To explain, when buying or selling investment certificates and leveraged products, investors either deal directly with the issuer – i.e. OTC (over-the-counter) – or with a market maker on a trading venue. In either case, the price is not determined on the basis of supply and demand. For investment certificates and leveraged products, the issuer usually also acts as a market maker.

Typical product groups

The price of investment certificates and leveraged products depends on the price of a reference asset, the underlying. Typical underlyings are indices, shares, bonds, currencies or even commodity futures. Investors therefore do not invest directly in an underlying, but in a financial instrument whose performance depends on that of the underlying. As a result, they receive no rights of any kind in the underlying. This allows private investors to invest in markets which would otherwise be difficult or impossible for them to access. Some of these products have an indefinite term but can be terminated or sold on set dates. Investors are able to buy these products not only within the subscription period, but also after they have been issued on the secondary market.

The complaints about price determination primarily relate to leveraged products such as factor certificates, warrants, turbo warrants and knock-out certificates. These derivatives reflect the price performance of an underlying in a leveraged form. Investors therefore have the opportunity to participate disproportionately in the price movements of the underlying. Leveraged products are considered high-risk, as investors face the risk of losing their entire investment. These financial instruments are normally bought in non-advisory transactions, and are therefore mainly bought by self-directed investors. Investor complaints about leveraged products can be explained in particular by the fact that they frequently do not hold these to maturity. Unlike with investment products, leveraged products are primarily traded for speculative purposes. The tradability of such products is therefore particularly important for investors.

Order book pricing

There is an important distinction in securities trading between order-driven pricing and pricing by a market maker, known as quote-driven pricing. The prices of shares and bonds are typically derived from supply and demand. The forces of supply and demand are brought into balance in the price of a security. The price is determined on the basis of the order book where buy and sell orders are compiled. The price of a security is the price at which the maximum number of trades take place, i.e. the price at which the largest number of market participants are willing to buy or sell the security (principle of highest execution volume). The price is therefore determined directly by supply and demand. The individual orders are matched with one another. Market participants transact directly with each other and the liquidity of the security results from the number of buy and sell orders.

Why market makers are necessary

The price of a security can only be determined based on supply and demand if there is sufficient liquidity and market breadth. If there are insufficient buy and sell orders, which is usually the case for investment certificates and leveraged products, a price cannot be reliably determined by supply and demand. In such cases market makers are often used. They increase liquidity in the market or in relation to a particular financial instrument, and, thus, ensure that trading takes place. If prices cannot be derived reliably from supply and demand, prices for less liquid securities, such as investment certificates and leveraged products, can still be quoted for the secondary market with the help of market makers.

The need for market makers is evident from the number of products alone: for example, around 11,200 shares are traded on the Frankfurt stock exchange and around 1,700,000 certificates trade on Frankfurt stock exchange’s regulated unofficial market (open market). Not all of these certificates have sufficient liquidity to ensure they are tradable at all times. For this reason, the issuers themselves usually act as market makers for these products and quote prices. This enables investors to sell a certificate through a trading venue during its term or to buy one after the end of the subscription period. In addition, the quoted price can also serve as a value indicator for investors.

Availability of prices

In principle, issuers of certificates and warrants do not undertake to provide continuous indicative (i.e. non-binding) bid and offer prices. This is set out in their base prospectuses. And even under normal market conditions, they are under no legal obligation to quote prices. Furthermore, issuers do not undertake to provide market-making at all times during the term of the security. However, as the issuers themselves only earn returns when the products are traded, they have a large interest in ensuring that, as far as possible, all products are tradable.

Although market makers are somestimes obliged, for example under the stock exchanges’ general terms and conditions, to provide continuous non-binding bid and offer prices, this obligation only applies vis-à-vis the stock exchange in question, and not vis-à-vis the holders of the securities. Moreover, to rely on continuous price setting by the market maker, investors would have to find out where a security was traded and what legal requirements applied to that particular trading venue.

On top of this, the relevant general terms and conditions also contain exceptions to this obligation. For example, prices do not have to be quoted during market disruptions or in unusual conditions. In the event of volatile markets, unusual movements in the underlying, technical errors or unusual circumstances when determining prices, the market maker may suspend the quoting of prices (see “Example of a suspension of price quotes”). Trading usually continues after the market disruption is over. However, this can also lead to upward or downward spurts.

