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STRUCTURED PRODUCTS EUROPE
What are the next main regulatory changes that will impact structured products
industry’s processes ?
November 18th, 2014 - London
Guillaume Eliet
Managing Director, Head of the Regulatory Policy and International Affairs Directorate
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Ladies and gentlemen,
Good morning everyone. Let me first thank the organisers of the conference for
inviting me to speak and particularly Richard Jory. I am really honored to be before
such a knowledgeable assembly today..
I would like to elaborate this morning on the concept of complexity. Structured
products are sometimes considered as too complex and therefore not suitable for
non-sophisticated investors. For this reason regulators may be tempted to restrict the
marketing or simply ban those products for retail investors. In this context, it is critical
to clearly define what is a complex product, not suitable for retail investors, and what
is a non-complex products therefore suitable for everyone.
So, what is complexity?
This is not an easy issue but I will try to shed some light on this tricky subject.
In one of his famous and well-known speeches, Steve Jobs, chairman of Apple, said
that he used to focus on simplicity which, according to him, could be harder than
complexity.
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Behind this quote, we can understand that a complex mechanism may be sometimes
necessary to achieve a simple solution.
Even if we are far from the financial industry and that smartphones cannot really be
compared to investment products, Apple’s success story does illustrate that
complexity can lead to a simple and user-friendly solution.
Complex does not necessarily mean innovative.
Innovative solutions are certainly not limited to sophisticated investors. Retail
investors can claim for innovation. So where is the problem?
The problem is that, very often, retail investors do not have the appropriate
knowledge to understand the risk - reward profile of some investment products.
Is that really a question of complexity? It might be. But it is more a question of
intelligibility of the product, or, more precisely, of the risk reward profile of the
product. What is at stake is the capacity of the investor to understand what kind of
risks he takes, on which market scenario he bets. Put in more practical words, it is
not because a product uses derivatives or sophisticated mechanisms to deliver its
performance that it has to be characterized as a complex product and be reserved to
sophisticated investors. I repeat: retail investors should not be deprived of innovative
products, as long as they can perfectly understand the risk they take.
You say complexity, I would say intelligibility!
That is the reason why, in addition to the suitability test conducted by intermediaries,
I consider clarity of the information given to investors and quality of the advice
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provided by distributors are of utmost importance in the decision process of retail
investors.
These three elements, I mean, information, suitability and quality of advice –
constitute the key success factors for an appropriate marketing of financial
instruments. This reality is particularly important when for instance a complex formula
or mechanism characterizes a financial product.
In other words, complexity does not mean “risky”, even if we can hear that quite
often. Likewise, “non-complex” does not mean “risk-free” either.
Therefore, complex financial instruments within the meaning of MiFID should not be
necessarily construed as riskier products.
Actually, the word ‘complex’ is often used to cover very different meanings:
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In the EU framework, the most common use of the term is “complex” in the
sense of MiFID, as opposed to “simple” products which can be sold on an
execution only basis; OR
-
But “complex” as we have just seen may also be used to mean difficult to
understand (in the sense of PRIIPs regulation for instance) in which case it
may warrant a specific warning or particular regime; OR
-
Finally you also have the situation of products which may be “too complex” to
be suitable for retail investors
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As a result, we should remain cautious on how this notion should or should not be
used in order to avoid misinterpretations or misunderstandings.
Taking these elements into consideration, the key question to ask is not whether the
product itself is complex or not, but whether its risk/reward profile is understandable
for retail investors. And the intelligibility of financial products should be assessed from
a retail investors’ perspective. Consequently, in order to avoid misunderstanding in
the marketing of structured products, one should think in terms of intelligibility rather
than in terms of complexity. This is the reason why the French regulator has always
promoted distribution through a process of personalized advice, especially towards
retail clients. And this is the reason why we are so worried when we hear that in a
view to protecting investors, inducements, which we know are the unique way of
financing advice to small and fragile clients, might be banned.
How can we regulate intelligible and unintelligible products?
In France, in 2010, the AMF and the ACPR (the French prudential authority) have
stepped up their vigilance concerning the marketing of financial instruments that may
be too complex for the wider public by issuing a common guidance.
To protect retail investors from mis-selling, we have established a non-exhaustive list
of criteria to determine whether the products are likely to cause investors to
underestimate the risks involved or simply to misunderstand the product.
The criteria according to which the risk / reward profile is deemed not easily
understandable are the following:
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- poor presentation of the risks of potential losses, especially when the product's
performance is sensitive to extreme scenarios; OR
- underlyings that are hard to identify or impossible to observe individually on the
markets (e.g. volatility);
- gains or losses that depend on the simultaneous occurrence of several conditions
across different asset classes; or
- multiple mechanisms incorporated into the formula used to compute gains or losses
at maturity.
This guidance also reminds distributors of their responsibilities when selecting
products offered to individual customers. It further reminds them that marketing
particularly complex products may lead them to breach their professional obligations.
Moreover, we request that marketing documents for products with a high mis-selling
risk should carry a public warning. This statement says that « the AMF considers this
product too complex to be marketed to retail investors and therefore has not
examined the marketing documents”. But I will come back to this notion later on.
Having spoken about French regulation, let’s take a look together at the last
European initiatives in terms of investor protection.
Let’s see what could be their impact for the structured products industry?
As you will have understood, there are different ways to regulate intelligibility. Of
course those ways are not exhaustive and could be put in place jointly. I will focus
today on two pieces of European legislation: MIFID II and the PRIIPs regulation.
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Concerning MIFID II: let’s say a few words about product governance, product
intervention and ban
What does product governance mean?
