The lawyer: Expensively complex

Simon Gleeson explores the UK’s regulatory environment for structured productsand finds a few problems with the FSA’s criticism of product ‘complexity’


The 2002 Sandler review of the UK’s long-term retail savings market concluded that there were three broad problems with the UK retail sector. First, products were too complex and expensive; second, the poor did not save enough; and third, consumers were too ‘weak’ to drive the market. The first point – that products are complex and expensive – remains a major driver of UK Treasury and Financial Services Authority (FSA) policy thinking, and we can confidently expect the major policy initiatives implemented over the next year or so to be addressed to these two issues.

Pretty much everyone agrees (at least in public) that retail financial products are complex and need to be made simpler, and that doing this will benefit retail consumers.

The problem with criticism of complexity in the financial markets is that what is criticised tends to be structure rather than outcome. Investors do not need to understand, and do not understand, the trust and corporation law issues that arise in respect of regulated funds, and certainly do not understand the tax issues that arise in relation to them. However, this inability to understand is simply not relevant to their investment decision. What an investor needs to understand is the extent of the expected benefit of an investment and the risks to which one will be exposed in obtaining that benefit. It is a point frequently made that structurally simple products (such as index-tracker funds) can have significantly less predictable returns than structurally complex products (such as principal-guaranteed notes). The key here, as everywhere with retail financial products, is for regulators and others to maintain a clear distinction between complexity of legal structure and complexity of economic structure.


The danger posed to consumers by this confusion can best be illustrated by imagining an equivalent process to the Sandler review conducted on the motor industry. It would conclude, rightly, that consumers do not understand much, if anything, about modern motor car design, and even those who understood the principles of internal combustion would be baffled by the details of electronic fuel injection or climate control. As a result of this lack of understanding, the report would conclude, there is a very weak correlation between the prices people paid for cars and the inherent value of the car itself. All this would be attributed to weak consumers, the fact that car salesmen are remunerated on a commission basis and to the complexity of the cars themselves. The motor-Sandler’s prescription for dealing with these issues would presumably be to require the sale of simpler cars, and the industry would revert to a basic Model T. One possibility is that consumers would be grateful for this regulatory intervention on their behalf.

If regulators manage to retain their focus on complexity of returns, this could be good news for the retail structured product industry, since structured products can be used to shape risk exposures into easily understandable shapes – indeed, that is one of the primary appeals of retail structured products over conventional retail products. If the focus moves to complexity of structure, then this will be good news for lawyers, since rules that require product providers to establish offshore companies or regulated funds in order to repackage products into approved ‘simple’ wrappers will add substantially to legal fees without benefiting investors in any way.


It is elementary economics that the effect of regulation on any market is likely to be an increase in barriers to entry, a decrease in competitiveness within that market and an increase in the gross margins of the market participants. It is equally elementary that all these market characteristics should increase with the level of regulation. It should therefore surprise no-one that this was the picture of the UK savings market set out in the Sandler report. Those who have read the report will have noted in passing the small logical lacuna between these findings and the report’s conclusion that the solution is more regulation.

It is interesting to note in this context that Callum McCarthy, the current chairman of the FSA, cut his teeth as a regulator at Ofgem, the UK government agency that regulates the gas and electricity markets. Ofgem is one of a group of regulators that are effectively established for the purpose of regulating prices in their industries. Where possible, these regulators prefer to regulate indirectly by promoting competition, but their foundation premise is that regulatory intervention in a market creates a pricing imbalance that must be addressed by the regulator as part of the regulatory process. Viewed from this perspective, the FSA is a very strange regulator, empowered to create market disruption but freed from any requirement to correct the impact of that disruption on customers. Put another way, regulation confers benefits on customers (in the form of higher standards of service) and imposes costs on them (in the form of higher prices). It creates a perverse incentive for a regulator if it is able to concentrate exclusively on the standard-raising aspect of its mandate without being required to take the cost side of the equation into account.

Both of these lines of reasoning lead to the conclusion that the FSA’s next move in the retail space will be some form of direct control of prices. The mechanism for doing this will almost certainly be the stakeholder products regime.

Stripped of the rhetoric, ‘stakeholder’ products means products that embody a relatively low level of risk and reward and that are subject to a price cap. Since products that embody low risk are already commonplace, the distinguishing feature of stakeholder status is price control. Promoting the use of stakeholder products therefore has the effect of implementing price controls in the industry. The question is therefore how and whether this will happen.

Many in the industry seem to take the view that stakeholder products will disappear into the same void that swallowed CAT standards. This seems unlikely. The correct perspective is almost certainly that the Treasury offered CAT standards to the industry as an experiment to see if voluntary adherence to a government code was a potentially useful tool in this area. The initiative was largely rejected by the industry. It seems unlikely that stakeholder will simply be CAT mark II, and it seems even more unlikely that the Treasury will permit the industry simply to reject stakeholder products.

The point to watch in this area is the development of the Child Trust Fund (CTF) product. The relatively small amounts involved have ensured that CTFs have not received significant attention among product developers. However, the interest here lies not in the product itself but in the way in which the regulatory structure around it is being constructed.

CTFs are the first retail investment product to be introduced in the stakeholder environment. There is no absolute rule that CTF products must be stakeholder compatible. However, the detailed rules that are proposed for the marketing of CTFs – particularly the rule that effectively requires an advertisement for a non-stakeholder product to be accompanied by an equivalent advertisement for a stakeholder product – make clear that stakeholder status is, in effect, mandatory. If, as seems likely, these techniques are effective in ensuring broad compliance with stakeholder requirements across the CTF product range, it would be foolish to assume that they will not eventually be rolled out to other products. This would result in ‘stakeholderisation’ of large chunks of the existing product range, and indirectly result in wholesale price control across the industry.

Price control is in many ways a positive point for retail structured products, since the profit on such products tends to be made out of the margin on the underlying trade rather than the formal extraction of fees from the investor’s pocket. Indeed, in the retail structured product world there would be nothing difficult about creating and selling products on a completely fee-free basis. This, however, raises difficult questions about what is meant by fees. Where a regulated fund manager buys an investment for his fund from a connected dealer, should any margin made by the dealer on the sale count as a fee paid by the fund? It seems likely that addressing such issues will become progressively more important as price control becomes more prominent in the industry.

Simon Gleeson is a partner at Allen & Overy. He can be reached at Tel: +44 (0)207 330 2706

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