Priorities for improving retail investor protection

Transcription

1 Priorities for improving retail investor protection This document was drafted by Eurofi with input from its members. It does not engage in any way the EU Cyprus Presidency or the Cyprus Financial Authorities. Context Improving investor protection, particularly for retail investors, was already a strong objective of EU distribution and product regulations 1 in order to avoid mis-selling and improve asset allocation. It has become a priority of EU regulation following the financial crisis also as a way of contributing to financial stability. Investor protection indeed plays a major role in developing investor confidence in service providers and products, which was damaged during the crisis and facilitates investment strategies adapted to the needs of customers, thus leading to more efficient and stable capital markets. Investor protection may also prevent the dissemination of products exposed to excessive liquidity or counterparty risks, which may pose systemic risks in case of market stress. The increased role that investment products and financial markets in general are expected to play in the future in the financing of the economy, with the reduction of banking and insurance intermediation due to CRD IV and Solvency II requirements, puts additional emphasis on the importance of having appropriate investor protection and investor guidance in place. This is indeed essential to re-develop the appetite of investors, which has strongly diminished with the on-going crisis, for assets with a risk component. and member state regulation. Rules at producer level may also be completed by broader prudential rules applying to banks or insurance companies. Three main areas of improvement need to be further assessed in this perspective: 1. Enhancing the quality of advice and appropriately managing conflicts of interest at distribution level 2. Improving pre-contractual disclosure and the consistency of investor protection rules across investment products answering similar needs 3. Improving the balance between investor protection rules at product and distribution levels. The MiFID review impact assessment published in 2011 highlighted several areas in which investor protection has revealed deficiencies and where improvements are required. Among these, the way to manage conflicts of interest appropriately, the quality of investment advice and the consistency of investor protection rules across products answering similar investment needs appear to be the most important and challenging to be addressed. The need to review standards applying to the sale of life insurance products with investment elements (e.g. unit-linked contracts) was also mentioned by the EU Commission in the course of the IMD review. Moreover, the way to evaluate the complexity of investment products and the relevance of such an approach for retail investors are much debated. These issues are addressed in the on-going review of MiFID and the proposals of the investor protection package published on 3 July This package includes a review of the Insurance Mediation Directive (IMD) and proposals regarding pre-contractual disclosure for PRIPS (Packaged Retail Investment Products). Some of these issues should also be addressed in the consultation launched in July 2012 by the Commission for reviewing the UCITS directive. Investor protection is covered at different levels (producer, product, pre-contractual information, distributor ) in present EU 1 Markets in Financial Instruments Directive (MiFID), Insurance Mediation Directive (IMD), UCITS directive, Consolidated Life directive at EU level. There are also local frameworks see Appendix 1. The Eurofi Financial Forum 2012 // Brussels // 27 &28 September Eurofi - The Financial think tank dedicated to financial services Rue de Mirosmesnil, Paris-France // Tel +33 (0) // Fax +33 (0) //

2 Mapping of current investor protection measures and present situation regarding UCITS (see appendix 1 for comparison with other retail investment products): Level Requirements Present situation (UCITS) Producer Product Pre-contractual disclosure Distributor Authorisation, capital requirements Producer governance: authorization for specific products and investment techniques (e.g. derivatives), on-going supervision Authorisation Monitoring of individual products Product rules: investment rules, risk / liquidity management rules Product guidance: specification of investor target, labeling or classification of products depending on investor-relevant criteria Product governance: on-going monitoring of product rules Depositary and administrative agent (valuator ) requirements Disclosure of product objectives, risk-reward profile, non-market risks Investor segmentation Mitigation of conflicts of interest: disclosure of advisor status / type of advice provided, inducement rules Conduct of business rules: suitability and adequacy tests, rules for advice Fiduciary duties of advisors: due diligence of products, justification of recommendations Advisor qualification, professional standards Authorisation and requirements at management company level Done by local supervisor Authorisation and monitoring conducted by local supervisors based on UCITS requirements Defined in UCITS framework Generic guidance provided by the UCITS label and regulation at local level Labeling exists for MMFs and should be introduced for ETFs Done at general UCITS level by EU Commission / ESMA Defined in the UCITS framework and amended in UCITSV (eg liability regime) UCITS KIID, to be extended to other PRIPS (ie retail structured products, unit-linked life insurance, ) Defined in MiFID, under review Defined in MiFID, under review Defined in MiFID, under review Defined in MiFID II, under review No harmonized requirements, usually focused on independent advisors Investor Financial education Very limited at EU level. Some local initiatives 2

