Third-party electronic platforms emerge, challenging traditional distribution models

By Emma Trincal

New York, June 30 –The business model for U.S. structured products creation, pricing and delivery is fast moving online. The development, which began with dealer-owned platforms, is now building momentum via third-party automation of issuer’s auctions, a trend which could deeply alter the traditional distribution model, sources said.

On Wednesday, Bloomberg announced that it joined forces with Spanish bank Banco Bilbao Vizcaya Argentaria SA to deliver structured products pricing in real time through its terminal’s dealer page.

Bloomberg

“It’s only one European bank right now. But every dealer has a Bloomberg terminal and a lot of people can access that capability. I would be very surprised if Bloomberg didn’t go to other issuers,” said a market participant with knowledge of the new technology trend.

The platform is designed for institutional clients of the bank. It also provides back-testing capabilities and product life-cycle management, according to a Bloomberg’s press release.

Bloomberg

“This partnership with Bloomberg helped shorten the time it takes to structure and price deals from hours to a matter of seconds,” Emilio Sainz de Baranda, global head of equity derivatives sales at BBVA, said in the announcement.

Bloomberg is now the second non-bank platform to that uses technology to facilitate the customization and competitive pricing of structured notes in the U.S.

Hallo

Halo Investing launched its own system in November with the ambition of tapping into the underserved market for registered investment advisers.

Currently three foreign bank issuers have signed up with Halo to join their platform.

The fintech firm expects two large U.S. banks to join within a month as well as one Canadian bank.

“From talking to issuers, we gathered that less than 3% of structured notes in the U.S. are done by RIAs. The primary market is private banking channel and broker-dealers,” Biju Kulathakal, co-founder of Halo, told Prospect News.

He declined to name the issuers that are in the Halo platform or expected to join soon.

The RIA iceberg

An RIA will do in average four to five trades a year when doing business with a firm the “old-fashioned way,” he said.

For more efficiency, banks impose usually a $1 million minimum size to their RIA clients on structured notes sales although the number is flexible. Halo has a much lower minimum notional of $250,000.

But it is not deal size that defines the appeal of the independent advisory market. Rather it’s the pool of assets that advisers have under management, which Kulathakal estimates to be $21 trillion.

“Almost none of this is in structured notes,” he said.

“Meanwhile there is demand for these products. People need income. People need market exposure with protection.

“Banks have just not been able to capture this market.”

Dealers have had their hands full servicing their private banking clients. Each adviser has an average of 20 to 30 relationships for larger accounts of $50 to $100 million, he noted.

The number of RIAs is large but they do smaller trades.

“You would have to have hundreds of people on a desk to reach this market.

“Catering to RIAs with such low volume of trades just doesn’t fit the business model of a traditional structured notes desk, he said.

“If you want to tap into this huge market, the only way you can do that is electronically.”

Cost- efficiency

Another obstacle for banks in accessing the large RIA market is the reputation of the industry for packaging expensive products. Fee-only advisers tend to be reluctant to use products with embedded fees.

“These guys would be doing more than five trades a year if the fees were cheaper and more transparent,” said Kulathakal.

Recent regulatory developments may push banks to revise their pricing model and move toward smaller margins but a bigger scale.

The Department of Labor fiduciary rule, set to take effect in January, will require brokers catering to retirement accounts to disclose fees and conflicts of interest to their clients. They will also be more vulnerable to lawsuits and class actions.

This is part of a trend pushing the industry to cut its fees, the industry source said.

“There’s a lot more regulatory scrutiny over commissions.

“Banks may be willing to offer best pricing but they still want to be in control of how they price.

“It’s going to be more and more of a problem for them unless they adjust.

“There’s a fee compression in every area. Regulators demand more transparency. People have embraced passive types of investments precisely to address those issues.”

Travel agents

Kulathakal and co-founder Jason Barsema, previously at Credit Suisse, created their start-up to take advantage of the margin-compression trend taking hold in the financial industry. Their model is simple: cut out the “middle-man,” tighten the fees, give investors more control and make the pricing transparent through technology.

One thing remains the same: issuers price their notes with their margins already embedded in the products. It remains the case with Halo.

However, significant differences exist between Halo and the traditional pricing model.

First, the automation leads to more competition, which should reduce margins. Second, the process eliminates the usefulness of having a broker.

