Where are we now on regulating structured products?

Paul Burgin examines the changing world of structured product design, marketing and distribution legislation.

The next few years could mark a radical change in structured product design, marketing and distribution legislation. The response from regulators and the industry has been patchy.

Across the world, regulators are on the march. They want to implement more prescriptive rules on unfettered markets that could represent systemic risk. Investor protection is high on the agenda too.

At a global level, plans are afoot to push the $600trn OTC derivatives market onto exchanges, which would allow for greater oversight by regulators of investment banks.

In December, the US House of Representatives agreed new legislation – the Wall Street Reform and Consumer Protection Act – amending a previous OTC bill passed just months before. Some banks and buyers argue such rules could increase costs and cut their flexibility. The legislation must be reconciled with forthcoming proposals from the Senate before coming into law.

Frances Cowell, director of risk consulting of R-Squared Risk Management, thinks the moves are sensible. She says: “Opinion is divided. You cannot stop people from making stupid investments, but having a central clearer and counterparty is a step in the right direction.”

She says any reduction in flexibility will be more than compensated for by the knowledge that a contract will be honoured. Reducing uncertainty will make contracts cheaper. Legal fees will also be reduced and contracts completed more quickly.

The new rules will not directly affect retail structured products. However, they, and similar EU proposals, will hit the investment bank’s hedging employed behind structured product note issues.

Other legislative moves could have a more direct impact. The EU is formulating proposals to beef up capital requirements applied to trading books of financial institutions. The Commission is reviewing overall supervision of financial markets and the Prospectus Directive. Legislation to regulate credit ratings agencies was approved in April 2009.

Europe has also embarked on an ambitious drive to harmonise legislation covering funds, life wrappers and structured products. The Packaged Retail Investment Product (PRIP) consultation covers disclosure, selling practices and conflicts of interest. It aims to impose stricter UCITS-type conditions on products covered by the weaker Insurance Directive, and those such as structured products not yet covered by EU retail law.

Exclusion of risk measure

The British fund industry and the FSA have already lost their battle to exclude the controversial Key Information Document (KID) risk measure from UCITS IV. Structured products may be equally unlucky and be forced to show a risk indicator as PRIP moves forward.

But even opponents of structured products agree that one size will not fit all substitute products. Richard Saunders of the IMA says: “You can criticise fund disclosure all you like, but it is still far and away the best in the market. But when it comes to the synthetic risk indicator, structured products are not susceptible in the same way.”

While imperfect, the fund risk indicator is at least based on past performance and volatility. Structured products are different, thinks Saunders. They have a cliff edge risk: if the counterparty fails, you can lose everything.

Proactive involvement in the consultation is patchy. Many European trade associations, providers and distributors have responded to PRIP,  but few British entities have done so.

The Joint Associations Committee, which represents the investment bank organisations such as the Securities Industry and Financial Markets Association, is an exception. Its response points out that defined return investments may not be suitable for higher risk seekers. In such products, the investor gives up some potential return to increase the predictability of the final return.

It says: “For these products there is a strong inverse relationship between complexity and risk: the more complex the product, the less risk it is likely to embed.”

The European Structured Investment Products Association, representing retail trade bodies from Austria, Germany, Italy and Switzerland, is concerned about the administrative burden of registration documentation and investors’ rights to withdraw if changes are made to original offers.

The UK domestic structured product industry response has been poor. Barclays and RBS are the only UK manufacturers to have responded publicly. No independent British packager is believed to have done so.

There has been no collective action from the newly formed UK Structured Product Association either. A spokesman said: “It is not the sort of thing it is likely to get involved in.”

Even if PRIP discussions prove difficult, domestic developments may overtake Europe’s ambitions for horizontal legislation.

Italy’s regulator Consob wants to enforce a two-page prospectus with simple basic information for consumers on all products. It is trying to convince the Italian insurance regulator to adopt the same approach.

In France, the Autorité des Marchés Financiers is upping its investor protection efforts. A new observatory has been charged with monitoring product trends, marketing and sales across the entire range of retail vehicles.

The domestic regulators have been pushed into specific action because of the worldwide losses suffered by retail investors from the Lehman Brother’s collapse.

In the UK, the bank’s demise led to Arc Capital and Income, DRL and NDF being forced into administration. The collapse sparked an FSA review and calls on the industry compensation scheme.

The FSCS now expects structured product claims to rise to 1,600 in 2009/2010. A further 2,200 could surface in the next tax year. It has already announced a £20m levy on intermediaries to cover compensation costs.

The FSA’s review has so far concentrated on product marketing material and sales. In October, the regulator said it had found a marginal improvement post-Lehman’s in promoting counterparty names and descriptions of counterparty risk. But it also found important failings in the advice process. Of the cases reviewed, the FSA found 46% unsuitable and a further 23% were unclear.

Not everybody is happy with the FSA’s review, conclusions or new guidance. Many in the industry point out that unregulated white-label and own-brand structured notes were excluded, despite heavy sales through bank and building society branches.

Gary Dale, head of intermediary sales at Investec, says: “The FSA clearly differentiates between SIPPs and Structured Deposits, as the latter are treated as cash-based products and as such are not subject to the same guidance principles.”

The FSA’s new guidance to advisers may also cause problems. Ian Lowes of Lowes Financial says the FSA’s thinking is not joined up. He says: “After the precipice bond scandal, you had to include the generic Capital At Risk document in customer communications. But it applied only to structured products, not other investments such as unit trusts. This is the same thing, the regulator is not thinking holistically.”

The new wording requirements could prove counterproductive. Over-simplification could dilute the message and confuse investors when not applied to all products, he thinks. Lowes adds he has been warning clients about counterparty risk since 2004, but his wording must be dumbed down to fit the new guidance.

The FSA guidelines do not fit certain uses of structured products. Lowes says a new fund that invests in structured products must carry the new warning, where as other equity-based mutual funds do not.

Lowes also worries the regulator has failed to address compensation issues adequately. He says: “Providers will find the loophole to get the compensation. It then falls on the rest of the adviser community to pay up.”

He thinks marketing material and advice on Lehman-backed Meteor products has been deemed appropriate. But through no fault of their own, investors have no recourse to compensation as the company was not forced to default.

The British Bankers Association, which represents both manufacturing and distributing banks takes umbrage at not being included in the review. It too has issues with the way the regulator’s guidance applies to all products and all distribution or advice routes.

One-size-fits-all disappointment

In a letter sent to the FSA, Peter Tyler, retail policy director at the BBA, expresses disappointment with the regulator’s one-size-fits-all policy. Tyler writes: “While the FSA’s guidance and template can be helpful our members are concerned that the content appears primarily designed for use by financial planners. In particular, our private banking and wealth management members have expressed difficulty in applying the template to the various business models they operate and client bases they serve.”

Mass-market bancassurers are also concerned about the impact on their operating model, current and future product strategy. Tyler continues: “We do not believe the FSA has fully considered the diversity of the SIPP market and the varying uses to which these products are employed when devising its advice suitability assessment guidance.”

The BBA said the regulator gave no consideration to structured products with underlying collateral, nor to a range of advice scenarios such as the role of structured products in trusts. In subsequent correspondence, the FSA rejected the BBA’s concerns. The industry is happier with the RDR, provided it goes ahead after the general election later this year.

Mark Dickson, product development director of Blue Sky Asset Management, says: “Independent advisers will no longer be able to simply ignore structured products. It clearly states that advisers will need to have knowledge of structured products and how to use them, when appropriate for clients in a balanced portfolio, if they want to call themselves independent advisers in the future.”