Guidelines setting out which investment products should be classified as complex under forthcoming European legislation have been criticised by senior structured products executives, who say the approach taken by standard-setters is "blunt" and "too broad" to be effective.
The European Securities and Markets Authority (Esma) is consulting on guidelines for the distribution of investment products under the Markets in Financial Instruments Directive (Mifid II). The directive requires investment firms to conduct an appropriateness test on retail clients for products classified as ‘complex', to determine whether or not the product is a suitable purchase.
But draft guidelines laying out how to assess whether certain debt instruments and structured deposits meet this complexity definition have met a frosty reception from trade associations, dealers and lawyers.
Esma's proposed list of products that the test should be applied to has been met with particular scrutiny. Andrew Sulston, partner at law firm Allen & Overy, says: "The concern is the clear blue line approach feels like a blunt instrument. Saying an asset-backed security is automatically complex, or that a special purpose vehicle-issued instrument is automatically complex doesn't necessarily work."
The UK Structured Products Association is similarly sceptical. Zak de Mariveles, London-based chairman of the trade body, says: "These guidelines address the aspect of the complexity of an investment and not their risk. It stands to reason that any regulation that attempts to fit retail investors into a single would-be average retail client bucket for the purposes of their ability to understand complexity is broad to say the least, with regulators themselves accepting there are many levels of retail sophistication."
A better approach, argues de Mariveles, would be for product manufacturers and distributors to determine the average level of sophistication of their own target markets to create a more finely detailed backdrop for the assessment of product complexity.
Among the products Esma lists as complex for the purposes of the appropriateness test include warrants, inflation-linked bonds, asset-backed securities and investments captured by the packaged retail investments and insurance-based products regulation (Priips).
"The interaction with Priips is interesting. Some people are saying: ‘If something is complex in Mifid II, that should make it a Priip as well.' That could be one direction you see Esma trying to take this, but doing so would confuse two regimes that are supposed to be completely separate things," says Allen & Overy's Sulston.
The French regulator, the AMF, has been actively involved in the drafting of the guidelines. Natasha Cazenave, deputy head of the regulatory policy and international affairs directorate, says the AMF is in favour of the guidelines, but declined to say whether or not it supports all examples on Esma's list of complex products.
"We welcome the emphasis on features that make products difficult to understand as a way to assess the complexity across the diverse range of products in the EU and the practical approach taken by Esma. Having concrete examples will be helpful when we implement Mifid II," adds Cazenave.
Deutsche Bank was one institution to publicly comment on the draft guidelines. In its official response to Esma, the bank wrote: "The difficulty in finding the right balance stems from the fact that complexity is not an objectively measurable characteristic of a financial product and depends on the individual investor's knowledge and perception."
The response goes on to challenge Esma's suggestion that proprietary index-linked investments and products linked to a currency other than that of the retail investor's domicile should be automatically stamped as complex.
Structured deposits wrangle
The inclusion of structured deposits in the complexity debate has also caused tensions. The UK Financial Conduct Authority issued a discussion paper on its approach to implementing Mifid II in March.
Ian Lowes, managing director of adviser Lowes Financial Management, wrote a response to the FCA – seen by Risk.net – which questioned the labelling of structured deposits or structured investments as complex simply because the underlying components of a structured deposit or investment may include an embedded derivative.
"Plain vanilla derivatives are not in and of themselves necessarily complex instruments – they are simply contracts between two parties stipulating the terms of obligation, which in the context of these products usually refers to returns, or lack of returns, or loss, i.e. risks, that will be linked to, say, a stock market index. There is nothing particularly complex or challenging for investors to understand in relation to such an arrangement," the response reads.
While acknowledging that advisers need to ensure investor suitability before distributing products, the response argues that understanding structured deposits and investments does not require any greater investment knowledge or experience than understanding mutual funds, and therefore that regulatory requirements for these products should be no more onerous than for other types of investment.
Others find sympathy with Esma's approach. Michael Thomas, a partner at the financial institutions group at Hogan Lovells, says: "You either get the certainty that having prescriptive rules makes it easy for the industry to interpret and apply those rules to their suite of products, or you have something that is less prescriptive and that is more based on criteria that could be applied to the different types of products. Esma probably has a view that the prescriptive approach is one that provides certainty to the industry, and can bring a consistent approach across Europe and different financial institutions."