Structured products regulations gain traction

Author: | Published: 9 Dec 2014
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It’s been a watershed year for structured product reforms. Attention has now turned to how the patchwork of regulations will interact

The agreement between the European Parliament, Council and Commission on the review of the 2007 Markets in Financial Instruments Directive II (Mifid II) at the beginning of 2014 was long awaited by regulators and politicians. They hailed the agreement as a major step towards ending regulatory uncertainty in Europe and supporting the ability of its financial markets to meet the needs of investors and issuers in a safe environment.

However, a number of European structured products participants remain cautious about the consequences and overlaps between Mifid II and other regulations such as the Packaged Retail Investment and Insurance-based Investment Products Regulation (Priips), Undertakings for the Collective Investment in Transferable Securities Directive (Ucits) and Insurance Mediation Directive (IMD II).

These EU-wide regulations make up part of the biggest overhaul of EU financial markets in more than a decade. The focus on structured products attempts to address concerns with counterparty risk, product complexity, disparities in rules between various wrappers, and mis-selling risk stemming from what regulators refer to as complex and poorly-understood products.

The European Securities and Markets Authority (Esma) has been the driver of all major EU regulation and policies involving structured products. This includes Priips, Mifid level II, IMD II, Ucits V, and the Prospectus Directive (PD) which member states were required to implement by July 1 2012.

Priips/Kids?

Most recently, in November 2014, the European Council (EC) adopted the regulation on Key Investor Documents (Kids) for Priips, which will come into force in 2017. This is intended to achieve consistent and efficient standards for investor protection, and ensure a level playing field for distributors and providers of retail investment products including investment funds, structured deposits, and life insurance policies with an investment element.

Priips recommends the use of a key investor information disclosure document (Kid) through which all competing financial products have to disclose the same information on risk, performance and charges. The Kid should be short, in plain language, presented in an appealing and consumer-friendly way, and focus on key information to enable investors to make an informed decision.

In mid-November, the European Supervisory Authorities (ECAs) issued a consultation on Kids. Following this, the Joint Associations Committee (JAC) on retail structured products – members of which include the International Swaps and Derivatives Association (Isda) and the International Capital Market Association (ICMA) – raised industry concerns about the potential for duplication and inconsistency between the Priips regime and the ongoing work and consultation on Mifid II.


There is no place for industry triumphalism, but the Priips outcome has taken into account a number of issues of concern for the industry


However, the structured products industry overall reacted positively to the introduction of the Priips rules endorsed by the European Parliament in April 2014. A senior source at an investment bank, who wishes to remain anonymous, says that although there is no place for industry triumphalism, the Priips outcome has taken into account a number of issues of concern for the industry and the work undertaken by trade bodies over almost six years.

"This could have been an absolute disaster and it really is quite good at the end of the day," he says.

The new information document, set out in a mandatory three-page A4 Kid, will have to indicate what the product invests in, its risks and potential rewards, and the consumer's total costs over the course of the product's life cycle. Tim Hailes, chairman of the JAC, says that the industry's positions had held strong and that many of them are reflected in the Priips draft. This, he says, includes the purpose of the Kid, the liability regime, the comprehension alert and the narrative that now needs to accompany the risk indicator.

"We all wanted to see the introduction of a sensible regime for consumers – and today we have – and we hope this will continue when the detail behind the regulation is fleshed out over the coming months," says Hailes. "The devil, as they say, is all going to be in the detail."

Hailes also points out that the Priips rules "could have been made even stronger to apply to all product manufacturers and distributors regardless of where they are located if the investment products are sold to retail investors located in EEA [European economic area] member states – something that the JAC called for – and we hope that is something that will be considered in the future."

Ucits?

On July 23 2014 the EU adopted Directive 2014/91/EU relating to Ucits. Investment funds under Ucits meet the definition of a Priip, but there is an existing requirement in the Ucits directive for key investor information documents (Ucits Kiids) and these are largely identical to Kids.

The regulation allows Ucits providers a transitional period of five years, during which they will be exempt from its terms and enforcement. It also provides for a review, on the fourth anniversary, to extend the transitional period or replace the Ucits Kiid with the Kid.

Ucits V is aimed at 'preserving' the integrity of the Ucits brand and replaces Ucits IV (originally introduced in July 2011). It has been adapted to accommodate other regulatory changes such as Mifid II and Priips including complex and non-complex fund distinction to address issues around hedge fund underlyings and risk diversification rules in need of clarification. One of the key questions that accompanied the legislative progression of the Ucits regulation was whether pension products would be included within the definition of Priips.

In the last draft the of Priips rules, the EC clarified that the Kid will only be required when the products are to be sold to retail investors, not to professional investors. It also confirmed that other pension products recognised or certified under national laws as providing income in retirement will not be covered. 'Occupational pension schemes, pension products for which the employer is required by law to contribute financially and where the employee has no choice as to the pension provider do not need the document,' Esma said in a written statement.

Mifid level 2

In May 2014, Esma launched a consultation on the revised Mifid II and Markets in Financial Instruments Regulation (Mifir).?The central aim of Mifid II is to establish more robust and efficient market structures, taking into account technological innovations, increased transparency in over-the-counter (OTC) derivatives, reinforced supervisory powers, a stricter framework for commodity derivatives markets, as well as stronger investor protection.

