The financial industry is quite adept at creating new products and successfully marketing them to the masses. Many of these products have been successes that have made money for investors and the financial institutions that offer them. Think mutual funds and exchange-traded funds, for example.
However, other products have either been outright disasters or worse, have brought the world to the brink of financial ruin. The prime—or should we say subprime—example of such toxic products would undoubtedly be U.S. mortgage-backed securities, whose implosion circa 2007 – 09 caused a global credit crisis and the Great Recession.
Here are the 10 steps involved in the creation of a new financial product.
Creating Something New
Obviously, creating a new financial product entails a greater degree of risk compared with manufacturing a widget. For instance, the purveyor of a new financial product faces risks arising from faulty risk management or conflicts of interest.
The bigger risks from new financial products, however, devolves squarely on the shoulders of clients. Recall the number of U.S. homeowners who faced financial hardship due to sharply higher mortgage financing costs on their adjustable-rate mortgages when U.S. interest rates rose from 2003 to 2006.
While new product debacles can occur from time to time in the financial industry, the reality is that these products generally go through a rigorous development process that can take many months to complete.
1. Concept of New Financial Products
The first step in developing a new financial product is to conceptualize it. The idea for a new product can arise from a variety of sources, such as client demand, internal sales force or a third party. Exchange-traded funds came about because they did away with the limitations of traditional mutual funds by trading on an exchange, and thus offering instant liquidity and transparency — traits that are of immense appeal to investors.
On the other hand, strip bonds or zero-coupon bonds likely evolved because some bright spark in a financial institution figured that taking a 10-year bond, “stripping” it of its 20 semi-annual coupons, and selling them individually would result in 21 separate commission-eligible transactions (20 coupon payments plus the bond principal), rather than a single bond transaction.
2. Product Development
Coming up with a product idea is one thing, but developing it is another thing altogether since the devil truly is in the details. At this stage, the product development team has to translate the idea into a tangible product that can be sold to the institution’s clientele at a reasonable profit. The development team has to walk a fine line in devising a product that is neither unnecessarily complex (a real risk with financial products), nor is so plain-vanilla that it is easy for the competition to replicate.
The clientele for the product is also identified at this stage since most of the subsequent steps are driven by whether the product is meant for a retail audience, or should only be targeted at institutional clients.
3. Regulatory, Legal Requirements
The new product must meet securities regulations mandated by the appropriate authority. For example, Regulatory Notice 12-03 from the Financial Industry Regulatory Authority (FINRA) provides guidance to financial firms about enhanced supervision requirements for complex products. FINRA defines a complex product as one with multiple features that affect its investment returns differently under various scenarios, such as asset-backed securities or structured notes.
As regulation is primarily designed to protect retail investors from dubious products or services offered by unscrupulous firms, ensuring that the new product fully complies with all regulations applicable to it is essential for ensuring its success (not to mention avoiding potential embarrassment later). On the legal side, the firm’s legal luminaries will ensure that the intellectual capital invested in the product is protected through the necessary filings. The legal team will also confirm that regulatory requirements pertaining to such issues as product suitability and conflicts of interest have been adhered to.
At this stage of a new product's evolution, the nitty-gritty is hammered out. This is probably the most important step in the entire new product development process since it encompasses all the key details involved with offering the product. This includes developing the forms and paperwork to be filled out by a client, ensuring the transaction will be efficiently executed on the firm’s platform and identifying the steps involved in processing the trade in the back office. It also includes other key elements such as devising risk management and controls to make sure that risks to the firm arising from the new product are mitigated, as well as client reporting, employee training (front office and back office) and supervision.
5. Registration of Products
The new product may need to be registered through a prospectus or offering documents with the applicable body such as the Securities Exchange Commission in the U.S., or the provincial securities commissions in Canada. Note that these bodies do not proffer an opinion on the merits of the new product or on its investment appeal. Rather, they ensure that all the “I’s” are dotted and the “t’s” are crossed in the prospectus and that it contains full disclosure of all the factors required by an investor to make an informed investment decision.
6. Marketing New Financial Products
Marketing a new product is vital to ensure its success. This phase also involves educating the client if the product is quite complex. In general, marketing cannot commence—or can only be conducted in a limited manner—until such time as approval has been received from the body with whom the prospectus or offering document has been registered. Developing marketing literature such as brochures and presentations that effectively communicate the product’s features and benefits, and formulating a cohesive media strategy, are time-intensive activities that can take weeks to complete.
7. Distribution of the New Product
This is another key step since if there is no effective sales force to sell or distribute the product, it will be doomed to failure. The firm or institution has to make a number of important decisions at this stage — who will sell the product, how will they be compensated, what is the level of compensation and so on. The product’s attributes are essential for determining the right target audience for it.
For example, a high-risk, high-reward product or one that is quite complex may be better suited for institutional investors, while a relatively simpler one may be attractive to retail investors. Once the target market has been identified, the right distribution channels can then be put into place.
8. Product Launch
Finally, the big day arrives when the product is finally launched, the culmination of months of effort. New financial products are typically launched with a lot of fanfare, right after or during a media blitz to raise product awareness. Some new products may fly off the shelf as soon as they are released, while others may take more time to gain traction. It all depends on which investor need is being met by the new product—income, growth, hedge, or other needs—as well as its risk profile.
The firm’s compliance department will monitor sales of the new product to ensure that it is only being sold to those clients of the firm for whom the product is suitable. Client suitability is a very big issue in the financial industry. An advisor who sells a complex structured note to an 80-year-old with limited means of income will soon receive a visit from a compliance officer and could be in jeopardy of being shown the door. Depending on the specifications of the (new) product being offered, compliance would also be on the lookout for prohibited practices such as front-running or manipulative trading.
10. Product, Profitability Review
In the final stage of a new product’s development cycle, it will be reviewed at set periodic intervals to assess various parameters — product sales versus projections, unexpected challenges, risk management, the product’s contribution to profit and so on. Depending on the outcome of such periodic reviews, the new product may either turn out to have a short shelf life, or it may be a winner that expands the firm’s portfolio of successful product offerings.
The Bottom Line
The 10 steps outlined above are essential to the creation of a new financial product, although they may not necessarily always be implemented in the order shown.