Q&A: Quizzing the regulator

Special report: Focus on Spain

The Spanish retail structured products industry has been expecting changes in rules which would allow alternative asset classes such as commodities, hedge funds and credit derivatives to be used as underlyings for structured funds and structured deposits. What has Comision Nacional del Mercado de Valores (CNMV) been working on with regards to this?

When we talk of 'structured funds' we must distinguish between guaranteed funds on the one hand, and hedge funds and funds of hedge funds on the other.

With regard to guaranteed funds, the new rules on investment funds recently approved in Spain (Law 35/2003 on collective investment schemes and the Royal Decree 1309/2005 approving Regulation under said Law) have in general widened the scope of derivatives underlyings, including credit derivatives, financial indexes and volatility. As a consequence, it is foreseeable that we will see an increase in the array of guaranteed funds offered to retail investors once the development rules of the dispositions are fully in effect. One of the future developments will clarify whether, and under what conditions, commodities indexes and hedge fund indexes qualify as fully financial indexes that can be used as a derivative's underlying.

As for hedge funds, which are vehicles oriented to institutional and qualified investors, the new rules allow them to invest in any financial instrument and in any derivative, regardless of the nature of its underlying. In addition, funds of hedge funds, which are more of a vehicle for retail investors because of their diversification and selection of investments, can invest in hedge funds with wide investment policies. This way, retail investors can gain exposure to typical hedge fund strategies.

With atypical financial contracts or structured deposits, no contract relating to derivatives, commodities or hedge funds is currently registered with the CNMV.

Reverse convertibles (convertible bonds with a put option) linked to volatile stocks were popular with retail investors in Spain. In some cases, investors who bought these products experienced significant losses because they thought they were buying deposits. These products have been subsequently categorised as atypical financial contracts since 2000. Which other products have been categorised as atypical financial contracts, and how does this affect them?

Before 2000, there was no obligation to register such contracts with the CNMV, but since then certain contracts must be registered with us. In particular, those contracts relating to the evolution of one or more securities or an exchange index where there is no guarantee of recovery of 100% of capital invested. The aim of registration is to improve transparency and the quality of information that is available to retail investors. But this is not the only initiative adopted by CNMV to monitor the distribution of financial instruments to retail investors, nor is it the most important.

Recent social and economic developments, coinciding with the rapid development of markets, have led to increased interest in ever-more complex financial products.

This is good news because it increases the options available for meeting the financial needs of businesses and investors. But complex, high-risk products may be inappropriate for many investors, which makes it necessary to pay very close attention to how they are sold in the retail market. As the costs to consumers of buying inappropriate products and services increase, so the potential risks and costs of mis-selling for the industry rises with them. Therefore, supervisory authorities with responsibilities for system stability and investor protection are concerned about the impact of mis-selling.

In fact, in recent years we have observed some bad practices in the distribution of structured products to retail investors.

This is one of the areas covered by the Markets in Financial Instruments Directive (Mifid) that has most bearing on investor protection. The CNMV launched a supervision plan in 2005 for the marketing of securities and financial instruments to retail clients. The plan builds on an earlier initiative inviting investment service providers voluntarily to register their marketing manuals with the CNMV. We made efforts - in some cases with notable success - to convince companies of the value of marketing financial products in an appropriate manner. However, the imminent arrival of Mifid calls for a more formal supervision to enforce effective compliance as early as possible.

Mifid, which comes into force in November, is likely to affect sales of complex instruments, especially those purchased without advice. Will this affect structured funds, which have been popular with retail investors? What about structured deposits and other types of structured product?

The sale of complex instruments will have to comply with the appropriateness test included in article 19.5 of Mifid, regardless of the fact that they cannot be included in the execution-only service as it is described in article 19.6 of Mifid. As long as the products mentioned in your question are considered as complex instruments, their sale will have to be done under the Mifid appropriateness test.

Article 38 of the Mifid level 2 Directive sheds some light on the type of instruments that are considered to be 'non-complex'. Basically, the following criteria must be satisfied:

- No derivative component in the structure of the instrument.

- Frequent liquidity at market prices.

- The instrument does not involve leverage for the client.

- Comprehensive information on the instrument is available and is likely to be readily understood by the average retail client.

Any instrument that does not fulfil all of these criteria must be offered to retail investors under the appropriateness or suitability test.

Mifid also seeks to regulate investment advice. Will this affect the existing regulation of investment advice in Spain?

