The restating of sector guidelines on retail structured products is politically well-timed, says Catrin Griffiths
Sometimes, saying something once is just not enough.
Just four years after they were released, the combined principles for managing the relationships between those involved in selling and buying retail structured products (RSPs) – a document thrashed out by the Joint Associations Committee (JAC) of financial industry associations – were republished last week (23 May) to a minor fanfare.
On the face of it, this seems an odd move. The JAC originally released the principles governing the relationship between providers and distributors (known as the PD principles) in July 2007 and those relevant to the relationship between distributors and individual investors (the DI principles) in July 2008.
In both documents, and following extensive consultation with the industry, the JAC sought to clarify the roles and responsibilities of financial services firms in the RSP supply chain. So why on earth relaunch what are effectively the same guidelines?
The simple answer is Lehman Brothers.
Since the financial crisis bank regulation has become an extraordinarily resonant political issue, and not just on the macro-economic level; it has become a retail investor issue, as first evidenced by the Hong Kong minibond crisis in 2008.
From 2003 Lehman Brothers had marketed minibonds to a range of retail investors in Hong Kong, with the products badged as low risk and of a low investment threshold. Take-up was enormous; the Hong Kong Securities and Futures Commission (SFC) later declared that, by 2008, approximately HK$12.7bn (£1.01bn) in bonds had been issued by Lehman through 20 licensed local commercial banks. In the wake of the Lehman collapse retail investors not only filed complaints about the mis-selling of minibonds, but also held high-profile protests and demonstrations featuring cymbals and bullhorns.
The saga was still rumbling on this year. In March Bloomberg reported that noteholders were being offered up to 96.5 per cent as part of a second attempt at a settlement, the first having failed in July 2009.
“The Hong Kong regulator took quite a robust attitude to the whole thing,” notes one financial services lawyer.
And in one of those neat appointments that confirms how small the global regulatory world has become Martin Wheatley, then CEO at the SFC, is now set to become CEO of the Financial Conduct Authority, one of the successor regulatory bodies to the FSA. His appointment provided, perhaps, an unconscious impetus for the JAC to underline its own reformist credentials.
Certainly, the JAC’s reaffirmation is part of a wider response to increasing regulatory pressure on the sector.
“It comes at a critical juncture for the regulatory debate in Europe and ahead of detailed implementation of [the] Dodd-Frank [Act] in the US,” acknowledges JAC chairman and JPMorgan assistant general counsel Tim Hailes. “Asia’s already reached the implementation stage with its new regimes, with changes coming into force in Hong Kong, for example. The EU’s now at the inflexion point for regulatory change.”
The JAC principles may be non-binding, but four years after the PD principles were first published they have had an effect, say financial services lawyers.
“Market practice has definitely aligned itself more closely with the original principles set
out by the JAC,” says one senior practitioner.
There has been considerable political success in getting wider buy-in, too. The most obvious difference from 2007-08 is the sheer number of participants signing up to the principles.
Back then they were being put forward on behalf of the European Securitisation Forum, the International Capital Markets Association, the International Swaps and Derivatives Association, the London Investment Banking Association and the Securities and Financial Markets Association (the last two are now together known as the Association for Financial Markets in Europe). The syndicate now includes the British Bankers’ Association, the Asia Securities Industry & Financial Markets Association, Italy’s intermediaries organisation the Associazione Italiana Intermediari Mobiliari, the Institute of International Finance, the US Structured Products Association and the Futures and Options Association.
“The biggest change is that more people are playing,” reflects one financial services lawyer. “When the guidelines were originally put together a number of institutions were slightly sulky. There was a sort of ostrich-style belief that if they ignored the problem it would go away. So when the principles were first put forward I suppose you could argue it was questionable how much of the market was represented. But now it’s clear [the principles] have solid market-wide support.”
Hailes is quick to downplay any politics.
“Participants [in the JAC] don’t have any particular sense of proprietary ownership over the principles and the philosophy behind them,” he states. “We welcome other groups supporting what the principles represent to the market and the message they send from the industry to the regulatory community. The addition of more associations to the line-up just shows [the principles’] increased relevance in the post-financial crisis world”.
So much for the participants – what about the implied audience? As Hailes has made clear, the mushrooming interest in RSPs among regulators across the world is what makes the JAC move to reaffirm its principles so politically astute.
“RSPs are a hot potato in multiple jurisdictions, particularly after the credit crunch,” agrees another lawyer. “There’s been big political noise around RSPs in Hong Kong, Singapore, Taiwan and Korea.”
“The reaffirmation is intended for multiple regulators,” says Linklaters capital markets partner Paul Lewis. “The JAC is saying, ’We have these principles already and this shows we’re thinking about the issues’.”
“The JAC is a rare example of the industry taking note of regulatory concern in a specific area and getting together to deliver a regulatory outcome before the regulators began legislating,” says Clifford Chance financial services partner Simon Gleeson. “The outcome’s been broad agreement between the industry and the regulators as to the outcomes to be achieved and the methods to be used to achieve them.”
