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SEC Shines Light on Derivative Backed Notes

26, 2013

Feb. 7, 2013 (Bloomberg) In a move to improve pricing transparency for U.S. structured notes, the Securities and Exchange Commission plans to require banks to disclose an estimated initial value of their securities in offering documents. The two largest structured note issuers in the U.S. by sales last year, Bank of America Corp. and Goldman Sachs Group Inc., have begun disclosing the initial fair value of their securities. The estimates appear on the first or second page of prospectuses for the products.
Most of the notes issued by the banks had an estimated value between 96 and 98 cents on the dollar, according to data compiled by Bloomberg. The lowest price was 89.6 cents on the dollar for 10-year range accrual securities tied to the Russell 2000 Index that Goldman Sachs issued on Oct. 26.


What does this mean for investors? By making this information available in advance of a potential purchase, the investor should have a better idea of what the note will be worth when it hits their account on settlement date. The new disclosure requirement is akin to knowing how much the value of a new car will drop when it is driven off the salesman's lot.

  Suggested Reading: Wall Street to Revise Note Disclosures

Regulator Weighs in on Structured Note Pricing

According to data compiled by Bloomberg, most notes' estimated value immediately dropped between 2% to 4%. The data suggests that the longer the term of the note and/or the  inclusion of any "exotic features", the greater the gap in value between purchase price and secondary market value.
Twenty-First Securities has been encouraging investors to "Replicate" their favorite structured notes by using some combination of ETFs and listed options on those ETFs that are backed by the Option Clearing Corp ("OCC"). Many of the notes that are sold to investors have very basic pay off profiles that can easily be recreated by using various combinations of options. For instance a "Buffered Structure on the S&P 500" is simply a combination of a put purchase plus a put sale and the purchase of the SPY ETF. The purchase of these types of securities is exactly how the dealer is hedging themselves behind the scenes; we are simply eliminating the counterparty risk and a layer of fees and providing the investor with their desired payoff profile.
The benefit of building your own vs. buying it off the shelf includes reduction of fees, reduced Counterparty Risk (remember Lehman Brothers?) and much greater liquidity, transparency and flexibility. Also, one of the biggest benefits is that the purchaser can sell in the market and is not beholden to any one single counter party if they want to exit early and does not need to beg their way out.
Investors armed with this new information should be empowered to ask the right questions and build a structured note themselves thereby cutting out the middleman when possible. We continue to stand ready to assist those so inclined.




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