The EU Maelstrom Gives Birth to Yet Another Headache

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  Thomas Wulf
  

Until the end of May, most people following EU developments still hoped that the Retail Investment Strategy would be derailed by some divine or institutional intervention. The asset management associations of five major EU countries scrambled at the last minute and, in a desperate effort, begged their ministers of finance to vote against the roughly 150-page legislative package put forward for approval at the last Council meeting under the Cypriot Presidency. Finally, though, to no avail. Only Poland had the guts to vote against, standing by what its government has consistently decried in the many working groups before unusually bluntly. Their point was that the absolutely last thing the EU’s internal market currently needs is another heap of red tape making selling financial products to retail even more cumbersome and administration-heavy without addressing any of the underlying reasons why EU retail investors are so reluctant to invest. 

Despite many interventions from national governments and other stakeholders outside industry circles, the hard-to-argue buzzword of “Value-for-Money” was made the holy banner under which the Commission services would go on a crusade for an agonizing 36 months. They were, until the last weeks of negotiating the RIS package, hoping to find a magic formula that would allow them to calculate, across payoff features, investor preferences and product wrappers, whether a financial product was “worth the money invested” – but to no avail either. 

As has been pointed out many times, the mere idea that it is possible to quantitatively evaluate each aspect of a financial product by benchmarking it against an abstract golden line or a peer group average to find “outliers” is widely seen as bound to fail given the myriad of aspects relevant for individual investors to be priced coherently. Such a concept is fundamentally rooted in an ill-guided thinking that dates back to the last decade of the previous century when the Commission tried to run over whatever differences there were with a one-size-fits-all solution in the endeavour to make things more European. That trying this in the complex area of retail products also massively discredits the activities of many national regulators, always very alert and active on this side of markets, dawned upon the Commission only very late in the process. It did not contribute to ESMA’s enthusiasm on the file. 

All this being said, the Brussels wheel could not be stopped in the end. RIS is coming and we have to deal with it. We are waiting to see, in the area of banking products alone, more than 20 topical challenges addressed by secondary legislation in the format of the so-called Delegated Acts and, as some will remember from the PRIIPs Regulation of 2014, the famous Regulatory Technical Standards (RTS). Drafts for both will have to be prepared by the EU’s regulators (ESAs), led by ESMA and EIOPA, the capital markets and insurance ones. They will cover peer group comparisons, benchmark calculation, appropriateness and suitability refinements, risk alerts, pricing process governance (yes, you read that correctly, the EU is inching towards a tight corset of de facto price regulation in the area of financial retail products), cost and charges disclosure as well as cross-border reporting among other matters. No one has an idea yet how this overload of information generated at the customer and regulatory end is to be sensibly collected, monitored and acted upon. When asking the question, one usually encounters shrugged shoulders and “AI?” as a standard response. Looking at the product through the RIS prism this edition is dedicated to, Actively Managed Certificates, a few issues quickly come to mind. 

First of all, AMCs are relatively unknown to the wider regulatory world. There have been discussions in France and Switzerland about this product type in the past while the instrument may actually be new to many other markets (and thus national regulators). One prime concern will obviously be to make sure investors understand what they are buying. Clear communication from the issuer and distribution side will be crucial to help retail customers grasp that the active component of an AMC sits with the issuer-side recalibration of the proprietary index that the AMC note tracks as a Delta-1 instrument and that it is not linked to a the active rebalancing of a share portfolio as known from the fund world. Should regulators not be satisfied they may impose specific wordings for the marketing material, as is the case now already. This area may see increased scrutiny though as the new RIS rules will lower the opt-out threshold from the MIFID retail client category from EUR 500,000 to EUR 250,000 (while also adding a few investor behaviour-related criteria). Regulators will likely zoom in on products that are more frequent in the sphere of knowledgeable investors (as AMCs undoubtedly are) with the access depending on the application of the MIFID opt-out threshold (as in Belgium, for example). 

But the far bigger issue is Value-for-Money. While the exact methodology to be used for comparing structured notes and checking their cost and performance against a peer group is is not yet known under the current RIS framework (ESMA will have to come up with the draft for this) , we do know that each recalibration of an index will trigger a cost. Now, the big question is to what extent such costs, which accrue over the lifetime of the product, may endanger the profitability for investors. Of course, recalibrations are (and should be) undertaken primarily to improve the underlying’s performance. However, regulators may quickly point out potential conflicts of interest, in particular if the fee policy for external advisors handling the index management is not sufficiently transparent. They may also feel tempted to question any situation where there was no discernible reason for or any impact of the recalibration of an index on the performance of the AMC. Clear internal rules, maybe reinforced through an association level industry agreement as already exists in Switzerland, may help here to contribute to the discussion at EU level on how specifically VFM applies to AMCs, going forward.

Another challenge in the Value-for-Money debate hides in the mentioned peer group comparisons, should it be decided in the final RIS implementation rules that such are required also for AMCs. There, the question inevitably arises whether the appropriate peer product for an AMC would be an actively managed fund rather than another (structured) note or bond instrument. Arguments can be made for both while the ultimate decision may be quite significant for the market success of these instruments.

Last but not least, a brief word on the enforcement of all of the above. Once again, things fall apart in a way typical for Brussels-originating legislation – it all depends. While national acts transposing the RIS Directive may come into force realistically only with a delay of 30 months after the legal act has been published and the Delegated Acts have to be drawn up (followed by a waiting period), the PRIIPs rules may come in a bit faster, while also here the application depends on the RTS, where relevant, coming into force first and, thankfully, a waiting period of 12 months has elapsed. A silver lining of the otherwise grey RIS may be that these timelines should give the industry ample time to become actively involved in the debate. 

With that I remain, with relentless optimism and best wishes for the summer,

Your Brussels observer

Thomas Wulf

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Thomas Wulf
Secretary General of EUSIPA

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The views presented in this article are solely those of the author and reflect his personal opinion.