The twin issues of the complexity of some investment products and how to protect investors from taking on risks they do not understand properly have been around for a long time. The latest Markets in Financial Instruments Directive (MiFID II) has thrown them into sharp focus, as compliance with the regulation is now mandatory.
MiFID II requirements are a delegated regulation and must therefore be implemented by national regulatory authorities – the FCA, in the case of the UK. So, what is MiFID II’s definition of ‘complex’ and what is deemed ‘appropriate’?
The definition of ‘complex’Following the call for greater clarity, the European Securities and Markets Authority (ESMA) issued an opinion in February 2014 –
ESMA/2014/146 – which states, in section 9: “For the purposes of this opinion, complex products/financial instruments are those that do not meet the criteria of ‘non-complex’ as set out in Article 19(6) of MiFID and Article 38 of the MiFID Implementing Directive. Financial instruments with structures that make the risks and likelihood of return more difficult to understand, including platforms giving access to complex products, are also likely to be considered ‘complex’.”
A key feature is that products “should generally be considered complex” if they are made up of or compounded by financial engineering involving derivatives, indices, structures which obscure a clear view of how they are put together or work in practice or what return an investor can expect.
Suitability and appropriatenessWhat does ‘appropriate’ mean? Again, the opinion is lengthy, but, in essence, before an advisory firm advises clients on a complex product, it should carry out due diligence into it according to a variety of risk and reward criteria to establish whether it is suitable.
Firms should also assess the client’s knowledge and experience of complex financial products. This particularly applies to execution-only product sales where clients have to make their own investment decisions without advice.
And it applies to Undertakings for Collective Investment in Transferable Securities (UCITS) products that are not structured products.
The FCA conducted several consultations on the implementation of MiFID II and its 1,000-page policy statement –
PS17/14 – is its final set of rules on the conduct of business and client assets, among other things.
Essentially, it says that where the definitions in the MiFID II regulations are not clear, sellers of products that might be deemed to be complex should err on the side of caution. This seems to suggest that they should treat these products as if they were complex and carry out due diligence into a client’s knowledge and experience accordingly.
A concise roundupThe key FCA document to look at for a concise(ish) roundup of when a product is appropriate or not is section 10 of the FCA
Conduct of Business Sourcebook (COBS) in the FCA Handbook.
To summarise, the FCA explains that a financial instrument is non-complex (10.4.3) if it is not a derivative or other security that depends upon a separate rate, yield or measure to determine the investor’s right to buy or sell it. The instrument must be liquid and can be priced against independent, publicly available market data.
The client is not liable for any other costs than those involved in acquiring the instrument. The information available to the buyer before buying is publicly available and enables the “average retail client” to make an informed buying decision.
However, some products defined as non-complex are in fact complex and some complex ones may be relatively simple. For example, shares in major listed companies are not deemed complex. However, most major companies use derivative instruments and/or leverage, the risk of which an investor may therefore be exposed to by proxy.
Structured products are regarded as complex although they may simply track an index and state clearly what the returns will be under different scenarios.
A with-profits fund is categorised as a non-complex product, although its price may be based on actuarial smoothing and annual bonuses rather than actual market levels.
The best course of action could be to assess each product and each customer on a case-by-case basis, at least until the current MiFID II compliance fog has lifted, but the administrative work involved could be very onerous indeed.
Seen a blog, news story or discussion online that you think might interest CISI members? Email bethan.rees@wardour.co.uk.
The full version of this article appears in the Q3 2018 print edition of The Review. All members, excluding student members, are eligible to receive the quarterly print edition of the magazine. Members can opt in to receive the print edition by logging in to MyCISI, clicking on My account, then clicking the Communications tab and selecting ‘Yes’.
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