What are the practical implications for providers of the FSA statements on structured investment products?
The FSA review titled Quality of Advice on Structured Investment Products, published last month, has already been the subject of considerable debate and blog activity in the adviser community. However, those firms marketing structured investment products are also affected by the FSA’s findings, in particular the guidance contained in papers covering the financial promotion of structured investment products and TCF implications. Some commentators have suggested it will take time for providers to absorb the detail of the review and anticipate product launches will be delayed or even cancelled. What are the implications for providers and what practical steps does the industry need to take to ensure that we meet the FSA’s desire for greater transparency around structured products?
The depth and detail of the FSA’s review suggests they accept this is an established asset class. There has certainly been continued demand for structured products from investors in recent years, although it remains to be seen whether the FSA’s spotlight on the sector has any impact on investor appetite in the short term. The key themes running through those comments from the FSA that directly impact on providers are around due diligence in product design and counterparty selection; ongoing monitoring of market and counterparty risk; and transparency and clarity of communication on products to both advisers and their clients.
Let’s look first of all at product design. Do providers have a clear idea of the target market at outset? Have we been sufficiently thorough in stress testing across different market scenarios and understanding the implications for the end investor of the full spectrum of outcomes? Many structured product teams have considerable expertise in the field and it is perhaps the end-to-end design and delivery process that needs closer examination. Is there room for stronger collaboration between fund managers and marketeers from the earliest design stages? This is best practice for any launch but becomes increasingly critical as the product becomes more technical and the customer it is targeting more narrowly defined.
Understanding and communicating counterparty risk has been flagged as a concern by the FSA: how are counterparties selected and what due diligence can be described as reasonable? How is the status of the counterparty monitored? Providers may also need to look at their criteria for counterparty selection (notably the jurisdiction in which they operate), though many will have tightened up their procedures in this area in the wake of Lehman.
What else do we need to do to manage the risk that clients are exposed to? This is where an in depth understanding of the target market for the product comes into play. Counterparty risk will, almost certainly, be an issue for the end investor. Do we need to investigate some way of mitigating that risk through, for example, collateralisation. How well is this concept understood? Furthermore, the FSA review concentrated on plan-based structured products when it is possible to build structured products as funds within a Ucits III framework, which provides an additional layer of protection to investors. The discussions with intermediaries in understanding their own client base and how this should
influence design are key here. All of this points to a need to ensure a thorough understanding of the products within organisations and to build a governance framework around design that captures these needs – both when launching initial products and when looking at products designed to target investors at rollover or kick-out.
A large part of the challenge with structured products is to ensure a balance is struck between the need to get across the technical aspects of the product and not relying too heavily on jargon to do this. There can be conflict, however, between the regulatory requirements on what to include in disclosure material, ensuring consistency across the full range of documentation, and being able to describe a product (including associated benefits and risks) in terms that an investor can understand but without losing some of the legal subtleties. Testing the product proposition and marketing collateral is the only way to really understand how clients will interpret what you have put in front of them. We need to enter into dialogue with clients and intermediaries to test their understanding and be prepared to take feedback on board if they cannot relate to the terminology that we in the industry can slip into using (though it could be argued that this is not just an issue in the structured product space).
It also has to be said that, while acknowledging we cannot sidestep our responsibilities with regard to clarity in communication, there has to be a degree of concern that investors do not read the detail we put into literature. There is also a high degree of subjectivity in deciding what is and is not jargon and how certain words are defined. For example, the industry needs to come to a consensus on the use of terms such as ‘protected’ or ‘secure’.
This is where the need for education/explanation in literature and accessible training for intermediaries comes in. Training not just on our product features but also the terminology that comes with the structures. Ensuring advisers understand how the product has been designed, what it will deliver to investors and what it will not deliver. This is one of the important messages we need to take on board as an industry. Many providers are already a considerable way along this road, but none of us can afford to be complacent if we want to continue to deliver structured products to retail investors.
Getting these messages across will take time. Attention to detail is key if we are to get this right going forward. And it comes back to ensuring clarity and consistency in designing, executing and promoting structured investment products. Will the FSA reports mean the launch of fewer structured investment products? In the short term, there may be delays to planned launches as providers take on board the fine detail of the FSA’s comments. However, most providers are committed to this asset class for the long term and have built resources appropriately. Structured investment products will evolve from here, but we think the asset class is here to stay.
John Clougherty is the chief executive of Aviva Investors Fund Services Limited
