EU structured products reforms lack co-ordination, says industry

The JAC fears disclosures on costs that issuers will have to include in a structured product's KID – proposed by European regulators as part of the Priips framework in November – will not satisfy similar, potentially duplicative requirements in Mifid II

Tim Hailes, Joint Associations Committee on Retail Structured Products

Trade bodies representing the structured products industry have issued a warning to European regulators over proposed changes to the way issuers disclose the costs of a product to investors. They argue that a lack of co-ordination between concurrent regulatory reforms of the market-place risks generating unnecessary costs for issuers and confusion for investors.

The Joint Associations Committee on Retail Structured Products (JAC) published its response on February 17 to proposed changes to the Key Information Document (KID) that issuers must include when selling a product. The JAC warned that market participants want to see high-level co-ordination between the KID proposals and other regulations that include new investor documentation requirements – in particular, the revised Markets in Financial Instruments Directive (Mifid II).

"One key issue is the extent to which compliance with the KID requirements satisfies obligations for compliance with Mifid II for various items: things like cost disclosure and performance scenarios, for instance. From an industry perspective, you'd want the Mifid II obligations to be covered off in the KID wherever possible, rather than having two regimes that have very similar disclosures but not exactly the same thing," says Mike Logie, a partner at law firm Ashurst in London.

In November, the three European Supervisory Authorities (ESAs) jointly issued a discussion paper on what information issuers need to include in a product's KID, opening a three-month comment period for industry responses. The proposals form part of the Packaged Retail and Insurance-based Investment Products (Priips) legislative framework, which itself aims to harmonise rules governing the sale of structured products in different European jurisdictions.

In its official response, the JAC argued that existing language in Mifid II and accompanying technical advice from the European Securities and Markets Authority (Esma) does not provide sufficient regulatory certainty to issuers, in the case of structured products, that Mifid's cost disclosure requirements for financial instruments can be met by providing such information via a product's KID.

"It is imperative that that the KID for non-insurance products satisfies Mifid II cost disclosure requirements, and that manufacturers... are not left with additional Mifid II cost disclosure requirements over and above the cost disclosure requirements in the Priips Regulation. Differing cost disclosure requirements in Mifid II and Priips may be misleading for investors as well as unnecessarily burdensome for manufacturers," it states.

It is imperative that that the KID for non-insurance products satisfies Mifid II cost disclosure requirements

Transparency on costs

One suggested framework for cost disclosures by issuers is based on requirements in the mutual funds industry, where all management fees are disclosed up front. But Tim Hailes, chairman of the JAC, says the ESAs' discussion paper failed to acknowledge the distinction between fund management fees and margins on derivatives. "The argument that the management fee charged on a fund is equivalent to the embedded margin on a derivative has been peddled by the asset management lobby since forever, and it's not a fair comparison," he says.

Typically, a portion of the initial fee charged by a structured products issuer is accounted for as profit – even though the potential profit will depend on the product's performance. If a product is not hedged properly the issuer may make no profit at all – unlike mutual funds, the industry argues, where a manager receives a fee irrespective of the fund's performance.

The JAC's response proposes that the KID instead includes unwind costs – defined as the difference between a product's price at issuance and what it would fetch if sold back to the issuer immediately. "We obviously think there should be transparency around costs to investors. Where this is particularly relevant with structured products is that if, for example, you try to sell one year into a five-year product, you're not going to get all your money back. Unwind costs in the event an investor exits the product early should be made clear, including the factors that will be used to determine them. But unwind costs are not the same as fees contractually deducted from the performance of a portfolio of assets held within a fund," says Hailes.

Risk ratings

The JAC's response also criticises plans for a single numerical risk indicator, echoing the sentiments of the UK Structured Products Association. While accepting that market, credit and liquidity risk are the three main components that should be disclosed to investors, the committee disputes the idea that these can be expressed as a single number.

Instead, it proposes a narrative description of liquidity risk and the use of pre-existing credit ratings to outline the risk of counterparty default. But the JAC agreed that market risk can be expressed on a scale of one to seven, similar to existing risk indicators in Undertakings for Collective Investment in Transferable Securities (Ucits) funds.

Some JAC members voiced doubts as to whether their counter-proposals for risk indicators would be taken on board. The ESAs are currently carrying out consumer testing to determine which methods of depicting risks are the most intelligible, in a bid to make the KID retail friendly.

"I don't think anyone has a problem with the characterisation of market, credit and liquidity risk. The main issue boils down to how do you measure and disclose those risks," says Ashurst's Logie. "Given the Priips-KID requirements are being driven by ongoing consumer testing, and that consumers will probably want a simple, visual metric as opposed to a long-winded lawyer's narrative, the bias will be more visual, more numbers and more aggregation."

Logie is more optimistic about the likely adoption of the JAC's other recommendations, however. "Having read the ESAs' discussion paper, it appears they're making a genuine effort to solicit as much information as possible. It seems quite open-minded within certain boundaries. But I think the consumer testing will trump any arguments the industry has," he says.

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