SHOULD STRUCTURED PRODUCTS BE DEFINED AS COMPLEX OR NON-COMPLEX?

Transcription

1 SHOULD STRUCTURED PRODUCTS BE DEFINED AS COMPLEX OR NON-COMPLEX? - Finnish Structured Products Association s opinion

2 1. Background The article 38 of the Implementation Directive defines the terms "other non-complex financial instruments" in the fourth line of the first indent of Article 19(6) of the MiFID as follows: "A financial instrument which is not specified in the first indent of Article 19(6) of Directive 2004/39/EC shall be considered as non-complex if it satisfies the following criteria: 1. It does not fall within Article 4(1)(18)(c) of, or points (4) to (10) of Section C of Annex I to, Directive 2004/39/EC 2. There are frequent opportunities to dispose of, redeem, or otherwise realise that instrument at prices that are publicly available to market participants and that are either market prices or prices made available, or validated, by valuation systems independent of the issuer; 3. It does not involve any actual or potential liability for the client that exceeds the cost of acquiring the instrument 4. Adequately comprehensive information on its characteristics is publicly available and is likely to be readily understood so as to enable the average retail client to make an informed judgment as to whether to enter into a transaction in that 1. General conclusions The Finnish Structured Products Association (SSS ry) sees that most structured products fulfil the requirements mentioned above and the starting point should therefore be that structured products are non-complex products. In this statement the association has not wanted to be too specific, but instead give a general guidance how it sees the complex / non-complex issue of structured products. The association is willing to give detailed opinions and arguments of the issues described generally in this paper. Another fact that supports this approach is that structured products or index-linked bonds do not embody a derivative component. One common misapprehension is that they do. However, the form of structured product investment is usually either a deposit or bond. The payout of these instruments is often dependent on some underlying index and the issuers may hedge this risk using derivatives or other positions or even leave the risk unhedged. This means that the actual investment vehicle does not include a derivative component and banks are not necessarily using derivatives to hedge the underlying risk, even though there are features in structured products that resemble derivative like behaviour. When deciding the complex / non-complex question, one important criterion is that all product types, mainly funds and structured products are treated equally. If this does not take place, the inferior product will disappear from markets within a certain period of time. This would lead to a situation where either funds would be

3 wrapped into structured products or structured products into funds, which would not be beneficial to any market party. Because listed shares and UCITS funds are considered as non-complex products, this also supports the fact that most of the structured products should fall into this category regarding risk and complexity as well. However, because the range of structured products regarding complexity, risk, the level of dynamics etc. is very broad, SSS ry sees that part of the structured products should after all be defined as complex products. There should be very clear rules, which products are placed as non-complex and which as complex products. SSS ry s opinion and criteria s are described in chapters 3 and 4. The association sees the fundamental split between complex and non-complex products should depend on two features; the complexity of the product and the risk level of the product. To make the definition of complexity more straightforward, possible dynamic elements would make the product complex and static products would be handled as non-complex, in case also the risk level definition supports this approach. SSS ry suggests that there are two levels of criteria and the product needs to fulfil both in order to be treated as non complex. 2. Risk factors Criteria regarding risk in complex and non-complex products: Complex products: All products where the investor might loose more than the invested capital should be treated as complex products. All products where by default the invested capital is not paid back at maturity should be treated as complex products, i.e. products where the investor does not receive the notional back in any circumstances All products that have not at least monthly liquidity All products with non-investment grade issuer or CDO tranche All products where the return of the capital is dependent on the development of the underlying should be complex, if o the diversification of the underlying is not sufficient o in some circumstances the payout is less than in the underlying index ie. leveraged down side risk. o the final notional payout is dependent on complex variables such as recovery ratio in collateralized obligations Example 1: The notional is returned if the index change is positive during the is reduced from the notional. The underlying index is one single share. Example 2: The notional is returned if the index change is positive during the multiplied by 2 is reduced from the notional. The underlying index is global world basket.

4 Example 2: The notional payout in equity tranche is dependent on recovery ratios of defaulted corporations. Note: Subscription costs or price above par up to 15 % does not affect the classification of structured products. Also, the dividend yield does not affect the classification. Same downside multiplier of 1.0 should be applied to both price and return indexes. Non-complex products: The risk aspect and the rationale above would mean that all notional capital protected products would fall under non-complex products. Also all products where the return of the capital is dependent on the index development with sufficient diversification and with maximum of delta 1 downside risk would be defined as non-complex. Example: The notional is returned if the index change is positive during the is reduced from the notional. The underlying index is a world index basket. 3. Dynamic factors Criteria regarding dynamic features in complex and non-complex products: Complex products: All products, which do not include dynamic features, should be defined as noncomplex products with the assumption they fulfil the risk criteria. Following features are seen as dynamic: o Rolling option strategies, where the volatility and other parameters of the derivative are not known at the time the product is launched o Products, where the leverage on underlying varies dynamically during the life of the product depending on the performance of the underlying or other parameters o Products where the underlying may be changed during the life of the product based on the development of the underlying or other parameters or options where underlying asset can be replaced in any circumstances with other asset o All products where there are some dynamic asset management type of features like trend following strategies where weights of underlyings changes based on their past performance Exception to the above mentioned, would be products where the underlying or weighting of the underlying is fixed on the maturity date or on predetermined observation dates based on simple rules should be considered as non-complex. Example: the best performing index gets 50% weighting, the second best 30% weighting and the third best 20% weighting. Note: if these complexity rules are artificially avoided by building the dynamic feature into the index, it is still seen as dynamic product, even though the investment on the dynamic index was passive it self. However, normal index adjustments based on e.g. market weightings by the index sponsor are not seen as dynamic feature.

5 Non-complex products: All static products would fall under non-complex products in case they fulfil the definitions regarding risk criterions. Only very simple dynamic features could be accepted as non-complex, like described in the last paragraph of the previous chapter. In these cases the pay out formula of the product must be known at the time the product is launched in an understandable format. Note: The seller of the structured bond should disclose whether the product in question is defined as complex or non-complex product in the loan documentation. Contact details Antti Parviainen Chairman of the Association Tel Antti.parviainen@nordea.com Jyrki Iisalo Vice Chairman of the Association Tel jyii02@handelsbanken.se