The Global Financial Crisis prompted re-thinking of the fundamental settings of the regulation of financial services and products in Australia. Financial product design controls and a duty of suitability for product issuers were proposed. These proposals were seen by some as a threat to innovative structured financial products.
The reforms that have been implemented can, however, be characterised as moderate incremental reform, directed at refinement of existing regulation. Consequently, the structured financial product market will continue to develop in Australia, albeit shaped by a new investor conservatism and an increased focus on adequacy of disclosure.
This article outlines important recent and future reforms that will impact on the way structured products are designed and sold in Australia.
In response to the Storm Financial and Opes Prime collapses, in 2009 the Parliamentary Joint Committee Inquiry into Financial Products and Services examined proposals to fundamentally change the way financial products and services are regulated in Australia. These included prudential regulation of a greater range of financial products, product design prohibitions or limitations, a duty of product suitability for product issuers and ‘licensing’ of investors. The reforms that have been implemented to date, as outlined below, are more consistent with the position of the Australian Securities and Investments Commission expressed in 2009: “ASIC does not consider that recent events and issues raised by the Inquiry necessarily justify a fundamental review of the policy settings and underlying economic philosophy of the [existing Financial Services Reform] regime.” 
A focus on disclosure
Capital protected products. With the aftermath of the GFC causing investor flight to safety, the notion of capital protection was an attractive option for many retail investors. Structured products such as ’deferred purchase agreements’ (in substance a form of over-the-counter derivative), and managed funds, with capital protection features flourished.
The complexity and limitations of the capital protection provided by these products prompted an ASIC review of retail disclosure documents in the market. ASIC identified a number of areas of concern, and in a number of instances required product issuers to amend their disclosure documents. The key findings of ASIC’s July 2010 report included:
- disclosure of complex products needs to be more effective, through the use of diagrams and the use of realistic examples, limiting the use of defined terms and giving appropriate prominence to both risks and benefits of the product
- counterparty risk needs to be clearly disclosed, and include supporting financial information
- the conditions attached to capital protection, such as early termination and discretionary powers, must be explained with adequate prominence
- for products structured as feeder funds, ASIC identified a deficiency in the level of disclosure of the underlying investments, with particular concerns relating to underlying investments located outside Australia
- there is a need for improved disclosure of the break costs for exiting the investment early. If it is not possible to include an estimate of break costs in the offer document (as is often the case), it is acceptable to include a description of the factors affecting break costs, a statement that an estimate of break costs will be provided on request and a risk warning concerning break costs. Overall, these requirements were accepted by the industry and in many cases were already met by product issuers.
Hedge funds. Hedge funds have been a clear focus of increased regulation around the world following notable failures during the GFC . Australia did not escape hedge fund failures and the size of the industry in Australia is significant, despite the general perception that it is less developed than in offshore markets such as Europe.
In February 2011, ASIC issued a Consultation Paper seeking feedback on a set of ten hedge fund disclosure principles and benchmarks.
The first challenge faced by any reform directed at hedge funds is to formulate a suitable definition, as the investment strategy of hedge funds is incredibly diverse. Not surprisingly, ASIC proposes a general substance over form definition. It is proposed that the disclosure principles and benchmarks apply to “any registered managed investment scheme that is, or has been promoted as, or is generally regarded as: (a) a hedge fund; or (b) a fund of hedge funds”. ASIC then lists the following factors as relevant to this question: the use of a complex investment strategy (eg to generate absolute returns); derivatives; leverage; short selling; and exposure to diverse risks and complex underlying products. If there is uncertainty whether a fund is captured, ASIC expects compliance with the proposed principles and benchmarks. ASIC’s definitional approach will inevitably create uncertainty for some funds which, although they may not be regarded as typical hedge funds, have some hedge fund-like features.
The Consultation Paper proposes that specific disclosure benchmarks apply to retail hedge funds in relation to the investment strategy, investment manager, fund structure, assets (valuation, location and custody), liquidity, leverage, derivatives, short selling, periodic reporting and withdrawals. If a fund does not meet the benchmarks, and “if not, why not” disclosure requirement will apply.
In some cases the proposed disclosure benchmarks single out hedge funds where special treatment is arguably not justified. Good examples are the requirement to disclose the identities and relevant commercial experience of senior officers playing a key role in investment decisions, which is not something that would typically appear in a product disclosure statement (PDS) for any other kind of managed fund, and the requirement to disclose the rationale for the fund’s structure and the jurisdictions used. More broadly, the benchmarks require detailed disclosure of matters related to the fund’s investment strategy, which could restrict the flexibility of hedge funds to adapt to changing market circumstances.
ASIC expects a second hedge fund consultation paper to be released towards the middle of this year, and a Regulatory Guide to be released at the end of 2011.
Over-the-counter contracts for difference. OTC CFDs have been subject to considerable ASIC scrutiny since well before the GFC. The regulator’s concerns with retail clients trading highly leveraged CFDs has resulted in restrictions relating to advertising, consumer warnings, and specific guidance on how client money must be handled by CFD issuers. The CFD industry has worked closely with ASIC to address ASIC’s concerns.
The latest development is ASIC Consultation Paper 146, released in November 2010. The Paper proposes nine disclosure benchmarks aimed at assisting retail investors in analysing the risks associated with CFDs. While the Paper proposes an “if not, why not” disclosure requirement against benchmarks, those benchmarks do reflect a more interventionist approach than we have typically seen. Most importantly, the proposed benchmarks cover the issuer’s criteria relating to client suitability. Although financial product issuers are not generally subject to client suitability rules in Australia, CFD issuers often impose suitability criteria as part of their internal controls. The client suitability benchmark proposed by ASIC will require issuers to maintain and apply a written client suitability policy that:
- sets out the minimum qualifications that prospective investors will need to demonstrate they meet before the issuer will agree to open a new account on their behalf and
- outlines the processes the issuer has in place to ensure that prospective investors who do not meet the criteria are not able to open an account and trade in CFDs.
