Esma has asked for the industry’s help in providing technical advice to the European Commission on issues important to structured products. What are the likely sticking points? Yakob Peterseil reports On May 22, the European Securities and Markets Authority (Esma) outlined its gargantuan task: translating into rules and regulations the greatest overhaul in European securities law since the financial crisis. Europe's chief securities regulator launched simultaneous consultations that day on both the Markets in Financial Instruments Directive (Mifid II) and Regulation (Mifir). To answer all 860 questions in the consultation by the August 1 deadline, banks and their lawyers would have to plough through 12 a day, or roughly one every two hours. Luckily, it appears participants in the retail structured products industry have been spared a bullet from Esma. Last October, the Deutscher Derivate Verband (DDV), a German trade association for issuers of derivatives, announced that its members would start providing the issuer estimated value (IEV) of their structured products. A rift opened up between the Germans and the rest of Europe when the latter declined to follow suit. With the German banks seemingly confident in their position, a showdown appeared imminent. But now that the European regulator has left out IEV in its advice to the European Commission, the truce will endure a bit longer. "I don't think this kind of consultation is the right place for promoting the German IEV, as it deals with issues other than disclosing the value of a product," says Christian Vollmuth, Berlin-based managing director at the DDV, on why it will not be raising IEV with Esma. A more pressing concern, he says, is how the proposals around cost transparency will square with the Packaged Retail and Insurance-based Investment Products Regulation (Priips) that was recently approved by the European Parliament. The regulation calls for product manufacturers to draft a key information document (Kid) that includes a cost indicator. That is all well and good, except that the Mifid II consultation paper also advocates cost disclosure, setting up what appears to be two separately produced documents saying much the same thing. "We don't think having different documents containing duplicative information is the right approach for cost transparency. Part of our response will be to ask: ‘How are you going to align these two initiatives: Mifid II and Priips?'" says Vollmuth. The practice when responding to past consultations has been for the DDV and the Joint Associations Committee (JAC), another trade body, to inform each other of their positions so that they do not disagree in front of the regulators, according to sources at both trade bodies. When they respond to the Mifid II consultation, both groups are likely to focus their energies on three areas: product governance, cost disclosure and product intervention. Product governance Product governance is a well-trodden topic, so with one exception there are unlikely to be many sparks flying between the industry and Esma here. Esma is advocating more holistic oversight of the product manufacturing process in Europe. Banks will need to ensure that staff possess the necessary expertise and receive the appropriate training to be able to understand the products they are manufacturing. Management must ensure that it has "effective control" over the manufacturing process. Gone are the days when a bank could issue a product and forget about it. Banks are now expected to monitor their products on an ongoing basis. Esma's advice proposes a duty on firms to "check that products function as intended, rather than only... react[ing] when detriment becomes apparent or at issuance or relaunch of the same product". Matteo Rava, senior policy officer at Esma's investor protection unit in Paris, elaborates: "The whole spirit of the product governance requirements set out in Level 1 [of Mifid II] and the proposed Esma approach is that product governance rules apply on a continuous day-to-day basis within firms. Firms need to set up clear rules on oversight, control, governance, and so on. I think the logic is that there needs to be a change from a purely supply-side approach to a more demand-driven approach." "There is a fair amount of established industry position here already," points out Tim Hailes, associate general counsel for structured products at JP Morgan in London and chairman of the JAC. The committee has laid out its positions in its response to a Financial Services Authority (FSA) consultation in 2012 and in a paper entitled Retail structured products: principles for managing the provider-distributor relationship. The JAC advocates that manufacturers have "detailed processes and procedures" in place so that there is less danger they will be compromised by commercial or time pressures. A balanced approach, in which various functions can review and challenge product decisions, helps to ensure that. The JAC also believes that manufacturers should be actively monitoring products even after they are issued. But Vollmuth says the DDV remains somewhat concerned about an opinion Esma issued on product governance in March that, unlike the Mifid II proposals, was not the subject of an industry consultation. Expect the DDV to question Esma about this opinion and how it should be reconciled with the Mifid II consultation. Cost disclosure Both trade bodies are likely to come out broadly in agreement with the proposals on cost disclosure, though they will likely have some concerns, especially the DDV. Esma is recommending that distributors show the aggregated costs of investment advice and financial instruments in "good time" before providing the advice or selling the products. This "single figure" should include one-off charges such as structuring and distribution fees, as well as ongoing charges such as management and performance fees. The goal, according to Esma's Rava, is to "enable the client to understand what he is buying and what he is paying". Broadly speaking, both trade bodies are in favour of revealing distributors' costs. Each has written about the topic before. They are also likely cheering the fact that Esma has decided to house the costs in a single, aggregated number instead of itemising them. The JAC has spoken out against disaggregation in the past, warning that it could "create an overload of information and jeopardise the point of the disclosure". However, the DDV's Vollmuth is concerned that Esma is proposing to include the manufacturer's structuring fee inside this number. "It seems somewhat awkward that the distributors would have to disclose information that is proprietary to the issuer," he says. "Why should the distributor know the structuring fee?" As far as the presentation of this information is concerned, Esma says it should appear in a uniform fashion across all marketing materials. The text should also be printed in a size "at least equal to the predominant font size used throughout the document". Font size should not be controversial, but after allegedly playing a role in recent multi-million-pound fines for Credit Suisse and Yorkshire Building Society by the UK Financial Conduct Authority, anything is possible. Product intervention The set of criteria proposed by Esma for invoking product intervention powers is the area to watch here. Articles 40 and 43 of Mifir introduced powers pursuant to which Esma, the European Banking Authority and national authorities can block the sale of products that pose "a significant investor protection concern". Products can also be snatched off the market for creating "a threat to the orderly functioning and integrity of financial markets... and to the stability of the financial system". The EC has empowered Esma to come up with criteria for invoking these powers, some of which are likely to be the subject of sniping from the trade bodies. The consultation contains 61 different factors, ranging from the type of client base served by the product to its leverage, its degree of innovation and the creditworthiness of its issuing bank. Vollmuth says that while the DDV has not yet decided how it will respond to these criteria, he predicts that Esma will be heavily inclined to stick to what it already has. The JAC's position is probably clearer given that it presented its arguments on the issue during a 2011 FSA consultation in which the regulator proposed similar criteria. After warning that one or more of the factors do not "inherently" add up to evidence of consumer detriment, the JAC singled out for criticism certain criteria proposed by the FSA: exit charges or other barriers to exit should not strengthen the cause for intervention, according to the trade body, because providers are not required to make markets in buy-to-hold investments like structured products; singling out complex products with bundled or opaque structures could inadvertently capture products that track strategic indexes or baskets of indexes where fees are paid to each index provider; and including products that feature a ‘teaser' rate could inadvertently ensnare products such as bonus certificates. Each of these criteria appears in one form or another in the Mifid II consultation. Expect the JAC to target them....
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