FSA releases final guidance on retail structured products and does not equate complexity with riskiness

The UK Financial Services Authority (FSA) published its final guidance on retail structured products on March 23. The guidance is based on the regulator's concern that "consumers continue to struggle with the effects of a slower economy, low interest rates and poor returns on investments... [and so] are increasingly attracted to products that claim to offer a degree of security but promise to deliver returns that outperform cash. However, in many cases the benefits and risks of these products are opaque and the potential for misselling or misbuying is high."

Under the heading ‘Information to Distributors', there is a hidden insight into the interpretation of complexity, which, when referring to the training and support required by distributors, the FSA says "should be considered in relation to other retail products and solutions rather than to wholesale activity or structures".

The statement follows one that makes clear that the guidance has been created for the benefit of retail investors: "Firms should... ensure that they provide information to the distributor base that can be understood by the recipients with the lowest level of knowledge," states today's document.

A spokesperson for the FSA adds: "We were not referring to any formal definition of ‘complexity'. It was more just to say that wholesale people working in a bank would think something is quite straightforward, whereas, in retail terms it would look very complicated. So, a retail standard should be applied in terms of complexity."

However, there was a valuable insight on how the regulator interprets complexity in the feedback document released alongside the guidance, in which the FSA stated: "We do not equate complexity with riskiness; we say rather that the more complex a product's structure and features, the more difficult it is likely to be to explain in a financial promotion without risk of consumer misunderstanding.

A spokesperson for the FSA confirmed that very little had changed in the regulator's views since it released Retail Product Development and Governance - Structured Products in November 2011. Draft guidance was then released by the FSA in January.

The substantive change from that document is a comment on stress-testing assumptions on the correlation between market variables, together with broader economic assumptions. Today's guidance adds, "These assumptions should be reasonable, and based on publicly-available data. Firms should establish thresholds on the probability of stressed outcomes that are likely to be acceptable to the target audience".

Today's publication sets out formal new guidance on principles for business contained in the FSA's October 2009 Treating Customers Fairly document. "Given the environment and the growth of the structured products market, and that they are increasingly complex, we felt that this would be a big strain on firms and their governance structures and could result in misselling and missbuying," says the spokesperson.

"Guidance from the FSA makes more sense when the market is evolving and still growing, and it is also a lot quicker to implement," says the spokesperson. "It is a quick way to get our position out there and state what we expect firms to be doing."

Referring to the investigation of seven providers of structured products assessed by the FSA between November 2010 and May 2011, the regulator is asking structured products firms to: put the identification of what an investor needs above their own bottom line; stress test new products "to ensure they are capable of delivering fair outcomes"; be clear what is a new product; and monitor the progress of the product through its life.

The spokesperson declined to name the firms investigated on the basis that "it may be damaging to them", which is a legal obligation under the Financial Services and Markets Act 2000. "We have held individual feedback sessions with all the firms in our sample, and are working with those where deficiencies were identified. This may include addressing issues as part of firms' close and continuous supervision and suggested improvements for firms' via risk mitigation programmes," says the spokesperson.

"If a firm breaches our rules and we consider there to be a necessary case for enforcement then we would take action. If we do decide to take formal enforcement action against a firm, any penalty is made public."

Further comments about product governance are careful to state that structured deposits are included in some of the guidance. "Definitely not all of the guidance is applicable to structured deposits, but where it is, we have identified that," says the spokesperson.

The feedback attached to the guidance document also clarified the FSA's view on product responsibilities: "we recognise that responsibilities flow from the actual roles or functions undertaken in a transaction, and firms should take this into account in considering their responsibilities under the Principles. In considering which responsibilities apply to it, a firm should consider the functions and roles that it undertakes in the product lifecycle."

UK market statistics

The regulator offers the following statistical backdrop to its guidance. "Structured products have been available to retail consumers in the UK since the early 1990s and the UK market is now the fifth-largest in Europe by sales and by outstanding value. Sales fell 8% to £13.5 billion in 2010 (following a 71% increase in 2009) but assets under management still rose 13% year on year to £51.96 billion at year-end 2010. Respondents to a survey by www.StructuredRetailProducts.com of the main UK players in January 2011 provided the consensus view that sales would grow 15% in 2011.

"The UK is an active market: for example, 1,006 tranche products were offered in 2010, the same number as in 2008, but down slightly on 2009's total of 1,096. The majority of products continue to offer at least 100% capital protection. However, in 2010 there were, for the first time, more capital-at-risk products available than those that offered simple 100% capital protection.

"Against the continuing popularity of more simple pay-offs, there was a significant increase in the use of the autocallable (knockout) feature in 2010, with 188 products, up from 123 in 2009. While the dominant underlying pay-off reference is still the UK FTSE 100, diversification was apparent in 2010, especially as the year progressed. The FTSE was the sole underlying reference for approximately 90% of products in the first few months of 2010, but by December that had fallen to 65%."

The UK product provider market is summarised as follows: "While there were 64 individual providers (44 provider groups) involved in the tranche market in 2010, market share remains concentrated among five provider groups, which accounted for 72% of the market in 2010."

As well as noting that some of the product approval processes adopted were ‘light', the FSA says: "In several cases, we observed an over-reliance on the judgement and discretion of key individuals to achieve acceptable outcomes and provide ‘sense-checks' rather than these safeguards being embedded in the actual product approval process. By contrast, in some firms we noted that a high degree of control and influence was exerted by product design staff."

The regulator says that when selling structured investment products specifically, firms should consider the investor risk profile, which it breaks down into a "willingness to accept capital loss, ability to bear loss [and the] importance of possible recourse to the Financial Services Compensation Scheme (or another EU guarantee scheme)". Investment objectives are broken down into "capital growth or income, the product's potential role as a ‘core' or more speculative holding [and] other specific types of investment objective".