Priips stakeholders in final push for German-style risk ratings

Dealers are lobbying for changes to be made to an incoming EU-prescribed risk indicator for structured products, claiming the proposed rules give a distorted view of how likely it is that investors will lose money on equity-linked instruments.

The European Supervisory Authorities (ESAs) – Europe's three principal markets regulators – published draft rules on the design of a single risk indicator for packaged retail and insurance-based investment products (Priips) in November last year. A consultation on the draft closed on January 28.

Respondents have lined up to criticise the proposed calibration of the market risk component of the standard Priips risk indicator, which every product will be badged with going forward.

"If we apply this as it stands in the text of the consultation paper, then most equity-linked products will be systematically assigned to higher risk levels that are not appropriate. Many would even be given the same risk grade as contracts-for-difference or leveraged products," says Thomas Wulf, secretary-general of the European Structured Investment Products Association (Eusipa).

The ESAs propose using a value-at-risk (VAR)-equivalent volatility metric to group structured products into market risk classes ranging from one to seven. For products referencing public securities or funds, the VAR is calibrated to a 97.5% confidence interval and based on a five-year history of the underlying's prices. For fund-linked products lacking this depth of historical pricing information, the VAR is calculated using a forward simulation. The VAR number is then converted to an equivalent annualised volatility measure.

If [the ESAs] chose to change the risk boundaries, we can change that in a heartbeat
David Stuff, Cube Investing

The higher the annualised volatility of a product, the higher the market risk class applied. Stakeholders say the bracketing of each class is unbalanced and biased against equity-linked investments. For instance, all products with an annualised volatility of 25% or above are loaded in class seven - the highest measure.

"The volatility buckets are too conservative in the low- and medium-risk classes. They would therefore not be in line with the expectations of market participants," Eusipa wrote in its response to the consultation.

Instead, Eusipa is pushing for the acceptance of an alternative risk scale developed by the German Derivatives Association (DDV). This scale segments products with annualised volatility of 25% and above into three risk classes instead of the single class proposed by the ESAs.

In a paper published in January, the DDV wrote that the alternative scale would lead "to more adequate and realistic results" that allow "a sufficient differentiation both for low-risk investments (bond-like) and mid-risk (broad equity indices/portfolios) to high-risk investments (volatile stocks)."

Eusipa's proposals have found broad support amongst issuers, many of whom have long argued that several of the standard indicators proposed as part of the Priips rating system would necessitate taking too inflexible an approach.

"Eusipa has expressed a desire to improve the risk-bucketing of the various asset classes. We certainly support this request as there are currently various cases of either inconsistencies or cliff effects," says a strategic adviser at a European bank.

In its own response to the consultation, the Joint Associations Committee on Retail Structured Products also spoke out in favour of a "broader potential range of [single risk indicator] ratings for structured products from 1–7, rather than a very limited part of the scale."

David Stuff, London-based chief executive at distributor Cube Investing, suggests implementing the change in risk scales should be relatively straightforward: "The Germans are not saying they disagree with the calculation. They are saying they are fine with the [VAR] calculation, but they feel that [risk class] seven is too big a bucket. If [the ESAs] chose to change the risk boundaries, we can change that in a heartbeat," he says.

A spokesperson for the joint committee of the ESAs says: "We recognise there are different calibrations that can be used, each with their own advantages and disadvantages. We have noted that views vary amongst stakeholders on this point, including between those familiar with different specific types of Priip and different national markets. In developing a meaningful scale, it is important that we calibrate the rating effectively for the full – and very wide – range of Priips currently being sold across the EU."

The final Priips regulatory technical standards must be handed to the European Commission for endorsement by March 31. The Priips regulation becomes active on January 1, 2017.