Open-end turbo warrant

Source: Own example © BaFin

Price components

As the prices for investment certificates and leveraged products are not determined on the basis of supply and demand through the order book, issuers determine them by means of internal pricing models. The price is determined at the sole discretion of the issuer or market maker. The relevant legislation does not require the stock exchanges or BaFin to supervise or review how these prices are determined.

Alongside the performance of the underlying, other factors can influence the price quoted by the market maker. The market maker or issuer is permitted to price in hedging costs, their margin and the costs of structuring and distributing the security. For example, the daily calculation of the strategy index underlying a factor certificate includes an index fee for calculating this index. This fee diminishes the price of the factor certificate.

For this reason, the price calculated by the issuer may differ from the mathematical value of the security. The mathematical value describes the economically expected value as a function of the intrinsic value of the security, which reflects price movements in the underlying, and the fair value, which is affected by factors such as volatility, interest rates, the credit worthiness of the issuer and – where the underlying is a share – the expected dividend.

Investors sometimes expect the warrant or certificate to replicate the price of the underlying on a 1:1 basis. Complainants assume, for example, that a rise in the price of the underlying of a call warrant should automatically lead to the price of the derivative rising by the same proportion.

However, with warrants, and especially warrants close to their expiration date, a loss of fair value may have to be priced in, in addition to the factors mentioned above. The mathematical value of a warrant is composed of its intrinsic value – which is in turn the difference between the strike price and the current price of the underlying – and the fair value. The fair value reflects the uncertainty about the performance of the underlying over its remaining term and the volatility of the underlying, which are additional components of the price. As a warrant approaches its expiration date, its fair value also approaches zero because, in the case of a call warrant, for example, the likelihood that the price of the underlying will be above the strike price at the expiration date diminishes with each passing day. Irrespective of the performance of the underlying, the warrant therefore loses value towards the end of its term as a result of this loss in fair value.

In summary, the mathematical value of a certificate or warrant can deviate from that of the underlying. In addition, the price of the security may also differ from this mathematical value because the issuer or market maker has priced in a number of factors such as margins, costs and volatility.

Does the issuer profit from investors’ losses?

In their complaints on price quotations for certificates and warrants, investors often express the suspicion that issuers profit from investors’ losses or that investors’ losses equal the issuer’s profits. According to the website of the Deutsche Derivate Verband (German Derivative Association), issuers try and adopt a risk-neutral position vis-à-vis investors in every transaction, hedging the transactions in order to achieve this. One method according to the site is to buy the underlying. To hedge an open position in a warrant, for example, an issuer could buy the underlying share. If the price of the warrant fell, the price of the underlying held by the issuer would also fall. In this case the issuer would have a risk-neutral position towards both profits and losses by investors.

However, it should be noted that issuers are under no legal obligation to hedge every open position. In addition, issuers do not themselves undertake to carry out such hedging transactions. There is no need for them to generate returns on open positions vis-à-vis investors, as they have other sources of income, such as the fees they have priced in, the issuer’s margin and the bid-offer spread in market-making. In addition, issuers profit from the issue of securities due to the funding effect.

[BILD]

Funding effect in the issue of certificates

Source: Own example Funding effect in the issue of certificates; © BaFin

Summary: investors need to be aware of the risks

Investors should be aware that the prices of warrants and certificates are usually not set through the order book, i.e. they are not based on supply and demand. These financial instruments can either be traded over-the-counter directly with the issuer or through a trading venue with a market maker. In both cases, issuers determine the price of the financial instrument themselves at their own discretion. This price may include margins or the costs of distribution or hedging. Moreover, issuers are not obliged to quote prices continuously. They can suspend or terminate the quotation of prices under certain circumstances, as for example, unusual market conditions or high volatility.

Moreover, investors should be aware that the price of the securities does not depend exclusively on price movements of the underlying. Although these instruments are based on the performance of the underlying, due to the inherent structure of the product, the development of their prices may be different. Other factors in addition to the price of the underlying can influence the price of the instrument. Investors should therefore be aware that the price of the security may differ considerably from its mathematical value.

When investing in such products we also recommend reading the risk notices of issuers in the base prospectuses. These state, for example, that the prices quoted by the market maker may differ from the security’s mathematical value and that the issuer is under no obligation to quote prices. It is therefore advisable to read the relevant terms of the issue in detail. Investors should decide themselves whether they understand how the products work and are willing to accept the risks.