Financial Products

From Open Risk Manual

Definition

A financial product (also "instrument" or "service") is most commonly a contractual agreement between two counterparties that establishes an ongoing monetary relationship for a period of time, along with possible ancillary services that facilitate this relationship.

The contractual agreement is typically summarized in a term sheet and has extensive legal provisions. The specifies the exchange of monetary value at various points during its lifetime, potentially depending on the realization or not of specified events.

Financial products are characterized by the fact that there are no real assets or services exchanged, even though there may be reference to such (e.g. in a mortgage, derivatives or insurance contract).

Ancillary services that may be coupled to a financial product are e.g. electronic accounts or other facilities that enable the execution and monitoring of the ongoing relationship.

Relationship with financial transactions

Entering into a financial contract constitutes a financial transaction but a financial transaction does not necessarily involve a product. For example the exchange of cash from one currency to another can be an anonymous, spot transaction (not a financial product), or a scheduled exchange between to eponymous counterparties under a swap contract (indeed a financial product).

Relationship with financial infrastructure

Financial services may provide access to infrastructure without this access implying a financial product/contract in the sense used here. E.g. a current account providing access to a payment system will involve a contract (and product fees) but does not specify any significant monetary exchanges between provider and user.

Financial Product Origination

While financial products involve contracts that are bilateral in nature, it is quite usual to denote specialized financial services providers as the product originators (also sell side) whereas the range of non-specialized contracting counterparties are product consumers (also "buy side").

When both counterparties to a financial contract are specialized financial services entities (e.g in derivatives swap contract) the bilateral nature is more explicit and they are typically denoted as simply the counterparties to the contract (not a product).

Financial Product Classification

Financial products come in a very large variety, linked for example to the diverse nature of:

  • Contracting counterparties
  • Legal or tax characteristics (linked to jurisdiction or mode of use)
  • Product functionality

Products by Type of Contracting Counterparties

Counterparties involved in financial products are either physical persons or other recognized legal entities. The list includes:

  • Physical persons
  • Private companies
  • Government / sub-governmental entities
  • Trusts
  • Non-profits
  • Supra-nationals entities

Each of the legal entities involved is bound to a legal jurisdiction which determines the nature of financial products it can be entering into and its rights and obligations.

Products by Legal / Tax Characteristics

  • Transferability (whether the contract can be transferred from one of the original counterparties to another)
  • Compliance with specific restrictions (e.g. as mandated by religious or other criteria)
  • Recognition for tax purposes (depending on the variety of tax regimes)

Products by Functionality

Product functionality is obviously a core attribute, being the reason for the existence and use of a product.

  • Banking Products: A large category of financial products who's primary functionality is enabling the acceleration or delay of consumption / investment via the lending or saving funds.
    • Lending products (loans, credit facilities) advance funds (cash) to be repaid in the future
    • Savings products (deposits, money market funds) store funds (cash) to be withdrawn at a future date
  • Foreign Exchange products: Products enabling the conversion of funds between currencies
  • Other Derivatives products: Contracts enabling fine-tuned risk management or speculation on future states on any of a large variety of financial or economic indicators
  • Insurance products: Contracts providing risk protection for any of large variety of risk factors
  • Capital Markets Products (transferable instruments)
    • Corporate Securities (Shares, Bonds)
    • Asset Backed Securities (RMBS, CMBS etc.)
    • Sovereign Debt

Products by Risk Type

An alternative to classifying financial products by functionality focuses on the key risk factor involved (e.g., altered or transferred) in the product. The following is a high level classification:

  • interest rate risk (including inflation risk)
  • foreign exchange risk
  • equity market risk
  • credit risk
  • commodity risk
  • insurance risk (with many subdivisions)

Many existing products may have complex dependency on multiple risks. E.g. a mortgage loan will involve both credit and interest rate risk)

Issues and Challenges

Given the huge range and scope of financial products there is no shortage of issues and challenges associated with their lifecycle. A broad categorization would split a key subset of all issues into the following two important subcategories:

  • Suitability of products for clients (in particular retail), typically linked to consumer protection authorities
  • Complexity and risk issues (including systemic stability issues), typically linked to prudential regulation authorities

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