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Home > Capital Markets Best Practice > Product Taxonomy: A Key Tool for Understanding Risk–Return Within the Banking Framework

Capital Markets Best Practice

Product Taxonomy: A Key Tool for Understanding Risk–Return Within the Banking Framework

by Markus Krebsz

This Chapter Covers

  • An introduction to products and taxonomy, product taxonomies for financial institutions, and the structure of a taxonomy.

  • Applications of product taxonomies in a financial setting and the objectives in using them.

  • Regulatory developments after the credit crunch.

  • A guide to developing and implementing a product taxonomy for financial institutions.

  • A practical approach to taxonomy for financial institutions.

  • Principles for the development of a product taxonomy.

Introduction: Products and Taxonomy

What does a callable, daily, dual-currency range accrual with quanto features have in common with a sugar-free, hazelnut-flavored, soya milk decaf cappuccino? The answer is that both are products.

Dealing with “products” (whether coffee or financial) requires an understanding of:

  • what their features are;

  • how to determine or measure their value;

  • the type of customers who would be interested in buying them.

It is also important to understand and manage the risks related to the products and to have the capability to drill down into their underlying components (in the case of the coffee, for example, to find out if the hazelnut-flavored syrup contains nuts).

If you are working with coffee it is relatively easy to drill down into underlying components and present the information to the customer. This is achieved by having a menu showing available products (cappuccinos, espressos, lattes, frescatos, etc.) together with product-specific features (semi-skimmed or soya milk, sugar-free, fair-trade, flavored, etc.), and trade-specific features (drink in or takeaway, short, tall, grande, venti, etc).1

But what about the capital markets? How do you classify a certain interest rate product that has an observable asset class, product class, underlying(s), optionality, call features, different coupon types, is inflation-linked, and has a high degree of market volatility? What are the risks of originating or trading such a financial instrument, how much capital does your firm need to put aside to manage it, and how will you need to report to your shareholders and to the regulator? What do you call it?

How can firms classify financial products in a meaningful way and tick most of the information requirement boxes of the consumers of such information—i.e. front office, middle office, quants, model certification, legal and compliance, finance and accounting, regulatory reporting, product control, risk management, and asset and liability management? The answer is simple: by having an appropriate product taxonomy in place that can support all those functions.

This chapter aims to provoke thought on this topic and to equip you with some pragmatic pointers about how to establish such a taxonomy.

Product Taxonomies for Financial Institutions

Taxonomies are not only used as part of scientific methodologies, they also play a hugely important role for many, if not all, corporations. For instance, think of a grocery store and how they manage their product inventory. Their taxonomy becomes obvious and easily visible when one shops for groceries online; you, as a consumer, can follow the supermarket’s taxonomy by clicking through the products on its website and you may be able to recognize an imposed, path-dependent tree structure that is representative of the grocery store’s product taxonomy.

Similarly, we can ask what financial institutions are dealing with. Of course, with financial instruments—i.e. products. The added complexity in the case of most of these instruments is that, unlike a shopping basket full of groceries, they cannot be visibly “seen” and hence are not that easily recognizable (apart from the legal documentation or piece of paper that represents the product, such as a banknote, mortgage documentation, or a bond term sheet).

Given that on a global scale there are probably many hundreds of different financial products that are being dealt with on a daily basis, you may think that many, if not all, financial institutions have a well-developed and clearly articulated methodology that enables them to properly manage these products. And as financial institutions’ bread and butter is dealing with financial products that represent both assets and liabilities, one may think that a product taxonomy plays an important, if not a central, part in firms’ asset and liability management (ALM) function.

Surprising as it may sound, many financial institutions have only relatively recently discovered the need for a firmwide product taxonomy and, even more concerning, many firms currently do not even have one.

The Structure of a Taxonomy

The word “taxonomy” originates from two ancient Greek words:

  • τaξις, taxis, meaning “order” or “arrangement;” and

  • νoμος, nomos, meaning “law,” “science,” or “method.”

More generally speaking, taxonomy can be understood as a classification system based on a controlled vocabulary. Each term in the vocabulary carries an embedded hierarchy, and taxonomic terms are closely related to each other.

The taxonomy’s embedded hierarchy is based on broader and narrower terms. These terms themselves contain equivalent or synonymous relationships, and the intrinsic relationships of the taxonomic components impose a naturally occurring topical tree structure.

The tree structure of the taxonomy consists, quite literally, of the taxonomic “root,” branches or “nodes,” and “leaves.” Most importantly, these taxonomic components are connected and interlinked via a unique path.

Similar to the leaves of a tree that are connected via (smaller and larger) branches to the tree’s stem and roots, each taxonomic “leaf” is connected to the taxonomic root via a path-dependent structure that connects it through the nodes of the taxonomy (Figure 1).

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Further reading

Book:

  • Krebsz, Markus. Securitization and Structured Finance Post Credit Crunch: A Best Practice Deal Lifecyle Guide. Chichester, UK: Wiley, 2011. Online at: www.structuredfinanceguide.com

Articles:

  • Bank for International Settlements (BIS) Financial Stability Board. “Observations on developments in risk appetite frameworks and IT infrastructure.” December 23, 2010. Online at: www.fsa.gov.uk/pubs/other/ssg_2010.pdf
  • Bennett, Mike. “Financial securities ontology.” Hypercube Ltd. May 2007. Online at: www.hypercube.co.uk/docs/ontologyexploration.doc
  • International Swaps and Derivatives Association (ISDA). “Product representation for standardized derivatives.” White paper, April 14, 2011. Online at: tinyurl.com/6sxtmnw [PDF].
  • International Swaps and Derivatives Association (ISDA). “Implementation plan for unique product identifiers.” June 30, 2011. Online at: tinyurl.com/d3ta9xa [PDF].
  • Sants, Hector. “Dear CEO: Valuation and product control.” Financial Services Authority, August 13, 2008. Online at: www.fsa.gov.uk/pubs/ceo/valuation.pdf
  • Whittaker, Mary, and Kathryn Breininger. “Taxonomy development for knowledge management.” Presented at World Library and Information Congress, 74th IFLA General Conference and Council, Quebec, Canada, August 10–14, 2008. Online at: tinyurl.com/74yuqau [PDF].

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