Investing

Structured market leery of open systems

Open architecture has been slow to come to the structured products market.

Structured products are unsecured debt obligations of the issuing brokerage firms, and despite growing concerns about Wall Street’s financial strength, only one wirehouse sells outside products.

UBS Financial Services Inc. of New York has given its brokers a choice of issuers since 2006, said UBS spokeswoman Karina Byrne.

In addition to its own products, UBS offers products from Lehman Brothers Holdings Inc. of New York, Deutsche Bank AG of Frankfurt, Germany, HSBC Holdings PLC of London, and Barclays Capital, the New York-based investment-banking division of London-based Barclays Bank PLC.

Other than UBS, there’s been no movement to open the doors.

Flows into structured products have almost doubled from $64 billion in 2006 to $114 billion in assets in 2007. Five years ago, in 2003, it was $28 billion.

The risk from a proprietary-only policy is that clients may not get the diversification they need, and they may pay too much when issuers don’t have to compete.

“Three years ago, we thought there would be a massive move to open architecture, based on what we’d seen with mutual funds,” said Keith Styrcula, chairman of the Structured Products Association in New York. “But we haven’t seen it yet,” he said.

After sales practice issues arose with proprietary mutual funds, wirehouses for the most part have stopped favoring internal funds.

Other than UBS, the only other traditional firms offering outside products are the private banking units at JPMorgan Chase & Co. of New York and Credit Suisse Group of Zurich, Switzerland, Mr. Styrcula said.

“If they did [use outside issuers], I would probably consider [structured products] a lot more seriously,” said a Smith Barney rep who asked not to be identified.

Spokesmen for Morgan Stanley of New York, Smith Barney, the brokerage unit of New York-based Citigroup Inc., and Wachovia Securities LLC of St. Louis did not respond to requests for comment.

Merrill Lynch & Co. Inc. of New York spokesman Erik Hendrickson declined to comment.

In contrast to the proprietary focus at the wirehouses, independent brokers and RIAs are using open architecture.

The custodial units of Fidelity Investments of Boston and The Charles Schwab Corp. of San Francisco have relationships directly with various product providers, Mr. Styrcula said.

“We don’t have proprietary products,” said Jim Frawley, spokesman for TD Ameritrade Institutional in Jersey City, N.J. “It takes out the conflict of interest.” He said TD Ameritrade limits its structured-product offerings, based on the needs of clients and advisers as well as the credit quality of the issuer.

Independent broker-dealers typically use Incapital LLC, a Chicago-based provider of structured products to brokerage firms and advisers whose approach is to offer an open architecture platform, Mr. Styrcula said.

About 40% of structured-product sales are done in an open architecture format, according to the Structured Products Association.

At the wirehouses, though, offering outside products “may take away from some fees [the firms get],” said Justin Capetola, chief compliance officer at Blue Bell Private Wealth Management LLC in Blue Bell, Pa., which manages $300 million for clients, some of it in structured products.

The products are highly profitable for wirehouses and have been targeted by firms as attractive places for growth.

“There’s always tension between the manufacturer and the distribution side,” Mr. Styrcula said.

Some brokers say many structured products can be duplicated more cheaply using options.

Providing trading and sales support for outside products is also a hurdle for firms in making a transition to open architecture, said Eric Glicksman, managing director and head of structured products development for UBS’s retail unit.

CREDIT CRISIS

The credit crisis could spark a move toward open architecture and bring prices down.

“We’ve all had our share of client calls about” the credit quality of issuers, said a UBS broker who asked not to be identified. “Everyone was worried after Bear Stearns.”

The Bear Stearns Cos. Inc. of New York imploded in March.

Citigroup, Merrill Lynch and UBS have all been downgraded since last fall, UBS most recently in April. And serious concerns about Lehman Brothers grew after the Bear debacle.

Lehman is one of the structured-product issuers that UBS uses.

With some signs that the worst of the credit-related write-offs may be over — and with Bear Stearns structured products now backstopped by the U.S. Treasury — concerns about credit quality have abated. But the need to diversify has never been clearer, observers say.

Before the credit crisis, “less savvy financial advisers probably didn’t understand they were effectively creditors of these issuers,” Mr. Glicksman said. “This credit crisis has required them to look deeper into what they’re purchasing, and ask those hard questions.”

In addition, the brokerage industry doesn’t “want to be seen as just offering its own products,” Mr. Capetola said.

Furthermore, with competing bidders, “you get much more competitive pricing,” Mr. Styrcula said.

Moving to open architecture “is a top line agenda item for the industry,” he added. “We want to make sure investors get the best possible exposure with structured products.”

Yet, open architecture does have some drawbacks.”There’s good and bad,” said the UBS rep. “A lot of [UBS] brokers [sold] Lehman products [and] now have to be worried about them,” he said.

Nevertheless, “it was the right thing for [UBS] to open up [and] make their investment bankers bid [for business],” the UBS broker added.

Mr. Styrcula said too many products can also confuse clients. In the meantime, firms are using some third-party credits to spread the risk.

The biggest player is Oslo, Norway-based Eksportfinans ASA, an export-financing entity owned by banks and the Norwegian Ministry for Trade and Industry. Eksportfinans is ranked AAA by Moody’s Investors Service Inc. and Fitch Ratings Ltd., and AA+ by Standard & Poor’s. All three agencies are in New York. It provides a triple-A credit “enhancement” to a structured product, Mr. Styrcula said.

Eksportfinans was involved in 400 offerings last year. Toyota Motor Credit Corp. of Torrance, Calif., the financing arm of Toyota Motor Corp. of Toyota City, Japan, is also active in raising capital through structured notes sold to investors.

These alternative backers appeal to clients who like a product “but don’t want it to be backed by the U.S. financial services industry,” Mr. Capetola said.

E-mail Dan Jamieson at [email protected].