3 1. Enhancing the quality of advice and managing appropriately conflicts of interest at distribution level The Commission makes proposals in MiFID II to improve the quality of advice and the mitigation of conflicts of interest. According to these proposals, advisors would have to inform their clients about the nature of the advice provided (i.e. whether the advice is provided on an independent basis and is based on a broad or more restricted analysis of the market) and whether the investment firm will provide the client with an ongoing assessment of the suitability of the financial instruments sold. Conditions for qualifying advisors as independent have been defined by the Commission: - Assessment of a sufficiently large and diversified number of financial instruments available on the market - Ban on commission payments (inducements) for independent advisors. MiFID I criteria would continue to apply to other advisors including bank advisors and tied agents. These proposals however have to be put in a context where distribution of third-party products is still limited in the EU and with distribution structures varying significantly across the EU (i.e. varying shares of third-party products and limited presence of independent advisors in many countries ) see Appendix 2. The predominant model in Europe at present is integrated distribution with banks and insurance companies distributing the products of their asset management subsidiaries. Estimates are that captive distribution (of in-house products) represents around 67% of investment fund sales with third-party funds amounting to the remaining 33% 2. Many issues have been raised regarding these proposals and alternative solutions suggested. Singling out and imposing overly restrictive requirements on independent advisors is believed to present downsides as long as this category of advisor is not well developed. The fact that independence is not a guarantee in itself for good quality advice was stressed as well as the possible negative connotation for other types of advice of an independent label (i.e. restricted or tied advice 3 ). Suggestions were also made that these different types of advice should be defined and regulated, rather than focusing only on independent advice, and that more neutral wording be used such as fee-linked advice (instead of independent advice) and order-driven advice (instead of restricted advice). As a first step, disclosure standards requiring all advisors to inform investors of the nature of the advice provided and of their positioning vis-à-vis producers seem preferable to regulating specific categories of advisors. Enhancing the fiduciary duties of advisors (e.g. with disclosure of the basis on which recommendations are made, requirements for the due diligence of products) could also be considered, provided it ensures sufficient added value to investors and does not create an unnecessary workload or unaffordable costs for advisors, some of whom operate very small companies. Many stakeholders also believe that strongly restricting or banning commissions is not appropriate given the present distribution structure in the EU. Strict rules on commissions indeed may be all the more justified as distribution of third-party products is already sufficiently developed (through open or guided architecture models 4 ), for commissions to influence recommendations made by a majority of the advisors / distributors concerned. A sudden ban of commissions may not be the best driver to facilitate the development of third-party sales and independent advice in markets where open architecture is limited, since distributors may be tempted in this case to privilege in-house products or move to restricted advice model 5. Some players also point out that advice involving fees paid directly to the advisor is not absent from issues and conflicts of interest (since advisors may attempt to increase the churning of portfolios, multiply assessments or focus on the largest portfolios to increase fees or products requiring on -going service). In addition some players stress that although commissions may raise potential conflicts of interest at the moment of the initial sale, this is not true over time, since ongoing commissions will be reduced if investors are dissatisfied and sell their assets. Proposals aiming at improving the quality of advice and appropriately managing conflicts of interest should be conceived in a dynamic way, with short and medium term objectives and with sufficient flexibility and phasing-in in order to accommodate the present diversity of distribution structures in the EU and anticipated evolution trends. Restricting or banning commissions should be a longer term option worth considering if and when open architecture models become dominant. Given the limited cross-border development of retail investment product distribution, countries with more developed Independent Financial Advisor (IFA) representation or distribution of third-party products should however be able to impose if necessary additional rules regarding commissions, so long as this does not impact negatively the single rulebook approach of the reviewed MiFID directive. In any case, the mitigation of conflicts of interest is only one of the areas that require to be investigated at distribution level to improve product suitability and asset allocations. Distributor qualifications, investor financial literacy, the supervision of distributors with regard to investor protection are other important drivers of improvement that need to be considered. 