When intelligibility is being debated, it is of utmost importance to make clear that
firms have a responsibility to design products that suit the needs of their targeted
market.
On the one hand, each investment firm should have established adequate policies
and procedures to ensure compliance with its obligation to act in the best interests of
its clients.
On the other hand, the manufacturer of financial instruments should adopt a product
governance policy that takes into account:
- the nature, scale and complexity of its business;
- the range of investment services undertaken in the course of that business;
- the types of financial instruments distributed; and
- the type of investors to whom the financial instruments are being targeted.
Furthermore, the financial instrument governance arrangements should ensure that a
balanced consideration is given to the interest of investors during the different stages
of the origination, launch and life of financial instruments.
Harmonised rules in terms of product governance will be set out at the EU level with
the implementation of the MiFID II directive.
Let’s turn now to product intervention.
What does product intervention mean?
A competent authority will be authorised to prohibit or restrict the marketing,
distribution or sale of certain financial instruments or financial instruments with certain
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features. In particular instruments characterized as “Inadequate Financial instrument
for retail investors”
This power stemming from MIFID II will be new for a majority of European financial
Authorities.
However, in France, we did not wait for MiFID II to set out measure in terms of
product intervention. Indeed, the AMF has a long-established experience concerning
intervention on marketing materials. For example, we require from manufacturers of
structured products to send us all the related marketing materials before their
publication. Moreover, as I mentioned briefly at the beginning of my presentation, we
published a few years ago a position (with the French prudential regulator)
concerning the marketing of financial instruments and investment insurance contracts
to retail investors focused on their intelligibility. And I would like to speak more about
what this position states. Where based on the criteria defined, certain structured
products are deemed too complex to be suitable for retail investors, our position
states that the marketing of those unintelligible products to non-professional investors
could only be envisaged if its marketing document includes a warning saying that the
product is too unintelligible to be sold to the average retail investor. This has had a
significant and positive impact on market practices as the industry has adjusted its
offerings. Innovation continues but the products offered now take into account the
need to ensure investors can understand the drivers of the product’s performance
and the corresponding risks.
Beyond the safeguards that bring these rules in terms of product intervention and
governance, what could we think about a ban in certain circumstances?
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Another type of intervention in the tool box of national and European supervisors is
the power to prohibit the origination, the marketing and the sale of financial
instruments where:
- they give rise to significant investor protection concerns, or
- pose a threat to the orderly functioning and integrity of financial markets, or
commodity markets, or to the broader financial system.
Of course, this power should only be used in extreme situations and as a last resort,
for instance when the product governance process of the manufacturer has failed.
These measures concerning governance, intervention and ban of products show that
MiFID II introduces a major overhaul of EU financial markets, by improving the
functioning of EU capital markets and expanding the scope of its predecessor in
various areas…
At last but not least, I would like to say a few words about the PRIIPs’
regulation.
The PRIIPS regulation work is a big and laudable challenge for the so-called “ESAs”,
I mean, the European Supervisory Authorities. As a matter of fact, Steven Maijoor,
the Chair of ESMA, recently said 1 that “PRIIPS regulation was the most extensive
and complex workstream that has been tackled by the Joint Committee of the three
ESAs so far”.
1
Conference in Madrid concerning
protection”
« The ESAs role in financial consumer
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The rationale behind this regulation is clearly about investor protection.
As you know, this new EU regulation will capture investment funds, structured
products and insurance-based investments; and it will provide a framework for
establishing consistent and high quality disclosures for retail investors across the
financial services sector.
We often hear that the Key Information Document stemming from this regulation will
be one of the most tangible outputs of the ESAs in the eyes of most financial
consumers. Indeed, this KID will contain sufficient information to allow consumers to
make an informed investment decision and to compare different offerings.
In other words, this KID deals with intelligibility!
It deals with intelligibility because it will have to present information in an accessible
consumer-friendly way and in the language of the retail consumer.
Otherwise, they will simply not read it!
At the end of the day, this KID will include information on the product itself, the
related costs and what happens if the issuer is unable to pay out; which should
ensure that the risk/reward profile of a given investment product will be properly
understood by its targeted customers.
With the help of national competent authorities, the three ESAs have prepared a
discussion paper, which has been published yesterday for a 3-month consultation
period. This discussion paper outlines the format and the content of the KID and
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open discussions to stakeholders. This is the beginning of the process that should
include at least two further consultation rounds between now and the end of 2015.
The feedback from that process will also be complemented by the results of a
consumer testing exercise that the European Commission, together with the ESAs,
should launch in the coming weeks. It means that the notion of intelligibility will be
tested by final consumers, which is a crucial point to make sure that it will work!
This KID should be used by millions of consumers across the EU on a daily basis.
A solution taking intelligibility into account will then be used by these millions of
people. And there is no doubt that this regulation should enhance the way that
investment products will be marketed, which, from a regulator’s perspective, is
definitely a positive achievement!
In conclusion, I would like to summarise all my presentation by saying that complexity
should not be regarded in all circumstances as a negative concept by regulators.
Complexity can be at the benefit of investors, even retail investors, if it provides
innovation and enhancement of quality and possibly greater performance. But
regulators would never accept that complexity of the functioning of a product prevent
any possible clear and comprehensive presentation of such product, especially when
it is marketed to non-professional investors.
We use to say in my country “What you understand well, you enunciate clearly”.
Translated into our financial jargon it would mean that, if you conceive a complex
mechanism, you always have to be able to explain it clearly.
Finally, Steve Jobs was right: simplicity can be harder than complexity!
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Thank you very much for your attention.
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