Derivatives · Intermediate · 4 min

Issuer risk

You can explain why warrants, certificates and notes depend on the bank that issues them, and why deposit protection does not apply.

Index up, certificate gone

An investor buys a certificate on a stock index. Over the next year, the index rises 20%. The certificate is nearly worthless.

It sounds impossible, but it has happened. The reason has nothing to do with the index and everything to do with the bank that issued the certificate. This lesson explains issuer risk, one of the least visible risks in derivatives.

A promise, not a deposit

Many derivatives sold to private investors in Europe are securities issued by banks: warrants, turbos, discount and bonus certificates, index certificates and exchange-traded notes. Legally, they are debt securities. The issuer promises to pay an amount that depends on the underlying, according to the product's terms.

Issuer risk is the risk that the issuer cannot keep that promise.

If the issuer is healthy, the product pays out as described.
If the issuer becomes insolvent, holders become creditors in the insolvency. BaFin warns that for certificates and warrants, a total loss then threatens.

Three points are often misunderstood:

No deposit protection. BaFin states plainly that securities such as certificates are not covered by deposit guarantee schemes. Those protect bank deposits.
Custodian and issuer can differ. Your securities account may be at Bank A, while the certificate was issued by Bank B. Bank A keeps the security for you. Bank B owes the payment. If Bank B fails, Bank A's health does not help.
The underlying does not protect you. A rising index does not change what an insolvent issuer can pay.

Exchange-traded futures and listed options work differently: they are cleared by a clearing house, not promised by a single bank, as the last lesson explained. Some products reduce issuer risk with collateral, such as physically backed ETCs.

Right view, wrong issuer

A fictional investor puts 10,000 into index certificates, all from one issuing bank.

A year later, the index is 20% higher. The certificates should be worth about 12,000.
The issuing bank becomes insolvent. Trading in its certificates stops.
Years later, the insolvency process pays creditors a fraction of their claims.

The investor was right about the market. The loss came from the issuer. Spreading the same amount over several issuers, or using a fund whose assets are kept separately, would have limited it.

Common mistakes

Assuming bank products are deposits. They are securities with issuer risk.
Holding everything from one issuer. One failure hits all of it.
Confusing custodian and issuer. They can be different banks.
Ignoring the issuer's credit quality. Check it like you would for a bond.

The takeaway

Warrants, certificates and notes are promises by their issuer. If the issuer fails, you can lose everything, even if the underlying did well.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the case in which you may lose your money even if the underlying rose.

Tap the chart.

BaFin warns that if the issuer of a certificate becomes insolvent, a total loss threatens.
2Are certificates covered by deposit protection?

Deposit guarantee schemes cover bank deposits, not securities issued by banks.
3Your certificates sit in your securities account at Bank A but were issued by Bank B. Bank B fails. What matters?

The custodian keeps the security. The issuer owes the payment. These can be different banks.
4Which product carries no issuer risk of this kind?

Cleared exchange products depend on the clearing house, not on a single issuing bank.

of 4 correct.