Regulatory confusion undermines investor choice
The secretary general of the European Structured Investment Products Association (Eusipa), Thomas Wulf (pictured), explains why some of the current regulatory developments in Europe are limiting investors' choice.
This July, European Parliament expects to vote on the final shape of its new distribution rules. The so-called KID (Key Information Document) regulation is designed to improve the comparability of different types of investments by standardising the information available to retail customers. As such, it is a healthy development.
Structured products will form a large part of the product universe governed by the new rules. Such products, particularly well known in Germany's certificate market but also commonplace in other wrappers and names elsewhere in Europe, give rise to particular disclosure and point of sale issues.
The project began under the guise of Packaged Retail Investment Products (Prips) in 2007, and you would expect having reached its end, that the basic issues would have been clarified. Unfortunately, the amendments presented last December by Economic & Monetary Affairs Committee rapporteur, Pervenche Berès, suggests otherwise.
As the main reviser of the original proposal, the French socialist MEP ought to have a handle on the key concepts underpinning it. Yet her amendments - as well as off-the-cuff remarks by some regulators in recent debating forums - show ideas such as complexity, risk, and the suitability of retail products for individual investors are often confused and misunderstood. Risk and complexity in particular are often used as proxies for each another. How can you create robust regulations if the premise on which they are founded is muddy or just plain wrong?
I want to explain my view on these fundamentals again in the hope of bringing clarity to these last stages of the KID debate. As I do so, I will add a layer to ideas about transparency which may help the discussion.
But first I want to plant an image in your mind. A hybrid-engine car. This car has both internal combustion engine and electric drive, so it's a fairly complex system. Do we deny the driver his right to buy this car unless he is capable of understanding the complex interface between its power sources? No. A car showroom is not a college. Do we ask whether its complex engine type makes it 'riskier'? How can we, when we do not know what risk means to the buyer? He may consider the comparatively low acceleration a 'performance risk,' or he might be focused on battery life, or the car's resale value, or whether the tax incentives for hybrid cars will be upheld in the coming year. Though a fair seller will try to answer all questions, his explanation will usually boil down to the car's fuel-saving and emissions advantages, particularly in urban driving, versus the idea that the savings may not be optimal for motorway driving. The battery should run a few years, but as hybrid cars have not been around long there is no life guarantee here - and God only knows what the taxman will be up to next year.
Yet as far as structured products are concerned, the source of risk is still sought in their complexity. The two are often confused, or even treated as synonymous.
So, what exactly does it mean to say a financial instrument is 'complex'? There are three potential areas of complexity: The legal implications of the product wrapper (deposit, note, fund etc); the features of the underlying asset; and, most importantly, the payoff mechanism which calculates the return of notional capital and any yield. In most cases, a product's 'complexity' will stem from at least two of these elements.
Product risk usually refers to the likelihood of losing the invested initial capital through issuer default (fortunately rare) or, more usually, due to underperforming markets. Issuers have developed ways to minimise both - collateralisation can protect investors against an issuer's default, while capital protection features guarantee the notional and other features fix the yield. Such protection can also be combined. When these new risk-reducing features are added, the payoff changes and the product become more complex. So, treating complexity and riskiness as synonyms is a serious mistake. Suitability, finally, is about ensuring a product fits the customer's yield expectation and willingness to absorb losses over a given time horizon.
Regulating product distribution as it relates to complexity, suitability and risk is, in my eyes, best done by imposing 'transparency' standards, though we need to be clear what we mean by that. Do we mean showing all detail all the time whether it is comprehensible or not? Do we mean that the investor should have appropriately been presented understandable material on which to base his investment decision? We are back to our hybrid car. I believe we can and should achieve transparency in all the above three areas (complexity, riskiness and suitability) without having to explain all the manufacturing elements under the bonnet.
In relation to complexity, transparency ('complexity transparency' if you like) means ensuring it is clear how a product 'works.' An investor needs to grasp that he might be paid in shares if he buys a reverse convertible, but does not have to understand the zero coupon bond sitting inside his capital-protected certificate.
Transparency in relation to risk ('risk transparency') is about knowing who the counterparty is, the likelihood of losing your initial capital and the conditions under which that might happen (to the extent they can today be reasonably expected to occur, unless you want the KID to resemble the prophecies of Nostradamus).
Transparency as it relates to suitability ('suitability transparency') is about ensuring that there are clear and uniformly applied guidelines for the sales process. A customer should never be talked into an investment. He should be sufficiently informed to balance potential yield against the risk of potential losses and assess the way a product fits his overall portfolio, time horizon and risk appetite.
If we build on this matrix we have a chance of creating a set of internally coherent regulations, rather than adding supposedly protective wildcard clauses that contradict other areas of regulation or make, no sense in relation to the products at hand.
Several of the amendments to the KID regulation, now submitted by Berès, show why. One amendment, for example, obliges issuers to indicate whether a product is 'a bet or an investment.' Yet, the term 'bet' is, of course, misleading in relation to financial investments and inaccurate from a legal point of view. Any product sold to retail clients reflects a market expectation, but neither issuer nor retail investor seek to engage in a 'betting' contract.
Overall, the regulatory balancing act is made easier (or harder) to the extent that we treat investors as rational adults (or like children). Rational adults need appropriate information. The regulators need only to ensure that the issuers' compliance departments do the job they were designed for. Where compliance falls short, the regulators will always have the backing of the market as they put things right.
If, on the other hand, retail investors are seen as children, their decision-making powers must be taken away. At the extreme, this means controlling access to products, either through product banning or deciding which products are appropriate for certain categories of investor. This patronising approach contradicts the goal of creating a society of responsible and educated individuals. It also contains its own layer of risk. Who will take responsibility for the opportunity cost of investing only in cash? Who will be responsible for products that are rubber-stamped by a regulator, but underperform nonetheless?
Despite the dangers, this kind of thinking informs some of the proposed amendments to the KID regulation. The rapporteur plans to make regulators de facto preapprove every Key Information Document before the product can be marketed. She also wants to forbid self-directed investors from executing a transaction before they have taken note of the KID. These investors have a solid product understanding and a clear market view, which they execute via trades done largely online and usually without calling their bank for advice. Berès would ignore their needs. Fortunately, the on-going European Union discussion shows her patronising attitude is not shared by many of her fellow parliamentarians.
Still, it may be a while yet before we accept that despite ensuring awareness of product structure, risk and suitability, there will always be a final decision for which only the investor can be accountable. In the end, you have to decide yourself whether to drive a hybrid car or not.
Thomas Wulf is the secretary general of the European Structured Investment Products Association (Eusipa). Connect with him here.