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Arresting warrants

Securitised derivatives have been available in Europe to private investors since the late 1980s and have proved enormously popular.

In July this year (a difficult month for equities), the combined premium turnover in these products in Germany, Italy and Switzerland was £5.5bn generated by over 1.6 million trades.

The relatively small average trade size of £3,500 reflects the fact that the majority of this activity originates from private investors rather than institutions. These products are now available in the UK.

Securitised derivatives are listed and traded on the London Stock Exchange and allow investors to execute a range of strategies – speculating on rising or falling markets, hedging a portfolio, extracting cash from existing positions or diversifying their exposure across different indices or sectors.

The regulatory framework in the UK had precluded private clients from trading these products. However, that all changed on August 1, 2002 when a new set of FSA rules came into effect providing guidelines for the listing of products and a conduct of business regime for firms and individuals.

There are three broad types of securitised derivative products:

•Covered warrants.

•Certificates.

•Structured products.

Covered warrants

These are securities that have similar economics to options in that they confer on the holder the right to buy or sell a certain underlying asset at a particular price within a specified timeframe.

The price the investor pays for the warrant will be lower than that of the underlying share which gives investors the ability to gain leverage, that is, earn potentially higher returns than they could through direct ownership of the underlying asset.

This leverage effect also increases the risk of the product. However, an investor can not lose more than their initial investment compared with other geared products on the market.

Certificates

Unlike warrants, certificates have no leverage. In other words, their price tracks the performance of the underlying asset directly. Certificates on diversified equity indices such as the DAX or MIB30 have proved very popular in Europe compared with other types of pooled investments.

Structured products

The final category – structured products – contains any securitised derivative which has more complex features. This complexity may lie in the underlying asset, for example, warrants on a custom basket of shares.

Taking a current theme, investors may want to speculate or hedge against price movements in the oil sector as a result of tension in the Middle East. These products are flexible enough to allow an issuer to quickly list warrants on a basket of oil stocks to meet this demand.

The popularity of securitised derivatives in other markets has stemmed from a number of different factors:

Access: These products are traded on stock exchanges, not derivative exchanges, and as a result are often easier for brokers to offer to clients. Private investors can also trade them through their existing equity trading account.

Flexibility: Four points here.First, covered warrants can give investors exposure to an enormous range of assets such as domestic and foreign stocks and indices, commodities and currencies.

Second, all these products are quoted in their local currency (even if the underlying asset is denominated in another currency).

Third, these products can offer investors exposure over a long time horizon. Listed options typically have maturities of nine months or less while securitised derivatives can go out to five years-plus.

Fourth, contract sizes are smaller, allowing lower minimum trade sizes.

Branded market making: These products are “branded” with the name of the issuing institution and hence private investors know who they have opened and closed their position with. If an investor feels that a specific institution has been pricing their products uncompetitively, they will know to take their custom elsewhere.

The other point to stress is that there is considerable price competition in these markets although this occurs across multiple securities with similar characteristics (for example, 30 different Vodafone warrants) rather than on one security such as in the equity markets (for example, Vodafone ordinary stock).

Limited liability: Investors can only buy covered warrants and as such, maximum losses are limited to the initial purchase price. Unlike other leveraged products, you cannot end up in negative territory and lose more than your initial investment.

Tax advantages: If the products are cash-settled (that is, the investor gets the cash profit on their position rather than the underlying asset), trading will be exempt from stamp duty.

Securitised derivatives are available through a number of UK private client brokers – both execution-only and advisory.

Investors will need to have signed a risk warning notice before starting to trade these products and if the broker is providing advisory services they will need to have specific regulatory registrations (for example, derivatives examinations).

The LSE has developed a two-tier structure for pricing and trading these products. First, it has developed a new segment of its automated trading platform designed specifically for securitised derivatives called the covered warrant trading service.

This segment provides a continuously priced trading environment where automatic order execution can take place against a committed principal (who is usually the issuer of the securitised derivative as well).

Furthermore, products can be listed and traded outside the order book in a quote-driven market against retail service providers. These are either the issuers of the product or, more typically, another institution acting on behalf of the issuer.

Although complex, this model closely mimics the current situation in the equity market where private-client brokers typically use the order book for price dissemination purposes but tend to execute trades against RSPs.

The LSE will also impose obligations on participants looking to provide liquidity in these products.

It has stated that all committed principals must price their products within a defined maximum spread (the greater of 1p or 10 per cent on the bid price) and offer a minimum size of 10,000 to buy or sell.

Finally, it is worth noting that all securitised derivatives are dematerialised (investors cannot hold paper certificates) and they will be settled through Crest in the same way as equities.

We believe that as time moves on, the product range in the UK will expand significantly. The range of underlying assets on which warrants are issued and the number of distinct strikes and maturities available on each of these underlying assets will grow. The direction of this expansion is likely to be driven by local market demand as well as macro themes within the financial world.

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