The FSA has been considering retail investors for some time. The financial services sector suffered a series of mis-selling scandals in the early part of the last decade – not least the precipice bond mis-selling scandal that largely involved retired people who were persuaded to switch their savings to these bonds to gain higher interest rates. Some £7.4bn was invested in the bonds between 1997 and 2004, most of which was lost.
In July 2006 the FSA made a concerted effort to respond to concerns about the protection of retail investors, but to a great extent it wanted the industry to come up with its own set of guidelines. In its Treating Customers Fairly (TCF) manifesto the regulator declared that, as part of the move towards a more principles-based approach, it was keen to avoid introducing new detailed rules.
“We want firms and their senior management to focus on the principles and the outcomes for consumers that we are looking to achieve,” the FSA statement ran. “And we believe that trade associations and other organisations can have a significant role in helping firms in different sectors to develop acceptable practices within a more principles-based regime, for example through industry codes and other guidance materials.”
The complexity of the market means that the regulatory task involved in identifying the different roles and responsibilities in the RSP chain has been immense.
“The primary difficulty is that providers and distributors come in all shapes and sizes – some distributors are mighty while some providers are puny,” notes Gleeson. “A hardwired regulatory regime that divided obligations without regard to this would be highly unlikely to be effective. The approach that both the JAC and the regulators have taken, focusing on consumer outcomes rather than formal liabilities, has the overwhelming merit of working in practice.”
Falling into line
While the FSA was supportive of the banking industry in its attempt to come up with its own guidelines, in the post-Lehman era all financial institutions have had to clarify their practices in the context of a much tougher regulatory climate.
“The reality is that there’s a marked change in tone from the regulators – there’s a distinctly more assertive tone,” warns a senior financial services lawyer. “Does it mean that the regulator will go berserk and do a regulatory Rambo? Well, some people might suggest yes, but the reality is that the people at the FSA are sensible – not necessarily soft and cuddly, but not bloody-minded. But the industry constantly has to recalibrate itself.”
The importance of the JAC’s reaffirmation of its principles can be deduced from its timing. It comes just a few months after the publication of an FSA discussion paper on 25 January this year on how it should handle consumer protection, and specifically the difficult issue of product intervention.
The FSA had already signalled a more interventionist approach the previous year, declaring its intent to anticipate harm to consumers. Instead of focusing on point-of-sale – the chief topic of regulatory discussion in 2010 – it was determined to examine the product life cycle from beginning to end.
“This might include interventions such as banning products or prohibiting the sale of certain products to specific groups of consumers,” the FSA declared.
Intriguingly, the issue of product intervention is referred to explicitly in the JAC’s May affirmation document, which states that “there is an increasing recognition that certain products might not be appropriate for certain target audiences and that some form of regulatory product intervention may be justifiable in those instances”.
However, the practicalities are thorny, as one lawyer dryly points out.
“There’s lots of dynamics involved,” the lawyer says. “If a small house is selling structured notes through UBS, say, you have no control of the distributor, whereas in other examples there could be large houses selling through some two-bit independent financial advisers.”
In a similar vein, the difficulties of regulating such a set of variables is referred to in the fourth of the JAC’s PD principles, which states that “the distribution structure means that it’s often the distributor who interfaces with the individual investor and whose client that investor is.
“In such circumstances, investor suitability as determined in the local market is accordingly exclusively an issue for distributors, since it must be considered in the context of confidential information provided by the client to the distributor.”
Hailes is diplomatic. “Enhanced consumer protection is clearly one of the key drivers to the current Treasury consultation on the UK regulatory landscape when the FSA is abolished,” he says. “The FSA discussion paper on product intervention is one example of exploring the ground in terms of the potential intervention powers of the [forthcoming] Financial Conduct Authority.
“We’re engaged in a dialogue with the FSA on these proposals and we completely support an appropriate and proportionate regulatory approach to achieve consumer protection objectives, but it must be appropriate and proportionate.”
Further afield, Europe has been awash with financial regulation initiatives. As Gleeson points out, the question now will be whether the model that has been constructed can be adapted to the EU context.
“In theory this should work,” he says, “because a model created to accommodate different distribution dynamics in the UK should be a good starting point for accommodating the even greater diversity of distribution chains to be found across the EU.”
Most pertinently for the JAC, the current RSP debate in Europe centres both on Mifid II and on packaged retail investment products.
“It’s critical that there’s a vibrant RSP market given the demographics of the state pension,” says Lewis, “so there’s a political need to get this right.”
But perhaps the most intriguing indication that the regulators have taken note of the JAC’s principles came in the middle of last week. Just a day after the principles were republished Richard Ketchum, chair of the Financial Industry Regulatory Authority, the main regulator for US securities firms, made a speech at the organisation’s annual conference in Washington DC on Tuesday (24 May). In that speech he referenced RSPs and acknowledged that the industry was taking practical steps.
“The breathtaking pace of innovation and availability of these more sophisticated and complex products pose significant challenges,” he said. “I’m pleased to hear that many companies are taking this challenge extremely seriously.”
Perhaps the timing of the JAC’s reaffirmation of its principles was more astute than anyone realised.