Yes. According to Spain's current regulations, offering investment advice does not require a specific licence, prior authorisation or capital requirements. Any individual or firm can therefore freely provide such advice in Spain as long as it accords with the conduct-of-business rules established in Title VII of the Spanish Securities Markets Act.

Nevertheless, due to investors' increasing reliance on investment advice, it is considered to be a core service that requires authorisation under Mifid. The directive defines investment advice as the provision of personal recommendations to a client, either upon request or at the initiative of the firm, in respect of one or more transactions relating to financial instruments. For that reason, Spanish transposition regulations will establish requirements for licensing investment advisers, be they private individuals or legal entities. There will be a public registry and the applicable conduct-of-business rules will be strengthened.

Another consequence of Mifid will be the reclassification of clients, which will affect private banks and the products they offer. Banks will have to demonstrate that their products are appropriate for their clients. Is this going to be an issue for banks in Spain in terms of the offerings of more complex fund/note products?

Mifid redefines, and in some cases significantly reinforces, the rules of conduct that entities must adhere to before and during their relationship with clients so that they act "honestly, fairly and professionally in accordance with (clients') best interests".

However, in order to maintain a balance between regulatory costs and investor protection, and to avoid over-regulation, measures will be applied gradually according to the type of client. The idea is for the regulations to fit as closely as possible to the peculiarities and protection requirements of each category of investor.

One of the main areas in which Mifid will have an impact on Spanish firms is in client categorisation and the assessment of suitability and appropriateness. For the first time in Spanish legislation, rules of conduct will establish discrete levels of protection according to the category of client or potential client and the type of product or service offered. Retail clients - distinct from professional clients or eligible counterparties - benefit from the greatest degree of protection. Firms must appraise clients' knowledge, experience and ability to make investment decisions in full awareness of any risks that are involved.

In addition, firms must procure all the necessary information to ensure that the product or service being offered is right for the circumstances of each client as regards their experience and knowledge, financial capacity and investment objectives, and keep such information properly updated.

Since the implementation of the EU's Prospectus Directive in July 2005, some EU member states - Portugal, for example - have seen an increase in issuance of retail structured notes. Is the CNMV responsible for looking at passported note products? If so, have there been many such offerings?

The CNMV is aware of passported products offered for distribution in Spain, but in line with the Prospectus Directive it has no authorisation power in this field. So far, more than 190 passports have been received, but there are no statistics available that could identify which of them are structured notes. Details of each passport can be found on the CNMV website at www.cnmv.es.

Several regulators in the EU have said that the level of disclosure in some marketing material is inadequate, and have demanded that issuers publish more information on the liquidity and performance of investments. What is CNMV's experience on this issue?

An important novelty of Mifid is its use of the concept of the 'potential client' in the application of investor-protection provisions. The new Mifid level 2 rules will improve the quality of the information that firms must provide to retail clients before, during and after the agreement for the provision of services. For the first time, detailed regulatory attention will be focused on the content of marketing and advertising communications to ensure that they are fair, clear and not misleading, with new safeguards for 'potential' clients.

The CNMV pays special attention to ensuring that information received by investors is comprehensive and accurate. We constantly monitor how investment products and services are advertised because - even though the prospectus is the official reference document - advertising plays a major role in private investors' financial decisions.

To this end, the CNMV seeks to ensure that firms do not use misleading information with regard to their offerings. Advertising should not present products or services in a biased manner, for example by highlighting advantages and downplaying or concealing any risks involved. Nor should it create unrealistic expectations.

As mentioned above, the new Mifid level 2 rules that come into force on November 1 will define a complete regime for marketing communications. In particular, the rules emphasise contents referred to the performance of investments by means of establishing detailed conditions to be fulfilled when the information contents indications of past performance or of simulated past performance of a financial instrument or an investment service.

In the field of prospectuses, the CNMV is constantly seeking to improve their quality and make them clearer and more concise. Apart from verifying that the prospectus complies with the content established by Ucits III and the Prospectus Directive, the CNMV pays special attention to certain aspects of this document.

For instance, in the case of investment funds, the correct and clear definition of investment objectives and inherent risks, fees and commissions and subscription and redemption policy have always been key objectives. More recently, as a result of the important growth of ever more complex guaranteed funds with peculiar liquidity conditions, the CNMV has sought to improve clarity of information about liquidity risk and costs of redemptions.

