Economic commentators have long remarked on the asymmetry in the UK between the City of London's financial markets, in which large investors can buy products that are tailored to their investment requirements at minimal cost, and the UK retail financial market, where it is prohibited even to offer such products to ordinary investors.
Elsewhere in the world, the sale of innovative financial products to retail investors is a rapidly growing area. In the UK, however, the Financial Services Authority (FSA) has its face set firmly against innovation of any kind. The reason for this is that innovative products are almost by definition 'derivatives', and the FSA has historically had a problem with the sale of derivatives.
Derivatives are simply contracts by which investors receive a return linked to the performance of an underlying asset; it is possible to create very risky derivatives. It is also possible to create very risky shares and bonds. There is no reason why the FSA should take the view that 'derivatives' per se are any more or less risky than 'shares' per se. Nevertheless, it does.
|The FSA has made major progress in driving out unsuitable advisers, but at the cost of those who remain|
That this belief springs from prejudice rather than analysis can be demonstrated by the quality of the arguments used to defend it. An interesting example can be found in the recent FSA consultation paper on the sale of derivatives repackaged as securities (CP 114). It says: “Unlike investing in a share where… the investor still retains a percentage of their original financial investment, with a… derivative the investor may lose their entire investment.”
Presumably, the FSA does not, in fact, believe that all listed shares have a minimum money-back guarantee. However, the fact that such a sentence can appear with the FSA's sanction shows how far the quality of analysis on this issue seems to have sunk.
The truth of the matter is that in seeking to base its regulatory structure on a legal distinction between 'securities' and 'derivatives', the FSA is bailing its leaking boat with a sieve. Using modern structuring techniques, the legal form and the economic substance of an investment can be separately addressed and separately combined, such that, in general, any economic form may be given any legal form. The only outcome, therefore, of requiring derivatives to be restructured as securities before they can be sold is to increase significantly the cost of the product – a cost which comes directly from the pockets of investors.
The current rules, for example, effectively require retail derivatives to be repackaged through a closed-ended investment company listed on an EU exchange, a process that can add nearly £250,000 to the costs of each product. Nor has the temper of product providers been improved by criticism from the FSA that such structures are “overly complicated”. For the FSA to require the adoption of such structures and then criticise their use seems to many to be at least disingenuous.
There is no doubt that the FSA's concerns about derivatives reflect public concern, and since financial regulation is in part a political act, this is a reasonable regulatory priority. However, in this area, even public concern is in advance of the FSA.
Public concern about derivatives arises in two very specific circumstances. First is the case of derivatives that incorporate an unquantifiable open-ended liability for the investor. Such derivatives probably should not be sold retail at all. The second relates to very highly-geared derivatives, where a small move in an underlying price can completely eliminate the return on the investment.
Concern about these revolve not around whether they should be available to retail investors (retail investors take much higher risks than this in high street betting shops every day of the week), but that the risks involved should be identified clearly in the relevant documentation and clearly disclosed to investors.
Finally, the FSA would argue that any investment can be sold to any investor who has either obtained independent financial advice or been classified by a financial adviser as an expert. In practice, this means that each investor must, before investing, pay an additional (and substantial) cost equal to the adviser's costs of doing due diligence on them.
In general, investors do not believe that they obtain any significant value from this and view the cost as a cost of purchase. This cost might be acceptable if it were small, but it is very large. By heaping obligations and threats of fines and expulsions on advisers, the FSA has made major progress in driving unsuitable financial advisers out of the industry, but at the cost of significantly increasing the burden of regulatory obligations on those who remain, and, by extension, the cost of those obligations.
The FSA needs to do two things. First, it must eliminate the restrictions contained in its conduct of business rules as to the advertising and selling of derivatives and warrants, so as to put all of the different legal forms of investment on the same regulatory footing. Second, it must move towards a regime that focuses on the economic characteristics of products rather than their legal form. Certain economic characteristics (such as contingent liability) should be prohibited for retail sales, and a clear framework for disclosure of economic structure must be developed and imposed across all legal forms of investment to facilitate cross-product comparison.
Simon Gleeson is a partner in Allen & Overy's financial services regulatory team