End of the line for mass distribution?
Under the European Union's Markets in Financial Instruments Directive (MiFID) (see box page 14), financial advice will become a regulated investment service, which effectively means that structured products distributors will only be allowed to sell financial products directly to customers if they are non-complex financial instruments.
Worryingly for many in the structured products market, this means the directive could damage the mass distribution of retail structured investments in the EU. In the UK, supermarkets such as Tesco, retailers such as Marks & Spencer and, famously, the Post Office have been selling index-linked investments over the counter without providing advice. This practice could, it appears, be outlawed once MiFID comes into force.
The definition of complex financial instruments includes bonds or securitised debts that embed a derivative. This potentially includes guaranteed equity bonds (GEBs) - index trackers typically linked to the performance of the FTSE indexes in the UK - which have been a hit with retail customers.
According to the Post Office, GEBs fall outside the directive because they are structured as a bank deposit, although other observers are unsure of the definition of non-complex instruments.
Jonathan Bayliss, a partner at law firm Farrer & Co in London, believes the number of execution-only services in the UK will be severely restricted under the directive. The definition of an execution-only service as indicated in MiFID is an investment service that consists only of execution, or the reception and transmission of client orders.
Chris Bates, partner at law firm Clifford Chance, also in London, notes that execution-only service providers include most stockbrokers and firms that sell products to customers directly without giving any advice. The definition includes venues such as supermarkets and the Post Office.
On the whole, execution-only services can still be provided under MiFID if the services are related to listed shares, Ucits, and other non-complex financial instruments that exclude covered warrants and warrants traded on regulated exchanges, as well as non-Ucits collective investment undertakings that invest in derivatives, according to the British Bankers' Association (BBA).
However, opinion is divided over what constitutes a 'complex' and 'non-complex' investment. In its response to the definition of non-complex products to the Committee of European Securities Regulators (CESR), BBA argues that the criteria set by CESR "should emphasise the complexity of the outcome rather than the complexity of construction of those instruments" and that "internally, a Ucits fund can be a tremendously complex thing, but in the hands of the investor it is very simple".
"The definition looks at what the products are invested in," says Samatha Mitchell, director of the BBA. "The definition is explicit and specific. We are waiting to see how it is implemented in the UK."
But some disagree. Philip Gilbert, London-based partner of Bespoke Financial Consulting, a UK-based Ucits specialist, says the definition is 'hopeless'. "It is not prescriptive at all," he says, adding that guaranteed equity bonds should be categorised as 'complex' financial instruments.
Several retail distributors in the UK, including Barclays, declined to comment on whether GEBs are 'complex' or 'non-complex' given the definition, which only heightens concern that GEBs sold without advice could soon become a thing of the past. "This should be a decision of the FSA," says a spokeswoman at Barclays.
However, according to Richard Norman, head of savings and investments at the Post Office, the GEBs that are sold to the customers should fall outside of the directive. "They are deposit products," he says. He expects the impact of the directive on the retail distribution of GEBs will be minimal.
As long as these investments are structured as bank deposits, adds Philip Warland, senior adviser at PwC, they fall outside the directive. "However, whether they will be allowed to carry on selling these products directly to customers will very much depend on the FSA," he adds.
No news from the FSA
A spokesman at the FSA says the regulator is still in negotiations with various member states on the subject of non-complex financial instruments and hence declined to comment whether the execution only sales model will continue under MiFID and whether the sales of GEBs will continue once the directive comes into force.
"The FSA is facing a dilemma," says PwC's Warland. "The sales of GEBs without advice will depend on the FSA's interpretation of the directive. A lot of these products have low volatility, but they still contain derivatives."
The UK's FSA is not the only regulator that is facing a dilemma. Spain's Comision Nacional del Mercado de Valores may share a similar problem, market participants note.
Capital-guaranteed funds are popular among retail customers in Spain. Some observers have doubts whether these investors are currently receiving proper advice from distributors about these products. "Funds are also covered by the directive," Warland adds.
"The directive can also be an issue in countries where independent financial advisers (IFAs) are not regulated," Bates at Clifford Chance adds. "They (EU regulators) don't like the idea of customers taking the full consequences if the investments fail to achieve what it is said to be able to achieve. The directive makes execution-only services difficult."