Other disclosure benchmarks relate to opening collateral, counterparty risk, client money, halted or suspended underlying assets, margin calls and fees and costs.
It is expected that the final disclosure requirements for CFD issuers will be released and commence in 2011.
Credit rating disclosure. Credit ratings have of course attracted great attention in the GFC wash up, particularly in the context of sophisticated products such as collateralised debt obligations or CDOs. Australia has not been without its own regulatory change in this area.
Prior to the GFC, it was common practice for structured product offer documents to disclose the credit ratings of relevant parties. A common example was the credit rating of a derivative counterparty, where a managed fund obtained a structured return through the derivative. It is now rare for credit ratings to appear in retail offer documents at all, for two reasons. Firstly, ASIC revoked relief that permitted issuers of some kinds of financial products to avoid having to obtain rating agency consent before quoting a credit rating in a retail offer document. Secondly, and most importantly for structured products, since 1 January 2010 credit rating agencies have been required to hold an Australian financial services licence in order to publish credit ratings. Although major rating agencies obtained licences, the licences sought by some were limited to providing services to wholesale clients only. The result is that credit ratings are now rarely quoted in retail offer documents.
Short product disclosure statement regime. Continuing the focus on product disclosure, a new short PDS regime will take effect on 22 June 2011 for “simple managed investment schemes”. The new regime is primarily intended to tackle the continuing criticism over the excessive length of PDSs, which discourages investors from engaging with disclosure documents.
The short PDS regime prescribes:
- a maximum length of 8 pages and a minimum font size
- section headings for comparison between products
- prescriptive content requirements and
- provision for material to be incorporated by reference.
One might question the relevance of the short PDS regime to structured financial products, given that it applies to ‘simple managed investment schemes’. The definition of simple managed investment scheme is, however, satisfied where at least 80% of the fund’s assets can be realised at market value within 10 days. Many structured funds would satisfy this definition, possibly even where a structured return is provided through a complex over-the-counter derivative. Over-the-counter derivatives can generally be terminated early for a price which reflects the value of the contract, including break costs.
It is therefore quite possible that many issuers of structured financial products will be faced with the difficulty of preparing a meaningful offer document within 8 pages, for a product that can hardly be described as ‘simple’. There is little doubt that issuers will be forced to rely heavily on the ability to incorporate material by reference into short PDSs.
ASIC has recognised that the definition of ’simple managed investment scheme’ will capture some products which are not so simple. In Consultation Paper 147, ASIC raises whether hedge funds within the scope of that Paper should be excluded from the short PDS regime.
Other recent developments
Related party transactions. In March 2011, ASIC released Regulatory Guide 76 dealing with related party transactions. This development impacts on structured financial products that take the form of registered managed investment schemes, as registered schemes are subject to a related party transaction regime under the Corporations Act. Registered schemes which provide structured returns often, for example, enter into derivative transactions with related parties, where the derivative transaction may provide capital protection, leverage or exposure to the performance of a particular asset or index.
Points of particular relevance to issuers of structured product in the Regulatory Guide are:
- ASIC’s guidance on the factors relevant to the ‘arm’s length’ exception to the requirement for member consent to a related party transaction. These factors include assessment against comparable transactions, the bargaining process between the parties, the impact on the registered scheme, alternative options available, and when expert advice should be obtained.
- ASIC also sets out its expectations concerning how related party transactions are to be disclosed in retail offer documents. ASIC expects disclosure to cover five specific areas: value of the financial benefit; the nature of the relationship between the parties; whether the arrangement is on arm’s length terms or some other member consent requirement applies; whether member consent has been sought and if so when; the risks associated with the related party transaction; and the policies and procedures the issuer has in place for entering into related party transactions.
Exchange traded funds. Like other markets, the interest in ETFs in Australia has significantly increased following the GFC. The index-based investment exposure and liquidity traditionally offered by ETFs has attracted many investors, and consequently a number of new ETF operators.
The increase in appetite for ETFs has inevitably resulted in the launch of increasingly innovative funds. These have included ‘swap-based’ ETFs, where index tracking returns are achieved through a derivative transaction rather than through investing in a portfolio of securities which replicates the index. While swap-based ETFs have been greeted with caution by some commentators, these products have successfully launched on the ASX’s ‘AQUA’ market platform for managed funds and structured products. Continuing the theme of product disclosure, controls have been imposed such as disclosure of a limit on derivative counterparty credit exposure, criteria for acceptable collateral and adoption of a naming convention requiring the use of “Synthetic”.
Regulatory capital. ASIC has proposed changes to the financial requirements which will impact on two categories of product issuers - responsible entities of managed investment schemes and issuers of OTC derivatives. These proposals are discussed in this edition and earlier editions of Regulator.
The fundamental principles of the Australian regulatory landscape for structured financial products remain intact despite the GFC. Adequacy of product disclosure remains a key focus, rather than controls or prohibitions relating to product design and access. The evidence suggests that this approach will foster continuing innovation in structured financial products, especially as investor conservatism moderates with improving financial markets.
At the same time, issuers of structured financial products are expected to meet higher standards when producing disclosure documents for their products. Disclosure documents are expected to be sufficiently simple to increase investor engagement, yet include all the information needed to make an informed investment decision. Meeting this challenge will be key to success in the Australian structured product market.