Regulation is a sensitive subject in Spain. Most of the banks active in the structured products business are unwilling to discuss the merits or deficiencies of the regulatory system for fear of antagonising the notoriously conservative Spanish regulators. Spain's watchdogs have been inclined to err on the side of caution in protecting the investor in this still maturing business. And, given the explosive growth of retail structured products in the last few years in Spain – over e18 billion of retail issuance last year alone – the cautious stance of the regulators is perhaps not without justification. But this has not always made things easy for issuers.
Spanish structured products are commonly issued in two formats – deposits and funds. The latter has dominated retail issuance, and around 90% of all issues take the form of fund wrappers. This area of the market is regulated by the Comisión Nacional del Mercado de Valores (CNMV), the country's fund management regulator.
Mutual funds attract a favourable taxation rate of around 15% on capital gains, and come with the possibility of daily redemptions. This makes them a more investor-friendly vehicle for structured products than deposits, where investors have to pay full income tax on their investment and are tied to the product for a specific maturity period. However, fund issuers face restrictions on the types of underlying they can use – banks, for example, are currently restricted from issuing products linked to hedge funds, commodities, inflation derivatives and credit derivatives in fund format.
Deposits, on the other hand, which are regulated by the Bank of Spain, can range across all assets due to their inherent principal-protection component. Furthermore, the level of disclosure required by the CNMV for fund-wrapped products is much greater than that required by the Bank of Spain for deposits.
"The amount of information required by the CNMV for the launch of a new fund structured product is enormous," says Agustin Ruiz de Arcaute, head of structured products for Spain at BNP Paribas in Paris. "This may not always make it easy for the issuer, but the CNMV does a good job as a watchdog."
This strict regulatory stance on fund structured products arises out of the need to protect investors. In particular, the extreme range of innovations seen in Spanish structured products in recent times means the job of regulating them is no easy task.
Regulators slow to keep up
"The problem for regulators across Europe has been that the structured product market tends to outpace regulations," says José Antonio López Jiménez, head of equity derivatives for Spain at SG in Madrid.
Market participants agree that, despite its best efforts, the CNMV lacks the resources and personnel to keep up to speed with the level of financial innovation in this business. However, issuers say that as most of the fund-wrapped products issued in Spain contain an element of principal protection, making them easier to sell to the generally conservative retail market, the 'nannying' shown by the CNMV can be excessive.
"Legislation can sometimes be stricter than is necessary," says the head of a Spanish savings bank, who asked not to be identified. "We are required to list all the potential problems, for example, but not always the potential benefits."
Banks have been trying to convince the CNMV that the capital guarantees included in most Spanish fund products should allow issuers to range more freely across the asset classes used as underlyings. And the CNMV does seem to be prepared to listen. "We have been working within a regulatory framework for the fund industry that has been in place since 1997," says Enrique del Rio, head of distribution, Iberia, for Barclays Capital in Madrid. "But we believe regulators are looking to allow the use of previously excluded asset classes, which will potentially make the fund business more efficient."
The CNMV is currently working on major new legislation for the fund industry. It is hoped that this will further open up the market for structured products issuers – and in particular allow them to structure products using alternative investments and credit derivatives as underlyings. The rangebound equity markets and poorly performing fixed income assets of the past couple of years means there is a huge amount of interest in this law being passed soon to encourage greater diversity in the market. However, as is so often the case in Spain, legislative change has been slow to arrive.
Indeed, issuers have been preparing for the new law for over a year now. It was originally due to come into effect in April 2004, but was delayed due to the change of government following the March elections. Rumours that the law would be passed late last year proved false, and most participants now expect nothing concrete until the fourth quarter of this year. The delay has not helped market participants. Most issuers have decided to hold off releasing new products linked to alternative underlyings in deposit format, preferring to wait until next year for clarification of the law before launching products in fund wrappers.
"We cannot afford to wait for this new law," says SG's Lopez. "When you design a new issuance campaign you do it for the year as a whole. This legal uncertainty means our clients have decided to wait until next year before issuing products based on alternative underlyings."
While the fund wrapper business remains closeted by the regulations, issuers have looked to utilise their most advanced structuring techniques to exploit the opportunities available in the market.
"Deposits are a more defensive product than funds," Lopez says. "The major decision-making area for new products in Spain is in the asset management side, and it is here that you will also see the most sophisticated retail structures."
Spain has seen some of the most complex and innovative retail structures of any European country in recent times. Best-of/worst-of products, dispersion trades, whale options, rotator options, cliquets, various basket structures, hybrids... the roster of products released displays a remarkable variety of financial innovation.
But innovation has resulted in increased complexity for the investor, who is typically fairly unsophisticated when it comes to analysing the underlying structures of some of these products.
No need to explain
A major problem for investors buying structured products is the proliferation of retail banking outlets that are able to sell the notes while not necessarily needing to explain the intricacies of the product, or even understand it themselves in some cases. Spanish financial advisers in charge of selling structured notes to the end client are under no obligation to certify their advisory status.
"In Spain there is a lack of clear rules regarding the suitability of a product and the type of information one needs to provides on it," says Salvador Ruiz Bachs, partner at law firm Uria & Menéndez in Madrid, who specialises in the derivatives markets. "You don't necessarily need any qualifications to become a financial adviser."
Regulators have been looking to prevent cases of mis-selling to retail clients, such as occurred three years ago when banks began pushing reverse convertible notes to the market.
A reverse convertible is essentially a convertible bond with a put option, where the bank is the buyer and the client the seller. If the underlying share value is higher at maturity, the investor receives the principal plus the premium on the put option. However, if, as occurred at the time, the underlying shares fall in value, the bank has the ability to deliver shares instead of returning the principal, often at a much reduced rate to the initial valuation.
Many of these products, unregulated at the time, were structured using volatile underlyings, such as technology and internet stocks, to increase the premium that investors received. However the subsequent crash in the high-tech market saw these shares hit hard – resulting in big losses for investors in reverse convertibles. It was only in 2000 that the CNMV passed a new law regulating these products under the category of "atypical financial contracts".
However, many investors who bought the products before then – and indeed Spanish financial advisers who sold them – did so under the misapprehension that they were deposits. The financial advisers selling reverse convertibles failed to mention that the investors received their initial deposit only if the underlying stock remained positive.
The CNMV says that it does not make public any complaints about mis-selling of structured products, and it remains difficult to get a precise handle on how many of the complaints against reverse convertibles came to court. "There have been fewer problems with structured products in Spain and so investors react to them more calmly than in countries such as France, where there has been more of a fuss," says BNP Paribas's de Arcaute.
A lot of cases tend to be settled out of court, as Spanish investors seem to be less vociferous in their complaints about structured products than in other countries. "People have taken the problems with structured products more calmly in Spain than in countries like France where there has been more of a fuss," says BNP Paribas's de Arcaute.
The Spanish structured product market looks set to grow even further over the next few years. One current regulatory consideration has been the harmonisation of tax regimes for structured products across funds, deposits, and the very small insurance wrapper market, which participants expect to come into effect in the next two years. This could open further doors for issuers, allowing for greater quantities of deposits and insurance wrappers to match the fund-wrapped products in the market. Consequently, the move could also bring more pressure to bear on the regulators to protect investors. It remains to be seen how they cope with this.