Following the release of the final Priips Kid regulatory technical standards (RTS) by the European Commission (EC) at the beginning of March which was accepted by the European Supervisory Authorities (ESAs) and the European Parliament (EP) shortly after, SRP spoke to a number of market players about the newly added risk indicator (stress scenario) to the draft rules and what issues are expected to be resolved via Level 3 guidance and Q&As.
What is your opinion on the newly added risk indicator - the stress scenario, to the RTS? Will this help investors to make an informed decision?
Phillip Lynch, head of markets, products and strategy, SIX Financial Information:
"While including past performance scenarios in the Priip-Kid has been the subject of much debate, it appears that a fourth performance scenario has been added to address the European Parliament's concerns about performance scenario calculations. This fourth scenario is the so-called 'stress scenario', which sets out significant unfavourable impacts of the product not already covered in the unfavourable scenario.
The amended guidelines retain the existing calculation methodologies instead of adopting the Ucits model, where a historical outlook is offered without being used to predict future performance.
This stress test scenario should address the issue that some products would have shown too optimistic scenarios in certain constellation. However, also the stress test has certain pro and cons. When a certificate switched from remaining term of '1 year' to 'less than a year' the stress-scenario could make a 'jump'.
The conclusion to all this is that there is probably no "one fits all" solution as the products on the market are also diverse."
Tim Mortimer, managing director, Future Value Consultants (FVC):
"The introduction of the stress scenario is aimed at providing investors an example of what the product will payout in the case of a very bad market situation. The way the RTS defines how to calculate the one-year stress scenario versus the one to calculate the scenario for longer than one year it means that the implied market prop for one year (on the FTSE100 for instance) is actually higher in absolute terms compared to the three-year market prop which is counterintuitive because in a longer term horizon you would expect the stress scenario would allow the market to fall further but the way the assumptions are set it would not show a very bad case. For the 10% case, it is possible for some products to not leap very bad and will fall under the 'unfavourable'.
Also, in the one-year stress calculation it is not logical to represent an extremely bad underlying performance. However, because it doesn't take into account credit risk if you have a capital protected product from an issuer with a bad or moderate, the chances of a credit even happening are much higher that the extreme market event they are talking about on the underlying perspective but the RTS takes no count of it. They have done this to keep everything to historical data for underlyings and credit ratings, so by using credit ratings they get a mechanism to do probabilistic methodologies. That set up in a one year horizon even if you are very conservative the probability of a credit event happening is non-zero and is much more likely by a measurable degree than extreme market movements.
It is effectively using historical data with what is actually simulation. They have standardized the angle so that it shows simple back-testing so that everyone can agree on the data and get the same results. The stress scenarios will bring out a lot the bad cases that could happen in a way that simple back-testing wouldn't. The aim of these provisions is good but there are still inconsistencies."
David Stuff, managing director, Cube Investing:
"We think it is a very complicated way of producing a document nobody will really use. The different market players are looking at the requirements to produce the Kid and there is a great deal of uncertainty. The assumption is that you can pick up the RTS and produce the risk/return calculations but I don't think this is easy at all.
This is an area of expertise for us and we don't think there's enough information to allow people to know what the calculations are. We don't think this will help inform the end client. When you get into the detail of the RTS requirements you realise how difficult is going to be to produce meaningful information on the calculations of costs and scenarios. Kids are very difficult to produce and there will be challenges for the market. However, we want to leverage our technical knowledge as we believe we can produce useful numbers.
We believe the new RTS adds complexity to the process of creating a Kid and we believe the end client needs a document that clearly states the expected return and risks of a product.
What issues do you expect the Level 3 guidance/Q&A to address?
Phillip Lynch: "Certain topics are also conspicuous by their absence. This latest guidance does not amend the review and revision articles and, hence, it is still not fully clear when a Kid needs to be updated, and how such updates must be communicated. However, recital 20 remains useful.
Updating frequency is a critical topic as firms work to put processes and data in place for investor protection compliance under both regulations. In particular, firms will need to consider how to align data flows for Priips-Kids and Mifid II pre-trade transparency checks with updating frequency requirements. The industry is now awaiting clarification on this topic in the Level 3 guidance."
Tim Mortimer: "The concerns now are around how brokers and advisers are going to explain this to clients, how much will they us. There are areas around the methodology that can be argued but overall the regime has some positives. Level 3 however should clarify a number of issues around risk and performance.
This was a very ambitious task and some of the problems around the different asset classes have only been brought forward at a late stage of the process. Funds, insurance products and structured products are different asset classes and the regulators have done a reasonably good job somehow in bringing all together under one framework. We have Ucits, Mifid and Priips all which overlap with each other.
Logically, the three regimes should be linked and this is also causing problems around implementation. The most concerned parties are those having to provide the Kids at the point of sale, and very few have been able to start implementation and train the people that will be selling the products. At a firm level, there are many challenges to overcome and a very tight deadline. After the summer we will have more clarity about where we are and we will probably see some providers feeling the pressure."
David Stuff: "We are particularly confused about the "what you may get back" calculations for products that have an early maturity feature. We are a bit confused about this section for other structured products as well. From what we can see other calculation agents (including Bloomberg) are filling this section with dummy values.
The questions we are puzzling over are around the simulation to determine the value of the Priip. Does "value" mean some sort of fair value? In which case, how to choose the conditional parameters? Do we use drift rates that are conditional on the percentile? Could the 10th and 90th percentile underlying levels have mean-reverting drifts? Should we instead use volatilities conditional on the percentile? Also does "simulation" mean use bootstrapped returns or a diffusion model?
Some providers are using market estimates to calculate the risk scenarios. The risk number is calculated by imposing a risk neutral framework on top of the real values, and we don't think that is useful because there is not an estimate of return."
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