Investments: Complexity of retail products in spotlight

Among Europe's markets for retail investment products, Germany's stands out for the sheer volume of offers it makes to customers.

Each month Frankfurt's banks produce tens of thousands of tailored retail derivatives known as certificates (Zertifikate in German), which bear descriptions such as "discount", "express" or "knockout" to categorise the way they are structured and their level of risk. Certificates are based on underlying assets such as market indices or individual stocks, and offer investors a range of ways to expose themselves to - and hopefully profit from - market movements.

Volumes are astonishing - almost 520,000 issued in Germany in the first quarter of the year alone. This is 95 per cent of the issuance logged by the European Structured Investment Products Association, which covers Germany and five other countries. There is also a steady stream of certificates maturing.

The DDV, the association representing 17 of Germany's leading certificate issuers, counts more than 930,000 different certificates available to investors. The variety is vast. For example, the share of carmaker BMW is the underlying for 15,000 different certificates.

Christian Reuss, chief executive of Scoach, Deutsche Borse's Frankfurt-based exchange for certificates, says: "It is probably a valid question whether you need so many products, and less could be more. Look at Hong Kong, which has the highest turnover of structured retail products with just 5,000 products. Choice is generally a good thing but the truth probably lies somewhere in the middle."

Scoach is one of two German exchanges where certificates can be traded: each month exchange volumes are some €4bn-€6bn.

The appeal of certificates took a knock in the financial crisis when owners of certificates issued by the German arm of Lehman Brothers, many distributed by other banks, became grimly aware of the hitherto little-acknowledged risk of issuer default. Many small investors waged court battles against banks that had sold Lehman products that became worthless.

Christian Vollmuth, a managing director of the DDV, says the structured products industry was "wrongly associated" with problems from the Lehman bankruptcy. He says: "It was perceived that the 'complexity' of certain structured products was the source of the trouble and that investors had been duped because of this. In reality, the relevant issues were exclusively about issuer counterparty risk and had nothing to do with the particularities of structured products."

The size of the German certificates market was put at €135bn at the end of 2007, then shrank to €80bn a year later. It is now about €100bn.

In the same period, the popularity of passive investment products such as exchange-trade funds has grown. Frankfurt is one of the leading European locations for trade in ETFs. Deutsche Borse's Xetra platform claims a market share of about 37 per cent in European ETF trading.

Deutsche Borse now lists some 900 funds and €165bn of assets under management in ETFs. The number of funds and trading turnover has more than doubled in the past five years.

ETFs are transparent, democratic and competitive in terms of cost, says Rainer Riess, managing director of Xetra market development at Deutsche Borse.

ETFs are used mainly by institutional investors but retail investors drive 40 per cent of trades, according to Deutsche Borse.

At Commerzbank, Germany's second-largest bank by assets, Thomas Timmermann, head of equity markets and commodities in Frankfurt, says: "Certificates can be a cheaper product than ETFs. But ETFs have become more appealing for many retail investors since the crisis, because investors have become more aware of the counterparty risk attached to issuers of certificates."

ETFs have critics. Regulators on the international Financial Stability Board last year expressed concern at the pace of innovation in ETFs, pointing to risks in "some corners of the market" and some "disquieting developments". Xetra's Mr Riess says: "the industry has suffered a little bit from the boom times". Providers need to "work a bit more on helping investors to understand" what distinguishes different types of ETFs, he says.

The DDV has stepped up efforts to bring more transparency to the certificates sector, while trying to stop German structured products being drawn into what it argues could be an overly zealous regulatory response to the financial crisis. Last year Belgium's regulators and issuers of structured products agreed a moratorium on the sale of "overly complex" products. That concerns the DDV, which defends the German approach based on transparency by making product information available.

"It is simply not true that 'complexity' is the source of increased risk. On the contrary, complex features are usually used to reduce the inherent risk of the underlying," Mr Vollmuth says.

Mr Reuss agrees it is "difficult" to regulate complexity. "It would be better to focus on transparency," he says. "Regulation is a sword of Damocles over financial products but I am still positive because structured products have lots to offer investors. We will see how far the pendulum swings but I fear that some overshooting is likely."

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