Tuesday, February 14, 2012

In the News: Structured CDs

By Tim Husson, PhD and Olivia Wang, PhD

Bloomberg News reported this week that FINRA is investigating a relatively new type of product that ties the returns of certificates of deposit (CDs) to derivatives. These products are known generally as 'Structured CDs' (SCDs) but also go by 'Index-Linked CDs', 'Equity-Linked CDs' or 'Market-Linked CDs'.  There have also been news stories concerning Market-Linked CDs issued by Wells-Fargo and Equity-Linked CDs issued by Goldman Sachs in recent years.

SCDs have existed since the late 1980s, but have recently become much more popular with conservative investors due to the low yield on traditional deposits and Treasuries. Because SCDs are not securities registered with the SEC, the size of the SCD market is not clear, but estimates range from $20-30 billion and growing according to the July 7, 2011 Bloomberg Structured Notes Brief.

An SCD is essentially an FDIC-insured deposit combined with some combination of options contracts on an underlying asset -- a basket of blue-chip companies or broad indexes such as the S&P 500. The CD part of an SCD serves essentially as principal protection (the return of principal at maturity), and typically bears no coupon. The option part gives the investor some degree of upside market exposure, usually subject to a cap (typically 7-10% annually). The customizability of this structure is similar in many ways to structured products except that structured products are typically issued by banks as debt, rather than insurable deposits.

The demand for safer investments that offer some degree of market exposure has increased as the demand for riskier investments took a hit during the financial crisis, and as returns to traditional fixed-income securities have become less attractive. Market-linked CDs, along with variable and equity indexed annuities, became more popular at this time since these securities combine the market exposure of structured notes with governmental guarantees cherished by risk-averse investors.

Although SCDs offer more robust principal protection than similarly composed structured products, the inherent disadvantages are quite similar.  The Securities and Exchange Commission offers a good introduction -- including a discussion of the risks involved --  to such investments.  They include significant liquidity risk, call risk, and market risk; in fact, structured CDs can be extremely complex investments, and we have seen examples of SCDs linked to term structure strategies, baskets of stocks and commodities, and other highly technical asset combinations, as well as including call features and very long (even 20 year) maturities.

It is not clear for whom these types of complex, illiquid investments would be appropriate.  Indeed, as with structured products, many investors may not understand the importance of the cap in limiting equity exposure, or the significant liquidity risk that comes with the typically multi-year commitment in a SCD.  Also, SCDs are not registered securities and can therefore be sold without a series 7 license, often at high commission levels.

Our research on SCDs is ongoing, and we are developing a broader understanding of the SCD market as well as pricing models that can allow us to quantitatively evaluate the various features of these products.

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