The regulatory landscape for retail products in the UK is entering a period of rapid change. Financial Services Authority (FSA), EU and Government initiatives are all running strongly and it seems that in the relatively near future the rules that shape the UK retail financial market will have changed significantly.
As a consequence of all this, predicting the future for retail structured products is more than usually difficult at the moment.
Regulating financial products
In respect of any financial product, regulation can loosely be described as the process of ensuring that the product delivers to investors approximately the returns which they expect.
This can be achieved in one of two ways. One is by regulating the product itself – for example, regulated funds have rules restricting the types of investment they can make and the concentrations in which they can make them. However, product regulation is almost never effective, since almost any set of restrictions based on the legal nature of investments can be structured around.
The other way is to regulate the way in which investments are sold. This approach is based on ensuring that investors have a clear understanding, at the time that they invest, of the nature of what they are investing in.
This again can be accomplished in two ways: one involves restricting certain types of investment to investors who are capable of understanding them, the other regulating the sales process. As an approach to the latter, in an ideal world regulators would require all investors to be either sufficiently informed themselves or to invest through or with the advice of an investment professional. In broad terms, the trend of regulation in the UK market is strongly towards squeezing out investors who do not fit one or other of these paradigms.
The consequence of this is that investors who have neither sufficient demonstrable knowledge of investment matters and are not willing to pay fees for investment advisory services will be compelled to take their money elsewhere. It is questionable whether this is a sensible overall policy for government and regulator to adopt.
This attack on investors has two prongs: one involving the restriction of sales to non-expert investors, the other involving pressure on investment advisers. These developments, although occurring simultaneously in the UK, have independent causes.
The first of these prongs results from the implementation of the Markets in Financial Instruments Directive (MiFID). MiFID promulgates a rule that execution-only sales of retail-structured products (and for that matter products generally apart from shares, nonconvertible bonds, money market instruments and funds) are prohibited unless the sale is on an ‘appropriateness’ basis.
The term ‘appropriateness’ is, in fact, a misnomer. The aim of the appropriateness regime in MiFID is to ensure that investments are sold only to investors who have sufficient “knowledge and experience to understand the risks involved in relation to the product or investment service”. In other words, the aim is not to determine whether the product is appropriate for the investor, but whether the investor is an appropriate sort of person to be offered the product.
The second prong, which focuses on the activities of advisers, results from FSA and Government action. The FSA recently tightened up the obligations of investment product providers through a policy statement issued as part of its ‘Treating Customers Fairly’ (TCF) initiative.
However, in broad terms TCF has done little more than articulate and promulgate industry best practice, and it has not in general imposed significant burdens on either distributors or product originators. More concerning in the context of advised sales is the position the FSA appears to be taking as a result of its Retail Distribution Review.
The Retail Distribution Review itself can only be understood in the context of the Government’s Financial Capability Review. This is a broad scope Government exercise intended to examine saving in the UK, and in particular the likely causes of inadequate savings. Part of this exercise has involved the creation of the Thoresen review, which has proposed the idea of a free basic advice service provided by the state and intended to give generic (non-product-specific) financial advice (colloquially known as the ‘National Wealth Service’).
It is possible that this proposal may end up as an indirect tax, in the form of an obligation on the financial industry to provide it. The FSA Retail Distribution Review is complementary to all this, and is looking at how the business of retail intermediaries could be restructured to fit in with the Thoresen proposals.
The essence of the FSA proposals is that financial advisers be divided into three – professional financial planners, primary financial advisers and an unregulated generic advice service. The idea is that the professional advisers will be required to demonstrate a higher level of skills, qualifications and ability than are currently required by the regulator for independent financial advisers. More contentiously, they also propose that such professional advisers should be remunerated exclusively by fees paid by the client and should not be able to take commission of any form.
It has also been suggested that such advisers should cover the entire product market and should not be able to specialise in particular sectors or product types. The independence standard applied to them will prevent them being associated with any product provider.
The result of this will be to drive up the costs of professional financial planners. This increase, accompanied by the burden of the costs of providing the Thoresen free generic service, will result in a significant increase in the cost of investment. The FSA accepts that this will result in the mass market being deprived of access to independent advice. There is considerable disagreement as to where the dividing line will come. The FSA suggests that the changes will price out investors earning less than £50,000 per annum, although industry estimates are at least double that figure.
Changes to come
The consequences of these changes for retail structured products are hard to predict. At the top end of the market, the development of a sophisticated class of professional financial advisers should encourage investment banks and other structurers to develop sophisticated products for distribution through such intermediaries.
However, the combination of the substantial increase in cost of these services and the consequences of the MiFID appropriateness test will significantly restrict the sale of structured products to mass-market investors.
This in turn is likely to result in significant shrinkage in the overall retail products market, as small investors decide that financial investment is just too difficult and too expensive and buy houses instead, and an increase in the importance of the money sections of the Sunday papers, which are likely to constitute the only financial advice to which the majority of the population will have access.
Simon Gleeson is a partner at Clifford Chance