Structured Products and the Mischief of Self-Indexing

Abstract

In the early days of structured products, issuers issued, underwriters underwrote, and index providers provided indexes. In the 1990s, underwriters bypassed operating companies and began issuing debt linked to operating company stocks or to stock indexes. In recent years, investment banks have gone a step further and issued structured products linked to proprietary indexes of stocks, commodities, currencies, and volatility, including the two VIX-derived proprietary indexes discussed herein, rather than just linking to standardized indexes from S&P and other index providers. When brokerage firms include hypothetical trading costs in their proprietary indexes—costs that are absent from third-party indexes—they render comparisons of disclosed costs at the structured product level uninformative. This mischief would not be possible if issuers linked to indexes provided by third-party vendors who had no interest in the payoffs from structured products linked to their indexes. We illustrate the problems with self-indexing structured products using proprietary volatility indexes from Bank of America and J.P. Morgan, although the conflicts we highlight arise equally with the proprietary indexes of other underlying assets, including commodities and currencies.