The German certificates market is diverse – not just in terms of products, but also in terms of categories of certificates, product structures and product names. The names used to market certificates often differ between different issuers and can cause misunderstandings among investors. BaFin’s experience has shown that worst-of certificates and open-end certificates cause confusion, for instance. Both structures can be found in a wide range of popular types of certificates.

What are certificates?

Certificates are bearer bonds under section 2 (1) no. 3 of the Securities Trading Act (Wertpapierhandelsgesetz – WpHG). They are based on the performance of an underlying instrument, for example shares, indices or commodities futures. However, the investor does not acquire any rights to the underlying instrument. A certificate does not securitise ownership or shareholders’ rights, only the payment or repayment of an amount of money or the physical delivery of an underlying. The certificate’s performance does not depend solely on the performance of the underlying; it is also affected by other factors, such as the volatility and the fair value of the investment.

As they are securities, certificates are in principle tradable. However, because they are less liquid than, for example, blue chip shares, the prices of certificates are generally not derived from supply and demand, but are determined by the issuer via market making on the basis of internal pricing models (see expert article on the BaFin website dated 4 March 2019). However, the issuer can suspend quoting or stop trade in the certificates. There is therefore no guarantee for pricing via market making.

The issuance/offering of certificates is subject to various supervisory requirements. For example, the issuers are required to produce a securities prospectus under the provisions of the Securities Prospectus Act (Wertpapierprospektgesetz - WpPG) and this prospectus must be approved by BaFin. Furthermore, they are required to produce a key information document (KID, see info box ) and identify the target market.

As might be expected from the name “bonds” (“Schuldverschreibungen” in German), the acquirer of a certificate is a creditor of the issuer and therefore carries not only the risk that the strike price will not develop as expected (market risk), but also the risk that the issuer becomes insolvent (issuer default risk). Deposit guarantee schemes do not apply to certificates. This means that there is no guarantee of repayment, and even securities with names such as “capital protection certificate” or “guarantee certificate” come with an inherent issuer risk, potentially to the point of total loss.

The rotten egg in the basket: worst-of certificates

Worst-of certificates are “basket certificates”. Instead of being based on the performance of an individual underlying instrument, “basket certificates” are based on the performance of a large number of underlyings. Depending on the structure, any claim to interest payments and/or redemption therefore depends on the performance of several underlying instruments. This means that basket certificates can essentially reduce the market risk (risk diversification by spreading). In principle, the higher the number of underlying instruments, the greater the diversification effect. The probability of all underlying instruments losing value is lower when there is a greater number of different underlyings. The diversification effect is greater for underlyings that have negative correlation with each other. This is the case, for example, if a basket consists of shares both of a pharmaceutical company and of an automotive company.

However, this is not true for worst-of certificates. With this variant, only the underlying with the worst performance is relevant for the amount of the repayment. The performance of the other underlyings in the basket, on the other hand, is not important.

The worst-of mechanism can be built into various types of certificates. This type of structure is typical for reverse convertible bonds, express certificates and bonus certificates, for instance. The worst-of nature of these certificates is often not directly clear from the names the issuers give to them for marketing purposes. The certificates do not necessarily have the phrase “worst-of” in their names.

How the worst-of mechanism works will be explained below using the example of a multi express certificate (this is another common marketing name). Express certificates usually have terms to maturity of three to five years and an annual “observation day”. At the point of issue, the issuer determines two different thresholds: the redemption threshold, which, if exceeded, causes the certificate to be redeemed early, and the barrier, which, if reached or crossed below, leads to the investor receiving the relevant shares instead of redemption at the nominal value.

Example: Multi express certificate with worst-of structure

In this example, both the redemption and the interest payments depend on the performance of the underlying and are subject to the worst-of mechanism.

Figure 2: Determining the redemption of a multi express certificate with worst-of structure

BaFin

If the prices of all underlying instruments are at or above the redemption threshold on the observation day, the certificate is redeemed early at the nominal value. The product matures before the designated date of maturity, and the investor receives their invested amount back. Otherwise, redemption occurs on the date of maturity at the latest. If the prices of all underlying instruments are equal to or above the barrier on the date of maturity, the investor receives the nominal value. However, if the price of one or more of the underlying instruments is below the barrier, the investor receives shares of the underlying instrument with the worst performance instead of redemption at the nominal value.

