Not all structured finance is evil

Mention the words "structured finance" and most financial types are likely to look at you aghast. This is the world of financial alphabet soup, consumed in haste and to excess, and now poisoning the financial world from the inside out – all those SIVs and MBS, RMBS, CDOs and CPDOs.

It was the mechanism by which the sale of dodgy sub-prime mortgages across America transmitted into a worldwide credit crisis.

But wait. Not all structured financial products are evil. And for some demand continues to soar.

The area where this is happening, of course, is in relation to commodities, where growing interest among investors the world over has encouraged the development of ever-more sophisticated tools for putting people's money to work.

Most notable has been the development of so-called Exchange Traded Funds, that allow investors to buy or sell a balanced portfolio of related assets – gold, platinum, European smaller companies, timber and so on. But there is an increasing array of more sophisticated structured products that allow investors to employ specialist investment strategies and to gain exposure to new classes of asset, such as freight and emissions.

Barclays Capital, the investment wing of the British bank, reckon that in the first half of 2008 the issuance of new structured commodity products reached $7.8 billion (Dh28.6bn), almost double the $4.2bn issued during the same period of 2007.

In a note to clients last week, BarCap analysts said that although there has been a bit of a slowdown over the most recent three months, with second quarter 2008 issuance falling to $3.3bn compared with $4.6bn in the first quarter, this class of investment continues to grow strongly.

The bank's Gayle Berry declared: "As in the last quarter, commodity index-linked structured notes were the most popular in Q2, with more than 150 issuances totalling $1.8bn in notional value. The agriculture story – rising prices in the face of global demand – has been one of the most persistent themes in structured notes this year. It has helped drive commodity volumes in the first half to record levels, though issuance has slowed in Q2, down 72 per cent q/q to $283mn."

For some reason, base metals continue to be least popular for these new structures, with less than 10 structures (carrying a notional value of just $211mn) being issued so far this year.

But, according to Berry, relatively unconventional commodity linked notes continue to be popular, with exposure to freight, bio-fuels and emissions on the rise. She adds: "In particular, there has been a significant shift from gaining exposure to environmental themes via equity underlyings to access carbon emissions via a single project-related emissions scheme."

It is also the case that sophisticated investors use these products to go "short" – to sell assets for later delivery on the expectation that the price is going to fall.

Should we be worried about these developments? If you are a politician in America the answer is likely to be "yes".

Both regulators and members of Congress in the US continue to delude themselves that the recent jump in energy prices has something to do with market manipulation rather than old fashioned global market forces. And this paranoia over hedge funds and the like spread to Britain last week, with a key parliamentary committee announcing an inquiry into the matter.

There is an argument – vividly illustrated by the carnage of the credit crisis – that such structured products encourage investors to employ excessive leverage, taking reckless bets – sometimes unknowingly. Yet it is difficult to "unlearn" knowledge. Since the financial world now knows how to create and trade structured investment products, the urge going forward will be to make these structures more robust and to make sure they are managed professionally. At the end of the day it must be a good thing that investors are able to spread their risk across as many asset classes as possible.

What is more, the actual process helps set fairer and more accurate prices for the underlying assets themselves.

Bubbles happen, markets over-shoot but free trade remains our best economic model to date. And using markets to allocate capital is a very efficient mechanism. All we need to ensure is that the construction techniques employed by those building the structured products really do ward off the threat of collapse.


Paul Murphy is Associate Editor of The Financial Times