Belgium's moratorium on retail structured products dissected

The Belgian Financial Services and Markets Authority initiative to restrict the distribution of structured products deemed unsuitable for retail investors is paving the way for new legislation later this year. Will the likely demise of reverse convertibles lead to a plunge in volumes? Magda Ali reports

When Belgian regulator the Financial Services and Markets Authority's (FSMA) issued its moratorium on the distribution of ‘needlessly complex' products in June, it came as little surprise to market participants, many of whom see the moratorium as broadly replicating the stringent regulatory measures being applied elsewhere in Europe.

"The moratorium has definitely been inspired by regulation in other countries, especially France," says Benedict Peeters, founding partner at Finvex, a structured products research boutique in Brussels. But while French regulation excludes capital-protected products, the Belgian moratorium includes protected solutions, says Peeters. The fact that most structured products offered in Belgium include capital protection means "it is ultimately those investors that the moratorium is trying to protect," he says.

"From the preparatory work, it became clear that it should be possible to impose restrictive conditions on certain products, particularly where their complexity renders them unsuited to the average retail investor," says an FSMA spokesperson in Brussels. The moratorium constitutes the first step in a process intended to "increase the traceability" of retail investment products, he says.

The moratorium is not retrospective. "The FSMA does not establish statistics on the impact of the moratorium on existing products. That would be the same as drawing up carbon dioxide emission limits for new cars and applying the new limits to existing vehicles," explains the spokesperson.

A lot has happened since the moratorium was first issued. A public consultation has been launched, allowing financial institutions to air their views about how the moratorium would be applied to their operation, followed by publication of a list of distributors that have signed up to it.

If a distributor within a financial group adheres [to the moratorium], all institutions within the group must do so

With more than 70 financial institutions - including Belgium's four big banks (Dexia, Fortis, ING and KBC) - already signed up, it is becoming clear that financial institutions have accepted that the moratorium is something they cannot ignore.

 

The end is nigh for some products

The structured products market in Belgium is one of the most mature in Europe, with $85 billion outstanding in 2010 according to the FSMA. Market participants believe Belgium will remain a core market for the products, but predict that the regulator's initiative could spell the end of the country's relatively small reverse convertible market, as well as damaging optical products, which have a lower likelihood of delivering returns and embed what is known as a teaser coupon.

The Belgian market includes a relatively high proportion of products that use quite complex analysis to define returns for investors when re-weighting the payout formula, says Peeters. "The payout formula contains several layers. I think it has been perceived as relatively opaque and is one of the things the regulator has decided to attack."

"It is right that the regulator is focused on these types of structure," says Peeters. "Investors might be under the impression they will get a high coupon, but they might give up substantial future returns because of the conditionality of the other payment."

Although generally in favour of the moratorium, Peeters says its main disadvantage is that it will limit open architecture, thereby putting a brake on product innovation and diversification.

Vincent Delfosse, head of product management at Deutsche Bank in Brussels, agrees. "The idea behind the moratorium is beneficial for retail investors, but the current text leaves room for improvement," he says. "The regulator is now prohibiting products that do not offer symmetry between gains and losses, so if there is risk in having capital losses for the full nominal, they should also get the opportunity to participate in the full upside." The main problem is that the moratorium looks only at complexity rather than the risks associated with products, he adds.

A Brussels-based distributor concurs. "The new framework is not yet tested and will result in uncertainty and ad hoc demand for the regulator to say whether or not a product is allowed. The market will need to understand how this will be applied and some products will definitely have to be made redundant."

Sylvia Kierszenbaum, Antwerp-based partner at law firm Allen & Overy, says: "If a distributor within a financial group adheres [to the moratorium], all institutions within the group must do so, and the rules will have to be complied with in respect of all types of products, regardless of their legal form."

"We will need to ask first for an approval of the payout, and then ask them for an approval of the marketing material once we have decided to go for products," says one Brussels-based banker. "The whole process will become a nuisance and will require a lot of superfluous work."

Under the moratorium, distributors who issue notes that rely on the credit quality of the issuer must include the issuer in the name of the product and provide full disclosure of fees in the marketing material.

The regulator will also impose a requirement to inform investors of any modification to the risk profile or market value of products, says Delfosse. "We will have to inform clients if there is a downgrade or a significant shift in market value. This is a bit vague, so we have asked for further clarification [from the FSMA] on what it deems significant."

The problem for distributors lies in figuring out how to apply the moratorium should they decide to sign up. "The voluntary moratorium is an example of the increased focus of the Belgian regulator on consumer protection in the financial sector and is part of a wider trend," says Willem Van de Wiele, senior associate at Allen & Overy in Brussels.