Europe Structured Products Conference

In addition the topics addressed here, there are many other regulatory issues affecting structured retail products. These include the suitability of structured products for retail investors, the amount of documentation investors must deal with for each product, fragmented regulation, as well as initiatives of some national regulators and trade associations.

These will be debated in detail at a roundtable discussion, including a Q&A with global regulators, during SRP's Europe Structured Products Conference in London's Guoman Tower Hotel on February 5 and 6 2015.

Tickets are available now at StructuredRetailProducts.com/Events

In addition, the Mifid II rules introduce a new category of trading venue called an Organised Trading Facility (OTF), tighter customer and product classification, and new guidelines on the use of derivatives which will be required to have sufficient liquidity and be traded on eligible platforms or multi-lateral trading facilities (MTFs).

It's an area in which there are discrepancies of opinion. Some believe the regulatory regime in both OTC and non-OTC markets obscures the process of defining what activities are acceptable to execute away from transparent venues. Regulators are pushing for an on-exchange type approach. The industry is asking for a distinction between OTC and non-OTC business, taking into account the distinction between execution and intermediation as an initial categorization, before subcategories such as OTF, MTF, Regulated Market (RM), and Systematic Internaliser (SI) are applied.

The scope of the new rules was broadened to include structured deposits in line with the EC initiative on Priips, as well as a number of other provisions. These include: an appropriateness test to prevent the sale of complex products on an execution only basis to retail customers; linkages with other initiatives such as the US Dodd-Frank reforms; banning of monetary inducements to certain firms; advice to meet certain criteria to be independent; and the addition of powers to national regulators to permanently ban products.

The JAC in conjunction with Isda responded to Esma's Mifid II/Mifir consultation paper on July 31, highlighting questions from the consultation that are specific to retail structured products.

The JAC's response addressed distributor requirements where the distributor is merely acting as a broker and not actively marketing the product or selling on an advised basis. Examples include a secondary market transaction on an exchange instigated by an investor, or where a distributor offers an exit opportunity from a buy-to-hold investment product. In these situations, it suggested that the proposed product governance obligations for distributors should not apply to secondary market sales.

'Imposing distribution obligations on secondary market trading where a distributor is acting as a broker will render such secondary market trading uneconomical, destroying liquidity,' the JAC wrote. 'The proposed distributor requirements should apply to distribution, not brokerage.'

The JAC also said that its members are generally supportive of the use of performance scenarios along with appropriate warnings regarding the limitations of the data used, and that the scenarios are not equally probable.

To avoid any duplication of obligations for retail structured products, the JAC is requesting that any obligation to provide performance scenarios is aligned with the Priips' requirement to provide 'appropriate performance scenarios, and the assumptions made to produce them' in the Kid.

The JAC also responded on the requirement to specifically address the risk of financial instruments involving impediments or restrictions for disinvestment or early exit. It stated that according to principle 7 (liquidity/secondary market) of the JAC's principles for managing the distributor-individual investor relationship, investors should be informed before investing of the likelihood of their being able to sell a particular structured product prior to maturity, and of the ways in which this might be done.

'However, in the context of retail structured products, we consider that it will be very difficult to accurately illustrate the consequences of an early exit and the estimated time frame as this is largely based on market conditions at the time that the investor wants to exit which are impossible to predict at the outset,' the JAC wrote.

The JAC believes this proposal should be limited to a clear description of the risks of disinvestment. This includes the fact that sales in secondary markets may be at prices that are below the amount payable on the product at maturity, the original offering price or the price at which investors acquired the product.

The breadth of Mifid II/Mifir can't be underestimated. It creates a new protection framework for retail investors, limits on the use of commissions, conditions for the provision of independent investment advice, stricter organisational requirements for product design and distribution, product intervention powers, and the disclosure of costs and charges. On top of these changes, it also contains more than 100 requirements for Esma to draft regulatory technical standards (RTS) and implementing technical standards (ITS), and provide technical advice to the EC to allow it to adopt delegated acts.

At the time of writing, Esma's consultation paper on Mifid II/Mifir technical advice was to be delivered to the EC by December 2014. A discussion paper on Mifid/Mifir draft RTS/ITS which provides the basis for a further consultation paper on the draft RTS/ITS are expected to be issued in late 2014 or early 2015.

IMD II

On January 14 2014, the European Parliament, Council and Commission agreed to amend the Insurance Mediation Directive (IMD) through Mifid II. The amendment of IMD is an interim solution, as it will be replaced by IMD II which is being debated by the EU institutions. IMD II is expected to be out at the same time as Priips, and will have equivalent selling requirements for insurance Prips so there is consistency across all wrappers.

The IMD II contains a range of changes to the way insurance products, including investment-based insurance products, are sold. It is expected to be voted in by the European Parliament later this year.

At this point, the operational cost of fitting all the pieces of the regulatory jigsaw together are not clear. But there is no doubt that it will be an expensive exercise for structured products providers. According to the EC, only the Mifid review will impose one-off compliance costs on firms of between €512 million ($639 million) and €732 million, and ongoing costs of between €312 million and €586 million per year.

By Pablo Conde of Structured Retail Products in London