The investor receives an interest payment if the prices of all underlying instruments are at or above the barrier on the observation day. However, if the price of one or more of the underlying instruments is below the barrier, the investor does not receive the interest payment.

Table 1 shows an example of a multi express certificate with a redemption threshold of 90% of the initial reference level, a barrier and strike price of 55% of the initial reference level and a nominal value of EUR 1,000. The basket on which the certificate is based contains eight shares. In this example, only the final observation period before the date of maturity is illustrated.

Table 1: Example of basket performance of a multi express certificate

BaFin

The prices of three of the underlying instruments (shares 2, 4 and 7) are under the redemption threshold on the observation date. This means that early redemption is not possible. However, in the present example this is irrelevant, as it only considers the final period before the date of maturity. Moreover, the price of one of the underlying instruments (share 4) is below the barrier. This means that on the date of maturity the investor receives the shares rather than the nominal value. In this example, the investor receives 81 shares listed at EUR 7.93.

Another potential structure for multi express certificates can entail the investor receiving not shares when the price is below the barrier but a payment in the amount of the corresponding share price. This is determined by the issuer on the basis of the strike price. When the payment mechanism is structured in this way, the investor in the above example would only receive EUR 642.62 instead of the nominal value (see Figure 3). The investor would suffer losses of approximately 36%. As one of the underlying instruments is below the barrier, they would also not receive any interest payments in this period.

Figure 3: Calculation of the payment amount for the example in Table 1

BaFin

High complexity

Because of these aspects of their structure, worst-of certificates are comparatively complex. For the investor, the benefit of an investment in worst-of certificates is usually only optimal if all underlying instruments are above the barrier on all reference dates and at least one remains below the redemption threshold. That guarantees the interest payments and, upon maturity, the repayment of the full nominal value.

The higher risk of default that basket certificates with worst-of structures entail means that the coupon payment is usually higher. This means that as a result of the higher risk that the investor has to bear with such certificates, they also have the possibility of higher returns. However, it is generally difficult for the investor to reliably assess the risk they are taking on and the risk/reward ratio. The investor needs to estimate the performance of a large number of underlying instruments. Furthermore, although they only enjoy the benefits of the performance of the worst underlying instrument, they bear the combined default risk of all underlying instruments in the basket. The investor therefore needs to ascertain and assess the probability of default of all underlying instruments.

In contrast to usual basket products, in basket certificates using the worst-of structure there is no risk spreading (diversification); instead, the risks are concentrated. Because the amount of the repayment is based solely on the underlying instrument with the worst performance, there is no risk diversification through spreading of market risk, despite the large number of underlying instruments.

In order to avoid such misunderstandings about product names and structures in the future, the German Derivatives Association (Deutsche Derivate Verband – DDV), representing German certificate issuers, recently published the document “Principles for the issuance of worst-of certificates for distribution to retail clients in Germany” (Grundsätze für die Emission von Worst-of-Schuldverschreibungen zum Vertrieb an Privatkunden in Deutschland - only availabe in German). These principles state that the name “worst-of certificate” is to be standardised and used when these products are distributed. The issuers are supposed to implement these principles by 1 January 2020 at the latest.

Only indefinite until terminated: open-end certificates

Open-end certificates are securities without a fixed term or contractually defined maturity date. Issuers have introduced product names containing buzzwords such as “open end”, “endless” and “unlimited”. Payout or disinvestment happens not when a maturity date is reached but, for example, when the investor exercises or sells the certificate or the issuer terminates it. It is a disadvantage for the customer if they are not able to hold the investment for as long as they had originally planned and as, in some cases, was implied.

As is the case with worst-of certificates, the open-end structure is a feature used in various categories of certificates. It is a typical structural feature in leverage products such as factor certificates and knock-out products. But investment products such as, for example, index and participation certificates can also be open end in nature. At first glance, that seems reasonable, as the term “investment products” as a rule covers certificates that an investor holds long-term, as seems to be the case with open-end certificates. However, the investment can end up being shorter-term against the investor’s will.