2 Cerulli estimates Restricted or tied advisors are advisors who provide advice on a restricted range of instruments or advise on their own products such as bank advisors or tied advisors 4 In the open architecture model investors are offered a large choice of products from different manufacturers. With guided architecture a distributor (usually a bank) offers the products of a restricted number of firms (including in-house products possibly) that it has pre-selected as being suitable. In the integrated distribution model distributors sell exclusively or nearly so their in-house products. 5 In addition retrocessions within integrated financial groups do not have the same impact since advisors are usually not personally incentivized based on the inducements paid to their distribution network. Some players point out that retrocessions within distribution platforms may cover processes of due diligence, and on-going monitoring and assistance to the investors. The complexity of tracking commissions in an effective way in an integrated environment is also put forward. 3

4 2. Improving pre-contractual disclosure and the consistency of investor protection rules across investment products answering similar needs The issue of the consistency of investor protection rules across retail investment products is addressed by the PRIPS initiative (Packaged Retail Investment Products) 6 published on 3 July 2012, although the proposed text focuses on pre-contractual information. The proposal is to extend and adapt the KIID (Key Investor Information Document) developed for UCITS to the other key types of retail investment products, which combine exposures to multiple underlying assets, are designed to deliver capital accumulation over a medium to long term investment period and entail a degree of investment risk (although some provide capital guarantees). This includes investment funds, retail structured securities, structured deposits, insurance-based investment products (including unit-linked life insurance). Every KIID should follow the same structure with key information notably on costs, risks, performance made as comparable as possible 7. These improvements are welcomed by most stakeholders as they may enhance the comparability of products answering similar investment needs. Clear and comparable information (on product features, risk / rewards and pay-off mechanisms ) may also to some extent help retail investors in their decisions and limit poor investments. Improvements in this area should also facilitate the work of intermediaries in downstream stages of the value chain (i.e. distribution and advice activities). Some players however point out that the current proposal should be clarified regarding which instruments will eventually fall within the scope of this regulation (e.g. the suggestion was made that the requirements should state more clearly that deposits that are not linked to any interest rate should not be considered as PRIPS). Other stakeholders have called for a wider scope of PRIPS extending to products which entail a degree of investment risk but that may not be packaged or wrapped (e.g. some securities). Some observers believe that non-market risks (i.e. counterparty 8, liquidity, custody risks ) should be more clearly communicated to investors 9. Such risks materialize much less frequently than market risks but may have a much more significant impact on the capital invested and therefore should be taken into account in investment decisions. Disclosure of counterparty and liquidity risks is already mandatory in the KIID, but is in free format, whereas market risks and the risk/reward profile of products are more explicitly presented. A further standardisation of the presentation of such risks in the KIID could potentially simplify their understanding by investors, increase their visibility and limit the marketing of products that pose excessive non-market risks. Investment product distribution rules will continue to be defined through two different texts: MiFID applying to securities and derivatives and IMD applying to life insurance products. This is due to the difficulty of proposing common distribution rules for products which may have different characteristics and distribution arrangements. The specific features of life insurance products in particular which do not have a harmonized framework at EU level and may involve other considerations than pure investment (i.e. biometrical risk coverage, inheritance ) and the present variety of distribution networks concerned in terms of size and legal status (i.e. ranging from self-employed IFAs to multinational banks, tied and non tied agents, etc ) are often put forward as examples of barriers to the establishment of crosssectoral distribution rules. The proposals currently made in the context of the MiFID and IMD reviews should however help to improve the consistency of distribution rules in several areas including the mitigation of conflicts of interest and the fiduciary responsibility of intermediaries: - Disclosure of the distributor s status and of the type of advice provided - Clarification of the basis on which advice is given (e.g. in terms of range of products) - Disclosure of distributor remuneration (nature, structure, scope ). The IMD II proposal also increases the coherence in the way distribution is approached in MiFID and the IMD e.g. with nonadvised sales being introduced in the IMD in the same way as in MiFID Improving the balance between investor protection rules