Open architecture: A work in progress, boosting issuance; more can be done, sources say

By Emma Trincal

New York, Nov. 20 - Structuring firms in the U.S. are increasingly sharing distribution platforms with other banks in a trend called open architecture many see as likely to continue.

Advocates of this distribution process say it benefits both the desks and the investors as it contributes to record sales and more credit diversification. But critics argue that the trend has either gone too far or not far enough. The consensus is around the fact that open architecture creates increasingly large deals and drives deal flow to new highs.

Big deals

"You just have to look at this autocallable Goldman Sachs deal sold through JPMorgan private banking. It was huge, and that's one of the benefits of open architecture," said a sellsider. "When a private bank or a wirehouse channel sells products other than their own, it certainly results in larger transactions."

This sellsider was referring to Goldman Sachs Group, Inc., the issuer of autocallable index-linked notes linked to the S&P 500, which JPMorgan sold in a $346.8 million transaction on Nov. 13. The deal, at the exception of several exchange-traded notes that have priced in the $1 billion to $2.5 billion range, was the largest new issue so far this year.

Credit diversification

The benefits of increased sales go hand in hand with the need for investors to avoid being exposed to the same credit.

"Open architecture is a great idea. It allows customers to diversify their risk," said Roy Blumberg, partner and director of client portfolio management at The Philadelphia Group, a wealth management firm in King of Prussia, Pa.

"What banks are attempting to do is broaden the distribution for their products. The salesman is the one that has the relationship with the clients. By JPMorgan saying, we'll sell other people's products, you are in effect diversifying away credit risk."

Suzi Hampson, structured products analyst at Future Value Consultants, said investors want to diversify risk.

"Investors want to be able to diversify," Hampson said. "A bank in order to keep its clients happy must be able to sell products issued by other banks. It's a good way to diversify credit and it's dictated by consumer demand."

Risk appetite

Some even believe that this investor-friendly distribution method has contributed to ease credit risk concerns, which rose last year in the aftermath of the collapse of Lehman Brothers.

"Sophisticated investors, those serviced by private banking distribution channels, have gotten comfortable with the credit associated with structured products," said the sellsider. "Concerns associated with credit risk have clearly receded in the market and issuance has been booming as a result."

Open architecture is a work in progress in the United States. Compared to the early stages of the industry, when the same bank would issue, hedge and distribute its own deals, providing its own salesforce with higher incentives to sell, price transparency has improved, said a market source. "But we're not there yet," he said.

False promises

The market source pointed to the fact that while open architecture enhances credit diversification, it may not have given investors much pricing power yet. He added that when sales channels do not lead to more price transparency and more competition, then the notion of "open architecture" is merely "fictitious," adding that it is often the case in North America, especially in Canada.

"You have situations for instance where a bank, instead of selling its own paper, introduces another issuer. It's good for investors since they get a new name and diversify credit risk. But it's not going to improve pricing because the same bank selling the deal continues to do the hedging and to make the same amount of money on it. There is no price competition," this source said.

The "worse" form of "so-called" open architecture that prevails in Canada is nothing short of a form of "oligopoly," he added.

"When two firms decide to sell each other's deals through their respective distribution channels, I really see this as two guys scratching each other's back," said this source. "If a firm ABC is going to do business with firm XYZ simply because XYZ has agreed to sell ABC deals, then you have an oligopoly. Creating oligopolies is not good for investors and not good the business."

Others are strong supporters of open architecture and want the evolution to resemble that of the mutual fund industry.

Open architecture ultimately is the direction the market is taking, said Keith Styrcula, chairman of the Structured Products Association, and it is the condition for its growth and maturity.

Top sellers

Styrcula said that he particularly liked the openness of UBS AG, a bank which created a large distribution channel opened to a large number of firms but operating on a selective pricing basis.

UBS this year acted as an agent for a variety of issuing banks, including Barclays Bank plc; Deutsche Bank AG London branch; HSBC USA, NA; JPMorgan Chase & Co.; and Royal Bank of Canada, according to Prospect News' database.

Overall, UBS sold $545. 603 million of deals on behalf of other banks, not so much behind the $795.177 million it sold for its own balance sheet, according to data compiled by Prospect News.

JPMorgan is the bank that has sold the most deals for other firms this year, according to data compiled by Prospect News. In fact, the bank has the distinction of having priced more deals for others than for itself. So far this year, JPMorgan sold $4.369 billion of notes issued by Barclays, Credit Suisse Nassau Branch, Deutsche Bank, HSBC USA and Morgan Stanley versus $1.77 billion for its own account.

Morgan Stanley acted as the bookrunner for BNP Paribas, Barclays and HSBC, selling $232.68 million for those rival firms but the bulk of its sales came from its own deals with $2 billion in proceeds year to date, according to data compiled by Prospect News.

Not there yet

Styrcula said that open architecture is making progress but that the industry has further to go if it wants structured products to become "mainstream" rather than a form of "specialized alternative investments."

"The real open architecture model is Charles Schwab when you have this mutual fund supermarket where everyone can be part of the platform for an administrative fee. I dream that one day we'll have that for structured products. The day you can go to one place and choose whichever issuer or underlying you want and buy it freely without having an intermediary, then you can take mutual funds assets away," said Styrcula.

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