EU regulators clash over structured products risk ratings

Dealers say the latest delay in Europe’s implementation of the Priips framework is down to a regulatory spat over whether quantitative or qualitative methodologies should be used to produce the risk indicator that must be included in a product’s key information document

European Securities and Markets Authority

A key discussion paper on European reform of the structured products market is being delayed due to squabbles among national regulators over how product risk indicators should be defined, according to market participants.

A discussion paper on the key information document (KID) – part of the forthcoming Packaged Retail and Insurance-based Investment Products (Priips) framework – was due to be published by the European Supervisory Authorities (ESAs) earlier this year. The European Securities and Markets Authority (Esma) now tells Risk.net it will be issued in the second half of June.

The discussion paper will lay the foundations for draft regulatory technical standards (RTS), in turn due in the autumn. Lawyers and trade bodies say the issue is being complicated by the need to define risk factors that apply across the universe of structured products and insurance-based investments such as unit-linked policies.

"It's hard to get one size to fit all and for that to be meaningful," says Andrew Sulston, partner at Allen & Overy in London. "One aspect is that on the banking side, with structured deposits, and the insurance side, with investment products, they've not had comparable regimes before."

Esma did not comment on the reasons for the delay. But one source at a European issuer says the cause is a regulatory wrangle over whether quantitative or qualitative methodologies should be used to produce the risk factors that must be included in the KID.

We weren't in favour of the qualitative method; the risk methodology should not be influenced by natural bias

The Spanish and Belgian markets watchdogs – Comisión Nacional del Mercado de Valores (CNMV) and the Financial Services and Markets Authority (FSMA) – are understood to favour a qualitative methodology, while other European regulators are known to favour a quantitative approach, as does the majority of the industry. Among those favouring a quantitative approach there are also disagreements about the specific methodology to be used, says the source.

"A qualitative methodology was promoted by Spain and Belgium. It was not supported by many other regulators but they were trying to push it. We weren't in favour of the qualitative method; the risk methodology should not be influenced by natural bias," the source adds.

A KID must answer the questions: "What are the risks and what could I get in return?" and "What are the costs?" for each product, according to the primary text of the regulation. Working out how these should be answered so that retail investors can compare products is frustrating European policymakers, says Thomas Wulf, secretary-general of the European Structured Investment Products Association.

A range of possible methodologies for a KID risk indicator was outlined in a November 2014 discussion paper published by the ESAs. The supervisory authorities promised a more thorough examination of the issues and options in the now-delayed spring 2015 paper.

Wulf says the challenge is to "find compromise solutions for the various models used" by issuers today. "This relates, for example, to the debate on whether a qualitative or a quantitative risk model is more appropriate for retail financial products," he adds.

The November discussion paper raised the possibility of using quantitative or qualitative methodologies for assessing the credit, market and liquidity risk of a product, as well as several theoretical approaches to aggregating these risk factors in a single indicator. Possible quantitative means of gauging market risk include using a historical volatility measure, a forecast of expected returns, or expected loss for a given value-at-risk, for example.

Mifid moans

Another factor contributing to the delay, say lawyers, is the difficulty in reconciling the Priips requirements on product cost disclosures for non-insurance products with those requirements included in the revised Markets in Financial Instruments Directive (Mifid II). Many argue that the overlap between the two regulations needs clarifying if issuers are to be spared duplicative requirements.

"There is a lot of crossover for firms between the requirements of Mifid II – such as the need to disclose customer charges in a specific format [and] break them down – and disclosing information from a product governance perspective. These are all obligations that firms will look to meet by having a fully formulated KID," says Nicola Higgs, partner in the regulatory group at Ashurst.

Clashes are also anticipated when it comes to the final KID requirements being transposed into the domestic laws of member states, with fears that a patchwork of national and supranational rules will be ill-suited to some products.

"At a UK level, the Financial Conduct Authority will be thinking about what local requirements will stay put in the UK regime once these European directives come in. The real challenge for the regulator is not to lose sight of the key objective of the KID – to aid consumer understanding – in light of the challenges it will face in finding a one-size-fits all solution to vastly different products," says Higgs.

The regulatory mishmash at the European level is being blamed on dysfunctional communication between the different task forces charged with drafting the respective directives. Tim Hailes, chairman of the Joint Associations Committee on Retail Structured Products, says the committee has been concerned about "regulatory policy silos" for some time, though he is in favour of delays where necessary.

"The commission timetable for the various deliverables creates a risk in itself that regulatory spaghetti gets produced. However, I would far rather that they take their time, join up the thinking and end up with something consistent, logical and not duplicative – or, worse, contradictory – than rush it," he says.

Esma says the ESAs are on track to send the draft RTS on cost and risk disclosures to the European Commission by the deadline of March 2016. A consultation on the draft RTS that will set out the ESAs' conclusions is scheduled for the autumn of this year. The Priips regulation is scheduled to be implemented on December 31, 2016.