Under the directive, all investment firms must obtain information from their customers to assess whether their investments are appropriate and suitable. "The directive seeks to regulate the distribution of complex financial instruments to customers who are not given advice," Bates says.
But since Ucits-compliant products are governed by the Ucits directive, some observers believe this will encourage structured products providers to develop more Ucits III-compliant products. This is because under MiFID, it is still possible for firms to carry out execution-only services in Ucits, along with shares and other money market instruments.
Gilbert at Bespoke believes investments outside the Ucits regime will have issues under MiFID. Bespoke has created and sponsored sub-funds under the Investment Company with Variable Capital (ICVC), a type of Oeic. The funds are authorised under Ucits III and also based wholly around derivatives. They track indexes such as the Dow Jones-AIG Commodity Index.
"The funds we offer are Ucits-compliant and are set up for what MiFID would designate as 'retail' investors," Gilbert says. "I can imagine some institutions struggling in certain areas with the proposed classifications."
Bayliss at Farrer & Co. agrees, adding that fund managers have the option to launch more Ucits. And the fact that the European Commission is looking to widen the scope of Ucits is encouraging, he says. According to Farrer & Co, more than EUR4.3 trillion of assets or 75% of the EU investment funds industry's assets were under management through Ucits in July 2005.
"Ucits provides some of the strictest fund legislation anywhere. We also feel it right that all other parts of the investment industry, including the life companies, have to work within this regime as any rules that create an 'uneven playing field' benefit nobody," Gilbert says.
Other structured products providers such as Abbey and Threadneedle Investments also say they will focus on issuing Ucits this year - adding to speculation that Ucits products will thrive under MiFID, unlike GEBs.
"Ucits is pan-European," says Gerry McGrath, Edinburgh-based product manager for investment products at Standard Life. "There is a high degree of what can be called prescriptive under Ucits III." He says other driving forces include the use of funds supermarket platforms and their self-invested personal pensions facilities.
Furthermore, the number of non-regulated structured products looks set to be reduced under MiFID due to a change of client classification, says Bayliss at Farrer & Co. This potentially has an effect on the distribution of structured products among private banks' clients in the UK, he says.
Under MiFID, there are three categories of client; a retail client, a professional client and an eligible counterparty. The most important difference between this and the FSA's definition is the disappearance of the intermediate category. Categories of clients under the FSA are currently private customer, intermediate customer and marketing counterparty.
Not all the customers currently labelled as intermediate will move up to the professional category. Complex financial products can still be distributed, but not without determining the suitability and appropriateness of the products. Bayliss reckons private banks may see half of their existing clients downgraded under the directive.
BBA's response to the distinction between professional and retail clients is that the definition is "over-simplistic", "restrictive", and that "CESR should differentiate to a greater extent than currently between wholesale professional and retail clients".
BBA also says "professional advisers and expert customers do not need to be advised to the same extent as retail customers on the products and markets in which they themselves often give advice". Firms are only entitled to make certain assumptions about professional clients. But under the directive, client classification will be standardised.
"The impact of directive on the execution services of structured products will be relatively small," says Guy Sears, London-based head of implementation and policy at the Association of Private Client Investment Managers and Stockbrokers (Apcims), adding that many members are prepared for the changes regarding the suitability and appropriateness tests. "We are still waiting for the FSA's proposal for that," he adds.
The European Union's Markets in Financial Instruments Directive comes into effect in November 2007 and has a total of 73 articles, each outlining specific proposals with the aim of creating a single financial market. MiFID is being adopted using a legislative approach known as the 'Lamfalussy Process'.
The Lamfalussy Process centres on a four-level legislative approach. The level 1 directive was adopted in April 2004. The European Commission published the level 2 implementation of MiFID in February 2006. The draft level 2 measures consist of two documents: the regulation and the directive.
The regulation covers issues such as the transparency and the functioning of the markets whereas the directive covers those areas where there is a relationship between the firm and the client.
Article 39 in the directive defines the concept of 'non-complex' financial instruments. A non-complex product must be liquid investments and it must not comprise any actual or potential liability which exceeds the cost of the instrument, and there must be adequate information about them available publicly.
Instruments of payments that fall outside of the directive are defined in Article 19(6) in the level 1 directive. These include shares, bonds or other forms of securitised debt, including depositary receipts in respect of such securities.Structured Products
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