"Because Belgium has adopted a similar regulatory initiative [to France], the potential is that this may set an international precedent, which makes it a sensitive topic," adds Van de Wiele. "This is an area to be closely followed, in particular the FSMA's consultation and pursuant regulations."

"We hope the moratorium as it is today will be adapted, otherwise a whole load of products will have to change," says Gaëtan De Vliegher, head of sales, structured products and derivatives at Degroof Bank in Brussels. "That's more for retail banking; in private banking, you are still allowed to do the same structures as before... as long as the customer has more than €500,000 deposited at your bank."

De Vliegher says Degroof will still be affected as it signed the moratorium, but less so than retail banks.

"We know it is going to have a negative impact on structured products in terms of volumes sold and hesitance on the part of distributors to sell structures," says Amaury Des Deserts, head of structured equity European distribution sales at BNP Paribas in Paris.

A small change that may appear more cosmetic in nature than anything substantial is that where the previous terminology of "needlessly complex" has been amended to "particularly complex". The reasoning is that the phrase "needlessly complex" implies something of a stigma, which was badly received by market participants.

"It is as though structured products are being categorised as very dangerous products, and this is not necessarily the case," says Des Deserts. "If we just have an approach based on the risk then the structured product could be very efficient. You can have an asymmetric risk profile with a capital guarantee, which can be seen as more conservative that some traditional mutual funds."

Some banks worry that the stringent regulations could result in investors abandoning structured products for mutual funds. "It won't increase transparency. Investors are already moving into exchange-traded fund (ETF) investments, which are not necessarily more transparent than structured products," says Degroof's De Vleigher. "I don't think this is a good way of handling things, because structured products make sense for a lot of clients."

Many products that are doing well in Belgium, including structures that embed call spreads, are incompatible with the moratorium, he says. "The greatest challenge in applying it will be to answer to certain demands. How we respond to this customer and demand for hedging and certain positions they want to take for certain underlyings?"

"My guess is that the regulation will mean the next generation of products will be ETFs with specific strategies, such as going long and short," adds De Vleigher.

As for how the moratorium will affect operations for BNP Paribas, Des Deserts says the impact will be both quantitative and qualitative. "The qualitative aspect is that we are only promoting structures with capital guarantees - if the product is not fully protected with a firm guarantee we don't promote or market it," he says.

On the quantitative front, the moratorium creates uncertainty in the whole market, he adds. "Moreover, structured products are subject to bad publicity and volumes are dropping by double figures."

Banks have been engaging in dialogue with regulators on a frequent basis. "What we want to avoid is too much uncertainty around the definition of ‘particularly complex' structured products," says Des Deserts. "We need clear guidelines for providers and distributors, because as long as these uncertainties remain our industry will continue to suffer and investors will not want to choose structured products.

 

Consultation process

The FSMA has updated its frequently-asked-questions document in a bid to increase clarity, and has indicated that once it has all the information on a product it will make an assessment within five working days. Distributors will thereafter be able to discuss matters with the FSMA before they market the product to determine compliancy with the standards set out by the regulator.

On August 12, 2011, the FSMA launched a two-month consultation on the new rules that will continue until October 15, allowing interested parties to express their views on the new regime by means of 18 questions.

Based on the results of the consultation, the FSMA will draw up a regulation promulgating the new regime. "When that regulation comes into effect, the voluntary moratorium will come to an end. The aim is to present a draft of the new regulation by the end of the year," says the FSMA spokesperson.

Market participants predict that the biggest challenges will lie with the regulator, as it has introduced a text for which the market may not be prepared. "December will mark the real implementation of the moratorium," adds Des Deserts. "This is not the best time for us. We are in the middle of something that is very unclear in terms of rules and the impact it is going to have."

Des Deserts predicts that in the medium-term Europe will see a harmonisation in regulations. "Each regulator is looking at what the others are doing," he says. "In the long run, once the rules are enforced and the distributors are dealing the same cards, it will bring an element of stability to the structured products market."

Finvex's Peeters says distributors offering high-quality solutions with a good degree of transparency stand to benefit from the moratorium. "It will also hopefully lead to new innovation, not for the benefit of the formula but for investor's returns," he adds.

So while prospects for distributors look uncertain in the short-term, on a longer view of things there is perhaps more reason for optimism. After all, it was only after the financial crisis that investors lost faith in structured products, so there is a chance that "the legislation will restore trust and consolidate the structured products market over the longer term," according to Des Deserts.

"If the legislation can deliver an organised, mature and transparent industry, investors will be more inclined to build their portfolios around structured products, but that cannot be done in three months. If we can see some harmonisation, the Belgian initiative will be a good one," he says.