With other types of financial instruments, such as subordinated debt or preferred shares, information about liquidity risk for targeted investors and complete, comparable performance data have been key factors in improving prospectuses registered by the CNMV. For atypical financial contracts it should be noted that it is necessary for the prospectus to disclose the different kinds of risk, such as liquidity risk and the possibility of not recovering capital invested. In terms of performance, it is mandatory to include different performance scenarios, depending on the underlying performance.

I must mention the constant efforts of the CNMV to simplify the language of prospectuses. Special attention is paid to prospectuses aimed at retail investors, in which plain language is essential to enable them to make an informed judgment about whether to enter into a transaction.

Finally, let me refer to hedge funds and funds of hedge funds. Their rules on prospectuses and periodic reporting are similar to those applicable to conventional collective investment schemes. However, investors are required to sign a consent form to the effect that they are aware of the peculiar features of hedge funds and how they differ from conventional funds. The consent form refers, among other things, to the reduced liquidity of these funds compared to ordinary investment funds.

It is also worth mentioning that the disclosure requirements for both types of funds establish a set of rules intent on guaranteeing the fairness and accuracy of the net asset value (NAV). Hedge funds and funds of hedge funds are allowed to use estimated NAV for disclosure purposes, but these estimated NAV cannot be used in subscription and redemptions, and differences of more than 10% in relation to the official NAV should be explained in the periodic information.

The majority of structured products distributed to the mass retail market by local banks are wrapped as funds because they are more tax efficient. How will this affect the way structured funds are taxed? Will the new investment tax rules change the way how the other vehicles such as notes or bonds are taxed?

New rules on the taxation of individuals' financial investments entered into force at the start of this year. The modifications have sought to unify the taxation of different financial investments on the grounds of guaranteeing tax neutrality in investment decisions. This way, the tax rate is 18% for all financial investments irrespective of their holding period. However, it should be pointed out that mutual funds have a tax advantage in that it is possible to transfer the investment in a mutual fund to another fund without being taxed. This is the so-called tax deferral by means of switching from one fund to another fund.

The Ucits III directive has allowed more open-ended funds to use derivatives and different underlyings. Will this affect the way that local mutual funds are regulated?

Funds can be more competitive provided some level of innovation is implemented. Ucits III has been transposed into Spanish law by means of the Law 35/2003 on collective investment schemes and the Royal Decree 1309/2005 approving regulation under said law. The legislation introduced major changes to the Spanish collective investment industry and had two main goals: first, to provide the industry with sufficient flexibility to enable its structures to adapt to the constant changes required by the market, and second, to strengthen investor protection.

Among other things, the increase in flexibility covers aspects such as: new legal structures (compartments and classes of units and shares); new products (hedge funds, funds of hedge funds, exchange-traded funds, index funds and index-tracking funds); and new qualifying assets (deposits in credit institutions, unlisted money market instruments, derivative financial instruments whose underlying can be credit, volatility, financial indexes and other risks approved by CNMV). In addition, a maximum of 10% investment is permitted in assets, such as venture capital firms, hedge funds, funds of funds and so on, that do not meet general requirements, depending on the provisions of the prospectus.

Full application of the new Ucits regulations in some cases requires more detailed legislation. Furthermore, lower-level regulations will remain in force where they do not contravene the provisions of the regulations. For example, this is the case in of the use of derivatives, where the Ministerial Order of 1997 and a CNMV circular are still in force.

We expect the pending development rules to follow the recommendations issued by the European Commission (EC) and the work that is currently in progress at the Committee of European Securities Regulators. In particular, with regards to the purposes of derivatives, the EC recommends that non-sophisticated instruments (meaning those that present no difficulties in valuation and risk measurement) can be used with hedging or investment purposes. Also, sophisticated instruments included in structures guaranteeing the return of 100% of invested capital can be used under certain conditions.

Retail investors have been able to access domestic hedge funds and funds of hedge funds since May 2006. But some observers say there are restrictions when it comes to setting up funds of hedge funds. For example, the circular published by CNMV did not include the possibility of having a lock-up period of at least two years and it did not indicate a maximum limit for redemptions on any given date. Is CNMV working on more changes to the requirements at present?

A modification in the Royal Decree approved in 2005 is needed in order to improve and introduce more flexibility to the subscriptions and redemptions policies of hedge funds and funds of hedge funds. For that reason, during the past year the CNMV has been working with Spanish Ministry of Finance to draft modifications looking at the possibility of setting up lock-up periods, limiting the amount to be redeemed in the liquidity windows and extending the period between redemption notice and liquidation up to six months. The modifications are expected to be approved by Spanish government soon.

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