at product and distribution levels. Ensuring investor protection requires putting in place appropriate and complementary actions at the different stages of the value chain i.e. product development, pre-contractual information, distribution and advice. MiFID and IMD provide distribution rules to mitigate conflicts of interest and define standards for advised and non-advised sales. However, the challenges posed in the short term by significantly improving the quality of advice in a profitable way, given the present level of advisor qualification, the training and operating costs involved, the limitations of wealth management tools, the reluctance of many retail investors to pay specifically for advice 6 PRIPS (Packaged Retail Investment Products) are defined by the Commission as a product where the amount payable to the investor is exposed to fluctuations in the market value of assets or payouts from assets, through a combination of wrapping of those assets, or other mechanisms than a direct holding. Some of these products may be used for private pensions but occupational pension schemes or products for which the employer is required by law to contribute financially are not part of the scope. 7 There should however be some flexibility to accommodate specific information required for certain products (e.g. private pensions with information on what to expect as a possible pension upon retirement) or differences across products which will be clarified in implementing measures. 8 For example counterparty risks related to the exposure to swaps or to the engagement in securities lending operations 9 Actions are under way to better define for UCITS funds the rules needed to mitigate counterparty and liquidity risks related to the exposure to OTC derivatives and the use of efficient portfolio management techniques (eg securities lending). Guidelines have been published by ESMA in July 2012 and the consultation on the review of UCITS launched by the Commission in July 2012 is addressing these issues. 10 Previously the IMD considered advice as integrated into distribution, whereas advice is an independent and optional service in MiFID. 4

5 services and the limited size of the average portfolios need to be taken into account. The relatively low level of financial literacy of retail investors is also often pointed out. Moreover, fully leveraging pre-contractual information may also be difficult in such a context. The KIID indeed provides much improved information on investment product objectives and risks but often requires a detailed assessment by the investor possibly supported by the distributor. This is why some observers believe that guidance at product level and product governance rules could play a stronger role than currently in the regulatory approach to investor protection. Different types of rules may be envisaged at product level in the EU: Product classification or labeling Proposals have been made by the Commission in MiFID II to restrict the list of products automatically classified as noncomplex, which can benefit from execution-only services. The Commission is proposing to exclude from the non-complex list instruments that embed a derivative or incorporate a structure which makes it difficult for the client to understand the risk involved (e.g. structured UCITS 11 ). This has opened up a debate on product complexity and classification, both from an investor protection and financial stability perspective. This debate is expected to continue in the context of the consultation launched in July 2012 by the EU Commission to review the UCITS directive where the questions of eligible assets, exposure to OTC derivatives and use of efficient portfolio management techniques will be addressed in particular. The primary objective of product classification would be to identify the products which may or may not be suitable for retail investors or which may require specific guidance at the point of sale (i.e. which may not be sold on an execution-only basis). Such a classification could also help investors to better understand the investment objectives and characteristics of each type of fund in order to optimize their asset allocation. This type of approach was recommended by M. Ferber in his report on the MiFID II proposal. According to this proposal, investment firms should specify a target group when designing a new product and should take reasonable steps to ensure that the investment product is marketed and distributed to clients within the target group. The notion of target group still needs to be more formally defined. This could be done with a classification of investment products based on objective investor-related criteria such as: investment objectives / horizons, the level of portfolio diversification, the main pay-off characteristics (including capital guarantees), the understandability of pay-offs for retail investors, the availability of data on underlying assets and the risks which may impact such pay-offs 12. Such characteristics seem more appropriate than technical criteria related e.g. to the investment techniques used by products such as the use of derivatives or the engagement in securities lending. Many observers indeed believe that the key point for retail investors is to be able to understand the risk / reward profile of the products they are offered as well as any capital guarantees, rather than the underlying investment techniques used. In addition, some of these techniques may bring very positive outcomes for investors provided counterparty and liquidity risks are well managed and that the resulting pay-off mechanisms are not overly complex. Some relatively sophisticated