The three European Supervisory Authorities (“ESAs”) are responsible for drafting various technical standards in relation to the PRIIPs regulation (Regulation (EU) 1286/2014) (the “Regulation”), for consideration by the European Commission. At the end of June 2015, the ESAs published a technical discussion paper, which focused on the possible methodologies for presenting some of the key indicators required to be contained in a Key Information Document (“KID”) under the Regulation, namely risk indicators, performance measures and costs.
The ESAs do not set forth any firm recommendations at this stage. Instead, they are more interested in market views and feedback on the options presented in the discussion paper.
Types of Risk. In relation to the presentation of risk indicators, the focus is on three key areas of risk – market risk, credit risk and liquidity risk. The ESAs have narrowed down the possibilities to what they consider to be the four viable options:
- a qualitative based indicator, combining both credit risk and market risk;
- an indicator which separates market risk (in respect of which a quantitative measure of 1-7 could be applied based on volatility) and credit risk (where a qualitative measure, rated A-G based on external credit ratings could be applied);
- an indicator based on quantitative market and credit risk measures, calculated using forward-looking simulation models; and
- a two-level indicator in which the first level would distinguish between products in a very broad manner (e.g., those where capital is at risk versus those which have capital protection), while the second level would provide investors with more granular insight into information provided in the first level. The first level might differentiate based upon product characteristics, while the second level might differentiate based on quantitative measures.
The second option has the support of the Structured Products Association in the UK. However, the Regulation itself refers to a “summary risk indicator” in the singular, and the ESAs state that they are still discussing whether a separate statement of market and credit risk would satisfy this requirement. The third option has the support of the German structured products industry (among others), with one possible approach within this third option being based on an approach used by the German industry since 2005.
Performance Risks. In relation to performance, different possibilities are provided to demonstrate how a PRIIPs manufacturer could potentially represent the performance of their structured product in a KID. One possibility is a “what-if” scenario, which would show the investor what could happen to the product under certain pre-determined market conditions. Within this scenario, there is the possibility either of permitting the manufacturer to determine what the scenarios should be, or alternatively, for the ESAs to prescribe the scenarios for use by all manufacturers for all types of products. Another approach is the so-called “probabilistic approach”, which involves defining the scenarios in accordance with the likelihood of the possible returns. A third option is to combine the first two approaches.
Investor Costs. In relation to costs, the discussion paper follows two primary considerations – firstly the identification of the different types of costs which are applicable to PRIIPs products, and secondly, developing appropriate methodologies for aggregating identified costs, so that they can be presented in the form of a single overall cost ratio (or a summary cost indicator).
Since the cost components of structured products are often embedded within the product’s purchase price, the ESAs consider that there are two different possible approaches – firstly to introduce a distinction between the price of the investment and the margin/fees incorporated in the price (such as sales commission and structuring costs), or secondly to make disclosure of costs based upon the “fair” or “intrinsic” value of the product, i.e. the value of the liability on the manufacturer’s balance sheet when the product is sold. Needless to say, the second approach is similar to the approach adopted in 2013 by the U.S., and more recently, by Canadian regulators.
The ESAs have identified the following types of costs as being potentially relevant – entry costs, ongoing costs, exit costs, early redemption costs, and possibly other costs –An example, the ESAs suggest, is the loss of interest on the amount invested between the purchase date and the commencement date for the product (as is relevant to the purchase of virtually any debt security).
In terms of aggregating the costs to create one or more cost indicators that would aid comparison of products, the ESAs have suggested two possibilities – firstly a total cost ratio, where the costs of operating the product are aggregated and presented as an annual percentage rate on the investment, or secondly, showing the reduction in yield, which is a method of expressing the overall impact of total costs in terms of their reduction in the gross yield of a product.
What’s Next. The ESAs intend to carry out a final consultation, setting out their proposed draft Regulatory Technical Standards, in autumn 2015. Following this, they will finalise and submit the draft Regulatory Technical Standards to the European Commission by 31 March 2016. The Regulation will take effect at the end of 2016.