FSA guidance on structured products sparked by concerns over product complexity

Alarmed by the temptation that investments such as structured products can create in a low interest rate environment, the UK Financial Services Authority (FSA) has offered further stringent direction and limitations on issuer practices in a guidance note published on November 2.

The FSA's proposed guidance follows an investigation of seven major providers of structured products, responsible for 50% of the products in the UK retail market by volume and value. Conducted between November 2010 and May, the regulator said its investigation revealed that, "while there had been some improvements, weaknesses remain in the way firms are designing and approving structured products - increasing the risk to consumers. Firms tended to focus on their own commercial interests rather than consumer needs".

While brash statements about the perils of structured products were made by FSA chairman Adair Turner in a speech in London on October 20 at Mansion House, the regulator has now specified its concerns as based on the increasing number of products being sold as well as a rise in product complexity, which it suggests is putting a strain on systems and controls.

According to Simon Gleeson, a partner at Clifford Chance in London, speaking at the Structured Products UK conference on November 3, there is likely to be more of an emphasis on product manufacturing rather than plain distribution in light of the FSA guidance note. "When you get to the sharp end of enforcement, the regulators' default setting still seems to be to blame distribution where it can and to shy away from criticising manufacturers," he said. "But sooner or later we will get enforcement based almost exclusively on the structure of a particular product. Although there is still a lot of terrifying wording being waved about in the context of product design that isn't quite being followed up yet by actual enforcement, I'm sure it will be."

Further reasons for the regulator's alarm include the discovery that firms displayed a "lack of clear strategic purpose in manufacturing structured products, or at least were unable to articulate a coherent strategy". The FSA also pointed to a lack of robustness in product development and marketing processes, which it perceives increase the risk of poorly designed products and, therefore, mis-selling. "We believe this [lack of robustness] fed into [issuers'] product ranges, which we felt were disproportionately influenced by pricing and market pressures," the FSA told structured products bankers and lawyers at a Joint Associations Committee (JAC) meeting on November 18. The FSA was represented by a team of four led by senior associate Richard Lawes.

When you get to the sharp end of enforcement, the regulators' default setting still seems to be to blame distribution where it can and to shy away from criticising manufacturers

"We were specifically asking the FSA about extraterritorial application, because this is not regulation at the point of sale but of the legal entities doing the product structuring," says Tim Hailes, chairman of the JAC. "If you create products with locally regulated legal entities in the UK and then sell them in Germany, under this guidance you will apparently be caught. The FSA expressed the opinion that a different interpretation would be ‘wrong'."

Calling for clarity

Other market participants speaking at the Structured Products UK conference expressed the need for greater clarity as to which institutions the review was aimed. "The review needs to clarify the issues that relate to each of the parties in the business," says one London-based plan manager. "The guidance is trying to cover the industry too widely." A London-based banker adds: "It's not clear who the FSA is talking to and why they say they will deal with distributors separately."

The guidance note published on November 2 came a day after the UK regulator and the Office of Fair Trading jointly published a first note about product design. The guidance was for a consultation aimed at firms that are developing or planning to develop protection products similar to payment protection insurance.

The latest guidance confirms a change in tack adopted by many regulators in Europe at the beginning of this year when statements and promised legislator action changed radically from disclosure requirements to the more aggressive intervention that would allow them to investigate and scrutinise products at the point of creation.

The FSA identified risks from ‘light' product approval, including a lack of clarity as to what constituted a new product, with controls often relying on the discretion of individuals. And the regulator outlined its concerns over its detection of the increasing complexity of products based on a "shift towards products that related payoffs to exotic or proprietary indexes and used complex payoff profiles without clear consideration of whether these would genuinely benefit consumers".

Furthermore, the FSA uncovered variations in the quality of stress testing. "We saw some evidence of comparisons of products to cash returns, but these were generally assessed against low hurdle rates," stated the regulator in the November 18 meeting.

But the validity of the regulator's stress-test simulations has been called into question. "If you look for academic papers on the validity of testing financial products by simulation, you won't find anything," says a London-based banker. "Everything says you should use a financial time series. I fail to understand how anyone can argue it's not a valid way of testing a product. Any idiot can sit down with a structure and ask ‘what would I get back if the market fell 80%?', and I'm not sure how that adds any value."

The few positive statements that the regulator had to offer market professionals included those about an improvement in the overall quality of financial promotions since its previous assessment - Fair, clear and not misleading - review of the quality of financial promotions in the structured products marketplace - which it published in 2009. The caveat was that the further shift towards more complex payoff profiles and product shapes has "increased the risk of consumers misunderstanding and, therefore, of mis-buying and misspelling".

The London-based banker says: "It's good to see the FSA recognises that there are people who are doing it properly and, if there are people who aren't testing products properly, if the FSA wants to give them a kick, I'm not going to stand in their way because it lets us all down."

The findings from the investigation of the UK firms also revealed that firms tend to measure the performance of their distributors in sales volumes rather than "fair customer outcomes", while the training the same firms offered to distributors was "variable" and a "number of firms relied on financial promotions to provide distributors with product information, which, as a result, was inadequate".

While the question of fees was not directly dealt with by the FSA in its November 18 presentation to market professionals, views on this subject were revealed at the Structured Products UK conference. "The FSA thinks advisers should effectively charge on the same basis that lawyers do," said Gleeson. A natural consequence of such an approach could be to abolish advised sales in the UK because investors do not pay for advice as a separate concept. "Once you've gone down this route, things that are going to be permitted to be sold have got to be in a closed and locked garden," he said. "How we get into that garden is going to be the big issue of the next few years. And this is not just a UK quirk, this is where the European market is going."

For the meantime, the FSA has offered market participants some insight into its views on product complexity - a subject that has been thrown into a new light in Europe since the decision taken by Belgian regulator the Financial Services and Markets Authority to put a halt on almost any element of a product that could be deemed complex. The FSA told market participants at the November 18 meeting that, while it believes complexity, especially in a payoff, can make it harder for investors to understand a product, it does [not] automatically assume that complexity equals greater risk.