hedging techniques for example based on derivatives may indeed considerably reduce market risks and volatility (e.g. in the case of structured UCITS 13 ). As for institutional clients, who are able to assess product risks there is no reason to make products embedding derivatives automatically complex or to impose specific classification. Due to the intensity of product innovation, regulators would need to review on an on-going basis and based on the latest market developments, the suitability for retail investors of products classified as suited for retail investors and the criteria used. This review would also help to adjust product rules or authorization processes if necessary. UCITS funds however require a specific attention in this context. With the progressive broadening of eligible assets and techniques, the sophistication of funds allowed by UCITS has increased and most investment strategies based on transferable securities or derivatives can be structured under UCITS 14. The absence of a framework for passporting alternative investment funds (AIF) before AIFMD was adopted also means that UCITS have increasingly been used by institutional investors (around 25% of total assets under management AuM are held by such investors) driving the expansion of more sophisticated investment techniques within UCITS products. Some observers are in favour of a streamlining of the eligibility criteria of UCITS and moving to the AIF category some of the more sophisticated funds structured under UCITS, in order to enhance retail investor protection. Many players however believe that differentiating UCITS according to their sophistication or complexity would be detrimental for the UCITS brand as it would affect the confidence of investors and possibly of some non-eu regulators in such a brand. They consider this would be unjustified as UCITS are highly regulated instruments subject to regulatory approval and to strict investment rules, which guarantee their liquidity and diversification and UCITS do not 11 Structured UCITS as defined by the Commission provide investors, at certain predetermined dates, with algorithm-based payoffs that are linked to the performance or to the realization of price changes or other conditions, of financial assets, indices or reference portfolios or UCITS with similar features 12 Such an approach was recently introduced for example in Belgium by the FSMA for evaluating the suitability of structured products based on critieria such as the characteristics and ease of understanding of pay-off mechanisms, the availability of data on underlying assets, the impact of product structures on the overall payoff. This avoids qualifying products broadly as complex, while identifying those which require specific attention at the distribution level and those which may not be adapted to retail investors. 13 Structured UCITS which often offer capital guarantees and reduce volatility are fairly complex in the investment techniques used, but their payoff mechanism may or may not be complex. 5

6 involve any liability beyond their acquisition cost. Furthermore having two categories of UCITS based on their sophistication or complexity could lead to confusion and issues for present product holders. Another argument put forward is that moving sophisticated products out of the UCITS framework might encourage the producers to structure them as nonregulated products (structured products, exchange traded notes ) if they cannot benefit from the advantages of the UCITS framework. A possible solution to maintaining the integrity of the UCITS label could be to further segment UCITS funds with a classification or labeling system as suggested above in order to clarify their suitability for retail and non retail investors and for different investment needs, while leaving them within the UCITS framework. This debate is expected to be pursued in the context of the consultation launched by the Commission in July 2012 on the review of the UCITS directive. funds or some retail structured products) could also be envisaged in order to standardize rules and improve investor confidence. Some players also believe that developing harmonized product frameworks for non-fund investment products answering similar investment needs to UCITS would be beneficial (e.g. some retail structured products) in order to ensure an equivalent level of risk mitigation across products and a level playing field particularly in terms of authorization processes. Rules on pay-off mechanisms More specific rules could be developed on pay-off mechanisms at product level in order to avoid excessively complex mechanisms and ensure access by investors to adequate information on pay-offs and to the required underlying data. There are no specific rules in this area at present in EU legislation, except mandatory disclosure of pay-off mechanisms and distributor requirements regarding product suitability if the product is considered as complex. Product governance and on-going supervision Some players consider that improving product development requirements as well as on-going supervision of product governance processes at producer level (e.g. the on-going management of product ranges), should also be considered. Such measures could ensure the quality and suitability of products for retail investors and that appropriate and understandable outcomes are delivered to investors. This could be done particularly for products which do not go through a formal authorization process based on harmonized product rules. The suggestion was also made that the capabilities of producers for implementing different investment strategies e.g. related to the use of