“Without the middle-man you get much better terms,” the industry source said.

That’s because notes include brokers’ fees in the embedded pricing.

“This is similar to what we’ve seen in the travel industry. Once you let customers book their own trips online, there isn’t much need for a travel agent anymore. In fact, they’re all gone,” said Kulathakal.

Do-it-yourself

RIAs looking for a particular product can customize it themselves. They input their parameters choosing the structure, the tenor, the terms and the underlying. The system automatically delivers these criteria to the issuers who participate in the platform. An online auction process ensues, allowing the end-user customer to get the best pricing.

IRAs can even select the credit they want by eliminating a specific issuer when doing their search.

Halo sells itself as an “issuing platform” as well.

The end-user receives a term sheet after the indicative pricing is displayed.

“If they like the terms, the prospectus is filed directly with the issuer. The notes will be struck within 24 hours,” said Kulathakal.

The offerings for the most part will be registered with the Securities and Exchange Commission.

But bank-issued notes exempt from registration under section 3(a)(2) as well as products from foreign issuers are also accessible.

Trading matters

Differences in prices between issuers’ bids are caused by several factors: margins, credit but more importantly trading, said Kulathakal.

“The system sometimes comes out with tremendous differences in option pricing from one issuer to another,” he said.

“A lot of the trading done by the banks is not [based on] much liquid[ity]. They carry the risk on their books and if they don’t have the positions to trade or are not hedging with enough liquidity, it will transpire in huge pricing differences.”

Halo charges a flat fee of 65 basis points to the RIA. The fee is billed quarterly, a useful feature with autocallables as they can often be redeemed prior to the first year or before maturity.

Big kid in the block

The new Bloomberg system and Halo have much in common. They let customers define their own terms, they both provide online pricing through an electronic auction between issuers and in both cases they offer analytics and backtesting.

Kulathakal said he was not too concerned about the new competitor.

“We cater to RIAs. I think they’re going to target large institutional investors. I don’t see much of an overlap,” he said.

One clear boundary between those two markets is that the average adviser does not own a Bloomberg terminal, he noted.

Proprietary models

The rush to electronic platforms began last year with Goldman Sachs. Prior to Halo, the bank launched its own system called Simon, an acronym for Structured Investment Marketplace and Online Network.

Since late last year JPMorgan has been working on its own product with IBM, according to several sources. The multi-dealer platform was supposed to be finished by mid-summer. It is not clear where the project stands.

Several sources expressed skepticism about banks’ initiatives to develop credible proprietary platforms in the face of new third-party web systems, which the public is expected to trust more.

“If I’m JPMorgan why would I want to put my products on the Goldman Sachs platform? I’d rather go to a non-denominational platform, a Halo or a Bloomberg,” the market participant said.

A form of “paranoia” has emerged between dealers, which “stands to reason given that they compete for the same dollars,” he added.

“The concern has been that the playing field might not be level,” he said.

While issuers have always competed for deals, it takes an extra step of openness to display a multitude of bids online using a competitor’s platform explained Kulathakal.

The future

Some on the sellside are wondering whether those recent technology progresses are going to disrupt or even “kill” the traditional distribution business model for structured products.

“Banks like the idea because it’s pushing the business to a new level. Banks don’t like the idea because it’s giving away margins, which is why they love these products. But do they have the choice?” the industry source said.

Kulathakal said that banks at some point will benefit from a more mature, mainstream industry.

“We’re ambitious. We want to grow this industry to a half-a-trillion to a trillion dollar market. That’s where we want to take this market,” he said.

Banks, having found it nearly impossible to conquer some large pockets of the market, especially the independent advisers, appear to be reaching the conclusion that cost-efficiency and scale may be the way of the future.

Already this year has seen a strong pick up in volume. While it is not the first time it happened, a lot of the growth seems to have come from more deals and more smaller deals.

“Automation of sales of structured notes seems to be the trend. You can clearly see that with the huge jump in the number of deals,” said the market participant.

Sales jumped by more than a third this year to $24.15 billion while the number of offerings is up 55% to 6,256 from 4,036, according to data compiled by Prospect News through Friday.

“I don’t think the mindset is to keep large margins in a tiny market. I think banks are ready to see their margins shrink somehow while the business scales up. It’s a much more desirable scenario, one that means the pie is growing. I haven’t met any issuer who doesn’t want this market to grow.”

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