Issuer’s right to short-notice ordinary termination

That is because the issuers of allegedly open-end certificates have the right not only to extraordinary termination if an extraordinary event occurs, but also to ordinary termination with, in some cases, very short notice periods. The issuer might decide to terminate a certificate simply because of unprofitable hedging transactions or unprofitable market-making or because an underlying instrument is no longer available. Particularly with speculative products such as factor certificates, the investor should be aware that the issuer can terminate the certificate at any time with effect from the next trading day. For many leverage products, termination is actually possible even on the date of issue.

The product name “open-end certificate” is open to be misunderstood in particular by investors pursuing long-term investment objectives. They often draw the incorrect conclusion that a certificate without a fixed maturity can be held for as long as the investor wishes. However, for the investor the “indefinite maturity date” only applies until the point when the issuer terminates the certificate.

The notice periods therefore make open-end certificates unpredictable for investors. Usually, they are not able to estimate reliably when the issuer will terminate the product. BaFin knows, due to complaints it has received, that investors not infrequently receive their money back at a point in time that they would not have chosen themselves. In contrast to certificates with a fixed date of maturity, with open-end certificates investors usually do not expect the money invested to be returned to them on the instigation of the issuer.

Additional transaction costs for reinvestment

Should the investor wish to continue to participate in the performance of the underlying instrument after the issuer has terminated the contract, they must make a new investment in a certificate with the same underlying instrument. This usually means that transaction costs have to be paid again.

If the investor is not able to find a follow-on investment at short notice after the issuer has terminated the contract, they are no longer participating in the performance of the underlying instrument, and can potentially miss out on an improvement in performance following previous losses (see Figure 4). This can be observed in particular with highly volatile underlying instruments.

Figure 4: Example showing an improvement in performance for an open-end investment certificate without reinvestment

BaFin

In the example, the issuer terminates the open-end investment certificate after 31 days (T₃₁). This causes the investor losses of 26.6%. The investor can only participate in the improvement in price that occurs later if they directly reinvest in a comparable certificate based on the same underlying instrument. In the following days, the price of the underlying instrument rises slightly. If the certificate had not been terminated, the investor would have been able to hold it for longer and reduce the losses they had sustained previously. If the certificate had been sold at T₄₆, the losses would have equated to just 12.5%.

In order to prevent misunderstandings, the DDV has published a document containing explanations - only available in German - regarding the rights of termination for open-end certificates. It has also set out minimum standards regarding notice periods. Under these standards, investment certificates with an investment horizon of three to five years should have a minimum notice period of one month. Certificates with an investment horizon of less than one year, on the other hand, can still have a minimum notice period of one day.

What should investors bear in mind?

Before investors invest in certificates, they should be aware of the risks. As described above, investors always bear the default risk and, in addition to this, they usually also bear the market risk of the underlying instrument. Anyone who invests in certificates takes the risk that all of the money they invest will be lost. It should also be borne in mind that not all certificates are appropriate for every investor. Leverage products or speculative products such as options, knock-out certificates and factor certificates demand a greater level of knowledge of and experience with trading in structured products.

Investors should take the time to run through a specific checklist of questions, and only pursue an investment if they can answer “yes” to all of them (see info box). Issuers are required to make the most important information available to investors. Documents that are available to the public include, for example, the securities prospectus, the final terms and the KID.

Summary

Certificates can have certain product or structural features that are not immediately evident from the marketing and product names.

Figure 5: Summary of the product features of worst-of basket certificates and open-end certificates

BaFin

With worst-of certificates, investors should be aware that although the certificates are based on a large number of underlying instruments, the redemption payment or interest payments are calculated based on the underlying instrument with the worst performance. This means that they do not provide any spreading of risk that the investor might have sought; instead, the risks are concentrated (see Figure 5).

Open-end certificates can also cause misunderstandings because of their names. With these products, the issuer sometimes grants itself a right to ordinary termination with a very short notice period of just one day. The investor therefore cannot hold the certificate indefinitely if they choose, even though product names such as “open end”, “endless” and “unlimited” might give this impression. Particularly if the investor seeks a long-term investment, they should pay attention to the issuer’s rights of termination.

Investors should therefore be aware of the risks they are taking on when investing in certificates. Above all, they should take notice of the product features and be able to understand precisely how the product works. It is useful to run through a specific checklist of questions in advance.