Annals of Regulatory Arbitrage, German Structured Products Division

What is it about German banks selling credit derivatives to their retail customers? Back in 2000 I wrote about a scandal involving Dresdner bank and many others, who used credit derivatives to transform Ecuadorean PDI bonds (dollar denominated, coupon 3.5%, minimum investment $250,000, get restructured in the case of default) into instruments sold to German retail investors (Deutschmark denominated, coupon 14.25%, minimum investment Dm1,000, expire worthless in the case of default).

Today, Carter Dougherty tells a very similar tale: that of "Certificates" sold into German retail which were pitched as being safer than stocks, but many of which were in fact the unsecured obligations of Lehman Brothers. Investors thought they were protecting themselves; instead, they were taking on a whole new level of risk which was never properly explained to them.

Similar things exist in this country: I've warned in the past about principal protected notes, for instance. But the Germans seem to be able to sell them in much smaller chunks to much less sophisticated investors than anything I've ever seen here or in England.

I suspect one of the problems is regulatory arbitrage. As I explained back in 2000:

CSFB and Dresdner seem to have got the best of both worlds. In England, it would be illegal to sell such securities to retail investors, while in Germany it would be illegal to structure such instruments in the first place. So the banks structured the instruments under English law, and then sold them to brokers who in turn sold them on to their retail clients in Germany.

This is a prime example of the need for what Gordon Brown has been pushing hard in recent days: an EU-wide system of financial regulation which can't be gamed. It's probably too much to hope that the US might participate too. But it should. In an age of global financial institutions, we need global financial regulation too.

Problems like the one in Germany will never go away entirely: part of this is cultural, with German retail investors historically being big retail consumers of fixed-income products. But with intelligent regulation, these problems should become much rarer than they are at the moment.