derivatives should be monitored over time for example on a periodic basis by the competent authorities. Developing harmonized product frameworks, when appropriate In addition, implementing harmonized frameworks at EU level for investment products which are regulated domestically and may have a cross-border potential (e.g. some non-ucits retail 14 The use of derivatives extended by UCITS III has been a major driver in the sophistication of UCITS funds. Up to 100% of investment returns can now be derived from derivative instruments within a UCITS fund and most hedge fund or absolute-return strategies can be replicated within UCITS III fund structures (such funds are usually labeled as newcits ). This of course broadens considerably the scope of strategies accessible with UCITS, answering investor demands for guaranteed capital products or for funds which facilitate exposure to more diversified market segments, but increases exposure to counterparty and liquidity risks in addition to market risks and augments the complexity of pay-off mechanisms. 6

7 APPENDIX 1 Mapping of existing product and distribution rules for packaged retail investment products Approximate volumes (AuM) Product regulation Issuer / manager regulation UCITS Non UCITS funds 5600 Bio 2300 Bio Unit-linked life insurance policies 1650 Bio (2) UCITS IV / V Domestic regulations Consolidated Life Directive UCITS IV / V AIFMD for those managing non retail AIF Consolidated Life Directive Solvency II Retail structured products Structured term deposits ~ 500 Bio tbc Domestic regulations Transparency Directive CRD Domestic regulations CRD PRIPS KID Rules on product information Pre-contractual disclosure UCITS KIID MiFID (1) MiFID (1) Life Directive IMD (1) Prospectus Directive MiFID(1) No rules at EU level at present E-commerce Directive or Distance Marketing of Financial Services Directive Selling rules MiFID UCITS Directive MiFID IMD MiFID Domestic regulations and codes of conduct MiFID 2 No rules at EU level at present E-commerce Directive or Distance Marketing of Financial Services Directive (1) High level product disclosure requirements and principles (2) Around 30% of total life insurance 7

8 APPENDIX 2 Existing investment product distribution structures across the EU: Generally speaking there are three main kinds of distribution in the EU: Open architecture where investors are offered a large choice of products from different manufacturers Guided architecture where a distributor (usually a bank) offers the products of a restricted number of firms (including inhouse products possibly) that it has pre-selected as being suitable Integrated distribution where distributors sell exclusively (or nearly so eg except in private banking) their in-house products. The predominant model in Europe at present is integrated distribution with banks and insurance companies distributing the products of their asset management subsidiaries. Estimates are that captive distribution (of in-house products) represents around 67% of investment fund sales with third-party funds amounting to the remaining 33%. The distribution of third-party funds was growing slowly in most countries before the crisis - mainly in the private banking area, through wrappers (unit-linked life insurance contracts or fund of funds), fund distribution platforms, but also independent financial advisors (IFAs). Thirdparty product distribution is now stabilizing with many reports of banks cutting back on external providers, The possible sale of some asset management divisions by banking groups may however modify these evolutions in the future leading to less integrated distribution and a stronger development of guided architecture models. products distributed. Commissions indeed play a more limited role in possible conflicts of interest at present in these countries, since in many cases the investor is not offered a choice between different providers in the first place or the presence of third-party products is marginal. - The allocation of financial assets held by households also varies strongly at present across EU countries, showing differences in preferences, financial literacy, practices The share of deposits for example ranges from 15 to 70% across European countries and the share of securities ranges from 10 to 40%.m - In some EU countries such as the UK, IFAs who offer products from a range of different producers have a strong market share of investment product distribution (in the same way as in the US). IFAs represent around 50 to 55% of the distribution of investment funds in the UK, compared to an EU average of approximately 10%. The UK Retail Distribution Review (RDR) rules, due to enter into force by 2013, will impose a ban on third party commissions to mitigate possible conflicts of interest both for independent advisors and for restricted advisors (who provide advice on a restricted range of instruments or advise on their own products such as bank advisors or tied advisors). A similar ban of commissions is envisaged in Denmark and the Netherlands and several other EU and non-eu countries. - In most European countries banks (and to a much lesser extentinsurance companies) dominate distribution representing 60 to 70% of investment fund distribution. Much of this distribution is integrated particularly in Spain and France, although guided architecture with a restricted offering of third-party funds has developed in Austria, Germany and Italy for example. The solutions put forward by regulators in these countries tend more towards ensuring that transparent information is provided to investors regarding the way remuneration is managed, payment structures and the 8