the customer wants. But, when banks tack on these bonus features, they usually charge the customer a bigger commission or fee to set the whole thing up.

What are Structured Notes and OTC Derivatives?

Structured notes and OTC derivatives are special kinds of investments. Banks make them for specific customers.

Structured Notes

A structured note is a debt security. That means when you buy one, you are loaning money to the bank that issued it. Structured notes have two parts:

1. A bond component that pays back your initial investment
2. An extra part tied to the performance of some underlying asset, index, or benchmark

The bond part gives you some protection against losing money. The extra part gives you the chance to earn a return based on how the underlying thing performs.

OTC Derivatives

Over-the-counter derivatives are contracts between two parties. They are called “over-the-counter” because they aren’t traded on an exchange like stocks. Instead, they are custom contracts negotiated directly between the two sides. The value of the contract is tied to some underlying asset, rate, or index. Some common OTC derivatives are:

• Swaps – The two parties agree to exchange one stream of cash flows for another. For example, a company might use an interest rate swap to switch from a variable interest rate loan to a fixed rate.
• Options – Options give the buyer the right, but not the obligation, to buy or sell an asset at a certain price by a certain date. Companies often use options to hedge against price moves in things like foreign currency.
• Forwards – These contracts lock in a price to buy or sell an asset at a future date. A farmer might use a forward to lock in a price for his grain come harvest time.

The value of the derivative changes as the underlying asset, index, or rate moves up and down. Banks make money by charging a fee to set up the contract. They also try to limit their own risk on the other side.

Adding the Bells and Whistles

Structured notes and OTC derivatives can be simple or complex. Banks will often add in extra features and conditions at the request of the client. These bonus add-ons are called “bells and whistles.”

Purposes of the Bells and Whistles

The bells and whistles let the bank customize the investment to the client’s specific needs. The client may want:

• A certain payoff structure – They may want bigger potential gains in exchange for more risk, or lower risk in exchange for lower returns.
• Exposure to a certain asset class – A pension fund might want a structured note that pays off based on emerging market stocks.
• Hedge a particular risk – An importer may want an OTC derivative that protects against the dollar rising compared to the euro.
• Match a liability – An insurance company might want an investment that helps cover potential future claims.

The variations are endless. If the bank can legally and profitably make what the client wants, they can add it to the product.

Some Examples of Bells and Whistles

Callable – Some structured notes are “callable.” That means the issuing bank has the right to “call” (buy back) the note before maturity under certain conditions. Usually they would call it if the underlying asset has gone up a lot in value. The investor gets their initial money back but misses out on future gains. Callable notes usually pay a little extra interest to make up for the call risk.

Knockout – A note or derivative with a “knockout” provision will automatically cancel if some specified event happens. The event is often the underlying asset hitting a certain price. The investor may lose some or all of their money if a knockout happens. Knockout provisions let the bank limit its risk.

Barriers – “Barrier” provisions block the investor from earning a return until the underlying asset reaches a certain level. This lets the bank offer a higher potential payout while limiting the chances of having to pay it.

Forex Dual Currency – Some structured notes let the investor choose which currency they want back at maturity. These are called dual currency notes. The rate will be set in advance. The investor is betting that the currency they chose will be stronger than the other choice when the note matures.

Digital Payout – Some structured notes and derivatives have a set all-or-nothing payout if some condition is met. That condition could be something like “Gold is above $2000 an ounce on December 15, 2024.” If gold is even a penny above $2000 that day, the client gets the full digital payout. If it’s even a penny below, they get nothing.

The Tradeoff of Bells and Whistles

In general, the more bells and whistles a client wants, the more they will have to pay. The bank has to run numbers and hedge its own risks. They usually pass that cost on through higher fees.

Clients have to balance their needs and wants against the extra cost. Sometimes a plain vanilla structure works fine at a lower cost. Sometimes the client has very specific needs that make the extra bells and whistles worth the price. It’s key to understand the tradeoffs and pick what fits best.

Pros and Cons of Fancy Features

As we’ve seen, bells and whistles can help fine tune an investment to a client’s needs. But they have their drawbacks too. Here are some of the major pros and cons.

Potential Benefits

Better match for goals – The right combination of features can create an investment that matches the client’s goals better than any “off the rack” product. This customization is the main appeal of structured notes and OTC derivatives.

Higher returns – Savvy investors can use bells and whistles to amplify their gains if they’re right about how markets will move. The digital payout structure mentioned above is an example. It’s high risk, high reward.

Flexibility – The wide variety of features available lets clients build an investment that matches their market outlook and risk tolerance.

Potential Drawbacks

Complexity – Each extra condition makes the investment harder to understand and value. Many individual investors have lost money in structured notes and derivatives because they didn’t grasp what they owned.

Cost – As we’ve discussed, banks usually charge more for more complex products. Those costs eat into returns.

Illiquidity – Most structured notes and OTC derivatives are not traded on public markets. The client usually has to hold them to maturity. Those that can be sold early often fetch a much lower price than the client paid.

Issuer Risk – The client is relying on the bank to make good on the contract. If the bank goes bust, the investment may become worthless.