EU regulators lean towards RIY cost disclosure for Priips

The European Supervisory Authorities (ESAs) so far prefer the reduction-in-yield (RIY) approach to disclosing structured products' costs, although they are yet to make a final decision, according to the chair of the standard-setters' joint committee.

The ESAs are pondering which of two methodologies – the RIY or the total cost ratio (TCR) – should be used in the instruments' key information documents (KIDs) under incoming regulation on packaged retail and insurance-based investment products (Priips). The question has deeply divided insurers and structured product issuers. 

"Our first indications are that the reduction-in-yield is superior to a measure of the total costs because it better takes into account timing differences across the lifetime of the product," said Steven Maijoor, who is also chair of the European Securities and Markets Authority (Esma), at a meeting concerning the standards on September 14. The meeting involved the three ESAs – Esma, the European Banking Authority and the European Insurance and Occupational Pensions Authority – and the European Parliament's Economic and Monetary Affairs (Econ) Committee, as well as members of the European Commission.

Maijoor also mentioned the risk rating methodologies to be used under the Priips regulation – another divisive issue – and said the ESAs had narrowed down their discussion to three of the four options on the table. Esma told Risk.net that the option of a two-level indicator incorporating quantitative and qualitative measures was no longer under consideration.

If the ESAs decide in favour of the RIY approach to cost disclosure, that will please insurers. The method expresses costs as a haircut to the potential final return of a product. Issuers, on the other hand, prefer the TCR approach, which aggregates all the costs and deducts them from the average annual value of the underlying assets. The key difference is that the RIY method takes into account the interest rate effects resulting from the exact timing of cost deductions – an important consideration for long-duration insurance-based products, which often have large upfront expenses.

However, the differences between the two ways of expressing costs are not clear to the buyers of structured products, said Sven Gentner from the EC's Directorate for Financial Stability, Financial Services and Capital Markets Union. Speaking at the meeting, he cited a survey of retail customers in 10 EU member states on some elements of the proposed KIDs. The pollsters, contracted by the commission, are due to complete the survey in October, but Gentner said preliminary findings showed that neither cost-disclosure method was "easy to understand" and that it was unclear whether buyers would prefer the RIY or the TCR.

Risk ratings

The findings also indicate that a simple quantitative indicator of a product's riskiness – similar to an ascending scale applied to Ucits funds – is "best understood" and that investors have no particular interest in seeing the risks broken down into market, credit and liquidity components, Gentner said.

None of the four risk rating methodologies initially put forward by the ESAs fit that definition of a simple quantitative indicator: the first option is qualitative, the second is an alphanumeric indicator where market risk is assessed quantitatively and credit risk through qualitative credit rating agency disclosures, option three is a quantitative measure that scores market and credit risk together using one of two possible value-at-risk methodologies, and option four is the combined indicator that is no longer in the running (see box: What's on the table?).

Esma's Maijoor said he would favour an approach that used both qualitative and quantitative data. But he recognised the limitations of any approach: "There is no perfect solution to challenges around risk disclosure and there will always be trade-offs to be made."

One head of regulation at a European investment bank told Risk.net that the ESAs might fuse options two and three. "It could be a kind of a simplified VAR. As the main concern for the VAR was its operational complexity, a simplified approach would be a welcome development," the source said. Both VAR approaches proposed in the ESAs' option three would require firms to generate risk measures based on stochastic simulations, which takes a great deal of processing power and may stretch the capabilities of smaller issuers.

At the meeting, a representative of Econ committee member Luděk Niedermayer argued that the risk indicator should reflect the changing extent and characteristics of a product's riskiness over time. The representative did not elaborate but did provide a hypothetical example of a structured product whose payout was tied to the performance of an oil company, saying that the value of that product could deteriorate over time as European governments took action to reduce carbon emissions, but that this future impact might not be obvious at the product's inception and therefore might not be reflected in the risk rating.

A final consultation paper on the risk ratings, cost disclosures and other elements of the Priips KID is expected in the autumn. This will inform the regulatory technical standards that will be submitted to the European Commission for approval by March 31, 2016. Maijoor also said two further sets of technical standards – one specifying at which point a Priips seller should provide the document to the retail investor, the other explaining under what conditions the document would have to be reviewed – would also be published by this date.