The European Union's Priips rules imposed new pre-contractual disclosure requirements on investment providers and distributors that are supposed to be for the benefit of retail investors when they are considering the purchase of packaged retail investment products or insurance-based products.
The 23-page paper, titled Call for Input: Priips Regulation – initial experiences with the new requirements, also revealed a lot about the concerns the FCA has about whether Priips and Mifid II have made investment products clearer and easier to grasp or more confusing to understand for the average investor.
Here are the four key takeaways from the FCA’s Priips paper.
1) Rules could have hampered launches
Apparently despite producing thousands of words on the subject, some investment providers are still unsure what products have to meet Priips rules.
The FCA has previously published a list of products that it considers fall within, or outside, the definition of a Priip such as investment funds (whether regulated or not), structured products and structured deposits, derivatives, certain non-pension annuities and several insurance-based investment products.
However, the regulator revealed reports from market participants suggested despite the existence of this list it may not always be clear whether certain investment products are Priips – in particular, whether certain corporate bonds (such as corporate bonds with ‘make-whole’ clauses or callable bonds) are in or out of scope.
As there are penalties for non-compliance with the legislation, to manage this non-compliance risk, the FCA stated recent bond market data had indicated that investment firms might be avoiding issuing certain corporate bonds to retail investors in the primary market in a bid to avoid the regulator's wrath.
The FCA also found distributors are stopping sales of certain corporate bonds to retail investors in the secondary market due to fears they could run into problems.
As a result the FCA is asking what more it can do to clarify what kind of products are and aren’t covered by the Priips rules.
2) Risks of risk disclosure uncovered
Priips regulation requires the key information document (Kid) to include a section titled ‘What are the risks and what could I get in return?’
A summary risk indicator (SRI), supplemented by a narrative explanation of that indicator, has to be included as well as a standardised risk score between one and seven, which is based on quantitative analysis.
The SRI uses different methodologies to calculate the risk score, depending on the characteristics of the product and whether the product has a performance history.
The main methodologies estimate the risk based on historical changes in the price of the product, or on some other factor on which the product’s return is based or may be assumed to be based.
Firms are also required to describe the other main risks that are not included in the SRI, but this is limited to 200 characters.
In a proclamation that would surprise no one, some product providers have raised concerns with the FCA that the "SRI might, in some cases, be misleading."
This may be because either the risk of the product does not appear to be adequately captured by the SRI, or the product has a significantly different SRI from other economically equivalent products.
The FCA has now asked for examples of products where the prescribed methodology for assessing and presenting risk leads to a counter-intuitive or potentially misleading SRI.
3) Investment providers struggle with calculators
The calculating transaction cost requirements under Mifid II are less prescriptive than under Priips in relation to the methodology for calculating these costs.
So the regulator found many are using the Mifid II methodology and while most funds were reporting small positive transaction costs, about 5 per cent of funds reported zero transaction costs, and a small number of funds reported negative transaction costs of less than minus 0.1 per cent.
This must have raised eyebrows at the regulator as they decided to test some calculations and "found significant calculation errors".
When these were corrected by the watchdog, the FCA found overall portfolio transaction costs for these portfolios were positive.
The regulator stated subject to the feedback it gets, and if appropriate, it will consider running workshops to support firms with their compliance activities in relation to these requirements.
However where the FCA spots non-compliance with the requirements, the regulator stated it will consider appropriate supervisory and enforcement action.
You have been warned.
4) Providers struggle to review performance
Firms are required to include appropriate performance scenarios in the Kid, together with information about the assumptions made to produce them.
One scenario simulates possible outcomes by considering the returns, and fluctuations of those returns, over the previous five years.
The moderate performance scenario is based on the average return.
The favourable and unfavourable scenarios reflect the ninetieth and tenth percentile returns, respectively, from the simulation.
The stress scenario is calculated according to a slightly different model.
The FCA revealed it is now aware of two issues about performance scenarios.
Examples where a product has experienced returns over the previous five years that are above the long-run average return, or what might be a reasonable expectation of future return, have been flagged with the watchdog.
In this case, the FCA has found the moderate performance scenario can give an unrealistic picture of the likely future return of the product and even the unfavourable scenario might also show an optimistic outcome.
Also, while the presentation of the scenarios, and the accompanying narrative, explains that they are not a forecast of future return, and that they are intended to be illustrative, the FCA now admits a consumer might assume that they are at least to some extent indicative of the potential return that might be derived from the product.
As a result the performance review could leave investors with the wrong impression of potential rewards on offer.
While the FCA has already stated providers with concerns that the performance scenarios in a particular Kid may mislead their clients can provide additional explanation as part of their communications, it is now also asking if they can report any practical issues with the calculation and presentation of performance scenarios.
The watchdog is also asking if consumers using Kids are struggling to make sense of performance scenarios.
emma.hughes@ft.com
