The UK’s Financial Conduct Authority (FCA) has published its Occasional Paper No. 9, setting out the results of the FCA’s research into how well customers understood structured products. The answer, according to the report, is not very well.

The report found that, while investors’ expectations of growth in the FTSE were in line with the FCA’s assumptions, investors overestimated the likely returns on structured products based on the same indices.

In addition, investors did not fully understand how certain structured products worked and were therefore unable to compare them with alternative products. This, the FCA suggests, emphasises the importance for those firms developing structured products to ensure that the products are appropriate for the level of sophistication of the investors they are targeting.

In particular, the FCA highlighted a number of areas of concern:

  1. Senior management need to ensure that customers’ interests are the primary driving force in corporate governance. This should be read in the context of the strong message that the FCA has been sending in relation to holding individuals personally accountable for any failings. Although the stats on action against individuals(subscription required) might suggest that this is still just rhetoric.
  2. The products need to “have a reasonable prospect of delivering economic value”. Although this sort of wording leaves the FCA plenty of discretion to determine exactly what “economic value” means in practice, the FCA made it clear that firms will be expected to have carried out robust stress testing on the products and be able to produce evidence to back this up.
  3. Firms must ensure that customers are provided with clear and balanced information on the product and any risks. This clearly fits with the FCA’s finding that customers found it difficult to understand how products worked. It will impose at least two requirements on firms. The first will be to ensure that products match the level of sophistication of the customer. Secondly, firms must strike a delicate balance between providing customers with all the information they need, without overloading them to the point where they cannot take it all in.
  4. Firms must ensure that any third parties selling the products to customers have sufficient information about the products to sell them appropriately. This again reinforces the need for the firms creating the products to keep the interests of the end customer at the front of their minds.

The findings of the FCA on structured products should be viewed in the context of both the product governance requirements which will be imposed on firms creating and distributing investment products by MiFID II, and the various requirements under the EU Packaged Retail Investment Products initiative.

All of these factors make it clear that firms which create or sell structured products will need to ensure that the products are a good fit for the customers’ needs, and that products are accompanied by an easy-to-understand explanation of how they work and what the potential risks are.

If not, firms and their senior management run a serious risk of having action taken against them by the FCA.