Structured Products: Counterparty Risk

Who are the other counterparties?

Below are examples of some counterparties needed to fulfill the obligations of structured products.

Swap Counterparties

Swaps are often used to manage exposure to a specific asset or currency. For example, consider a structured product that swaps the returns between the US dollar and the UK sterling using a counterparty that fixes interest rates and foreign currency of the US dollar and the Sterling.  If that counterparty defaults on its obligations, investors in the structured product could lose a substantial part of their investment.

Trustees

The role of the trustee is to safeguard the underlying assets and ensure the fulfilment of the agreements, including payment. Errors in the fulfillment of these duties, such as inaccurate monitoring of funds, or late payment distributions, could damage investor returns.

Collateral Managers

In complex products, such as collateralized debt obligations (CDOs), a specialized collateral manager may be involved in building and managing the portfolio of the underlying assets. Poor asset choice or poor management could impair returns significantly.

Underwriters

Some structured products listed on public exchanges may use a third-party underwriter to evaluate and price the product. Overvaluation or undervaluation may cause losses for the investor.

The failure of other counterparties may also damage investor returns. For example, brokers responsible for trading an underlying basket of currencies may delay transactions in error, and rating agencies may cause irreparable damage to countless financial institutions by assessing the risk of structured products improperly. 
 
While the multiple counterparties in structured products may mitigate the failure of the issuer, the sheer number of moving parts in many structured products raises the probability of malfunction by a single counterparty.

Comparison with private market investments

The key difference between structured products and private market investments is the number of counterparties involved.

Unlike the complex web of service providers in structured products, a private market investment entails a single entity entrusted to a single counterparty, being the asset manager.

Given the comparative limited transparency and control in structured products, the central lines of defense against counterparties lie in regulations (e.g. Securities Investor Protection Act (SIPA)[1], Investor Compensation Schemes under MiFID II[2]) that dictate proper process after investors incur losses.

Private market investments are less heavily regulated and permit higher transparency afforded by in-depth due diligence and the ability to intervene when necessary.

Conclusion

Although structured products are customized for specific investment objectives, they entail many hidden risks involving issuers and counterparties.

Risk is inherent in structured products and private market investments alike, making due diligence of paramount importance to protect investors

[1] United States Courts

[2] European Securities and Markets Authority