UKSPA contests EU stance on liquidity risk ratings

The UK Structured Products Association has declined to include a metric for liquidity risk in its new rating system for structured products, diverging from the course EU regulators are likely to take under Priips

UKSPA chairman Zak de Mariveles

The trade body representing the UK's structured products industry has struck a defiant note over proposals by European regulators to include mandatory liquidity risk ratings on all structured products from 2016, refusing to include the metric in its own rating system which it unveiled this week.

The UK Structured Products Association (UKSPA) designed its proprietary rating system to explain the riskiness of different products to independent financial advisers (IFAs), pre-empting forthcoming legislation from European watchdogs which will force all European retail investments to carry a numerical risk ranking from 2016.

"We don't think that liquidity risk can be turned into some form of alphanumeric score, unlike market and counterparty risk," says Zak de Mariveles, London-based chairman of the UKSPA and head of UK IFA sales at Societe Generale. "We still believe that it exists, but that it is more appropriately described as a narrative."

In November, the three European supervisory authorities (ESAs) jointly issued a discussion paper that included a section on how risk ratings could be calculated under the Key Information Document (Kid) regulation – part of the Packaged Retail Insurance and Investment Products (Priips) framework. Early statements from the ESAs imply that the final Priips legislation is likely to conflict with the UKSPA's methodology.

In order to avoid potential confusion when the Priips Kid comes into force, the UKSPA ratings will be made available only to IFAs rather than the wider public. Though the UK will eventually have to adopt the Priips risk number, the UKSPA says it intends to raise an objection as part of its response to the Kid discussion paper, which it must file by February 17.

We don't think liquidity risk can be turned into some form of alphanumeric score

The UKSPA's current rating system will use a two-digit alphanumeric code to indicate a product's risk level, in a programme designed to offer clarity to advisers serving the retail market. The first digit is based on the market risk of a product, and shares some similarities with existing methods used to rank funds under Europe's Undertakings for Collective Investment in Transferable Securities (Ucits) framework, including the 1-7 scale, in a bid to offer consistency for IFAs.

De Mariveles says the UKSPA decided to adapt the core Ucits methodology for structured products so that it takes factors such as counterparty risk into account – something that does not apply to Ucits funds. To reflect this, the ratings system will assess an issuer's creditworthiness on a scale from A-G.

Across the combined scale, the lowest risk score a product could be assigned is 1A, with 7G representing the riskiest products.

"It was tough as there was no previous basis for risk rating in structured products. But Ucits uses standard risk-reward indicators from 1-7 so it made sense to come up with something similar to what IFAs use already," says Gary Dale, head of intermediary sales at Investec and a member of the UKSPA committee that designed the rating.

The UKSPA calculates market risk for products by adding the volatility of the bond and the embedded derivative. The volatility of the bond is determined by multiplying together the level of capital protection, the length of the term and the volatility rate implied by the annual appreciation of a zero-coupon bond.

Similarly, the amount of capital at risk, the level of delta exposure and the five-year realised volatility of the underlying asset are multiplied together to assess the volatility of the derivative. If a product embeds more than one derivative, then the final measure is the combination of each derivative's volatility.

Some market participants have criticised the reliance on five-year realised volatility in the UKSPA's measure as backward-looking, however. "They've adopted the European standard and, to a certain extent, if this is the way that Europe is going then they have made a sensible bid. But an estimation of the distribution of the annualised returns and an expected return number would be a better way," says David Stuff, chief executive of structured products distributor Cube Investing. "The Europeans haven't adopted that because a lot of the market on the continent is for relatively short-term products, and this is a very good way of estimating the short-term mark-to-market volatility of a product. But you're looking through a pinhole to try and estimate what the whole room looks like."

But de Mariveles argues that the UKSPA is simply aiming for consistency with current best practice across the industry. "There are many different ways of describing risk. What's important is that you standardise any calculation across the board and provide a sensible yardstick that can be used to compare products, which is clearly the goal of the regulators. It seems logical to adopt the approach currently taken by the entire funds industry, rather than take a contrarian approach."

The UKSPA's A-G counterparty credit risk indicator is based on the counterparty's rating with agency Standard & Poor's (S&P). If the counterparty is not rated by S&P, then the rating from Moody's or Fitch is used. Any unrated issuers automatically receive a G, the lowest possible assessment.

For collateralised products, the credit risk is assessed on the collateral issuer's rating. The Bank of England's classification would be used for a gilt-backed product, for instance. Products that diversify counterparty exposure are assessed according to the median credit rating of the various issuers.

The introduction of a risk rating forms part of a wider effort to make structured products more retail-friendly, including the recent introduction of standardised product codes.