Priips risk indicators under fire from industry

Industry associations condemn market risk measure, which they fear is biased against many equity-linked products

Market risk methodology is "prejudiced against equity-linked investments"

Structured products lobbyists have criticised European regulators' proposed risk indicators for retail investments, saying they ignore the recommendations of a consultative expert group and will make it harder for investors to compare products in different asset classes.

The Joint Committee of the European Supervisory Authorities (ESAs) held a public hearing on new disclosure requirements on December 9 in Frankfurt. These will be introduced under incoming packaged retail and insurance-based investment products (Priips) regulation, due to come into force at the end of 2016.

Stakeholders used the forum to criticise the design of the risk indicator included in the new disclosures, which is intended to "enable retail investors to more easily compare" products, according to draft regulatory technical standards (RTS).

"They [the ESAs] created a so-called consultative expert group asking for their advice, and my information is they did not really listen to that advice but created something of their own. At the hearing they pointed out there were different views in this expert group and so they took something of everybody, but I'm not sure this is the right way forward," says Christian Vollmuth, managing director of the German Derivatives Association (DDV) in Berlin.

The draft RTS's risk indicator proposes a mixed qualitative and quantitative approach, combining market and credit risk in a single numeral. The European Structured Investment Products Association (Eusipa) wrote in a paper sent to the ESAs in advance of the public hearing that this will frustrate comparability across products as some will be automatically assigned a risk class based on qualitative characteristics, while others will be assigned based on a quantitative assessment.

"It was clear to the expert group and to the regulators that the more qualitative the risk measure the worse it is for comparison purposes," says a senior structured products pricing engineer at a European dealer close to the discussions. "Still, they decided to use a part of the qualitative measure – probably due to insurance companies that wanted their products to be classified independently in any simulation mechanism."

The quantitative assessment uses value-at-risk (VAR) equivalent volatility to group most structured products into risk classes one to seven. For example, products where the annualised volatility of the underlying calculated using this methodology is less than 0.5% will be put in class one, the lowest market risk rating, whereas those with volatility greater than 25% will be put in class seven, the highest. The market risk class is then combined with the credit risk class of the issuer, defined using credit rating agency data, to create the overall risk indicator.

Vollmuth (pictured) says the market risk methodology is prejudiced against equity-linked investments. "We did an analysis of the market risk measure choosing popular indexes including the Dax, FTSE, and so on, as well as real economy shares and finance industry shares. Nearly all the single shares are in risk class seven, and the broad indexes are in six. If you look at the main findings, there is no differentiation between high-risk products, such as contracts-for-difference and knock-out warrants, and blue-chip [equity] investments," he says.

This proposed risk indicator builds on a technical discussion paper issued by the ESAs in June. Here, the authorities laid out four options for industry stakeholders to comment on. But the indicator described in the draft RTS does not reflect any of these options – an outcome that Vollmuth called "weird".

He adds that the DDV's "main aim" is to change the parameters of the market risk classes. "I think there will be some further work there in January," he says.

Others are frustrated that the ESAs will not consider a two-part risk indicator that displays market and credit risk separately. This form of indicator is already in use among members of the UK Structured Products Association (UKSPA).

Zak de Mariveles, chairman of the association and head of sales to UK independent financial advisers at Societe Generale, says that at the hearing "everyone around the table could see the benefits of splitting it out," but that according to customer testing conducted by the European Commission "it wouldn't be appropriate for retail investors".

Another concern is how the proposed delay to the Markets in Financial Instruments Directive (Mifid II) will impact the implementation of the Priips regulation. For example, Priips borrows certain definitions from the Mifid II text – such as that for "retail client" – and Mifid II also contains provisions on cost disclosures and appropriateness testing that may need to be aligned with those in the Priips regulation.

The UKSPA's de Mariveles says that, despite recognising "a strong consistency" between the two, European policy-makers said they did not believe Priips would also be delayed.

"They highlighted there wasn't a strong crossover between the two and that Priips should be seen as a standalone regulation and not dependent on Mifid II," he says.

The draft RTS document is open to consultation until January 29, 2016. The final version is scheduled to be published two months later.