Changes set to test banks' adaptability

Structured products and fund providers and distributors across Europe are facing unprecedented regulatory change on multiple fronts, with 2011 and 2012 shaping up as key years for retail financial products.

But regardless of the final drafts of the rules, two trends are clear: structured product providers are going to have to be more transparent in the way they price products; and both internal bank sales forces and third-party distributors are going to have to invest heavily to ensure that staff fully understand the products they are selling.

The Markets in Financial Instruments Directive (MiFID) that came into force in November 2007 and has already introduced more transparency on retail products. As part of the process embedded in MiFID for reviewing and updating some of its provisions, the Committee of European Securities Regulators (CESR), is providing technical advice to the European Commission so that it can report to the European Parliament on possible changes in early 2011.

Parallel to this, and specifically in the investment funds space, Undertakings for Collective Investment in Transferable Securities (UCITS) III is being updated to UCITS IV and will be implemented in mid-2011. This is expected to drive consolidation in a fragmented European investment fund industry, both at fund and service provider level.

In the UK the Retail Distribution Review (RDR) will come into effect at the end of 2012, and will apply to all advisors in the retail management market, regardless of what type of firm they work for - banks, other product providers, independent financial advisors or wealth managers. It will be in line with the wider EU review of packaged retail investment products.

To add to the all the activity, from next January the CESR will reinvent itself as the European Securities and Markets Authority, while in the UK the Financial Services Authority (FSA) is being reformed and split up by the new Conservative/Liberal Democrat coalition. There will be a new macro regulator under the Bank of England, and a new Consumer Protection and Markets Authority established as a single integrated conduct regulator. The scope of firms regulated by the CPMA will range from those offering a simple product on the high street to investment banks dealing with sophisticated counterparties in wholesale markets.

Challenging times

"There are a number of different financial services proposals coming through at the same time, at both EU level and in individual jurisdictions, so it is a challenging time for providers and distributors selling products on a pan-European basis," says Jonathan Herbst, corporate finance partner and financial services regulation specialist at law firm Norton Rose in London.

"UCITS III totally changed the profile of funds by allowing them to offer investment strategies based on derivatives. Ucits IV will not have such a big impact on fund profiles, but it does contain some important proposals on the domicile of funds and passporting them into other countries," he adds.

Under the current UCITS passporting scheme, an issuer goes to their home state regulator and must subsequently notify the regulator in each country where they want to sell a product.

"Under the new UCITS IV rules the issuer will only notify the domestic regulator, which will in turn notify other regulators across Europe. The quid pro quo is that there will be tougher regulation of managers in the EU, with more MiFID-type rules," says Mr Herbst.

Three-pronged approach

When it launched the RDR, the UK's FSA stressed that its aim was not simply to treat the symptoms of what it regards as persistent problems in the UK retail market, but to address the root causes. It set out three measures it regards as most fundamental to delivering the desired market outcomes that should materially alter and improve the interactions between consumers and the industry: to improve the clarity with which firms describe their services to consumers; to address the potential for advisor remuneration to distort customer outcomes; and to increase the professional standards of investment advisors.

"The RDR will revolutionise the UK domestic market by effectively banning product provider commissions, and this is expected to come into effect in 2012," says Mr Herbst, a former FSA lawyer.

The FSA acknowledges the measures are far reaching and that there are concerns about introducing such significant changes at a time of market turmoil and uncertainty. However, given the market's appetite for change, which became increasingly evident during its review, the FSA believes there is a golden opportunity to rebuild the confidence and trust of consumers at this crucial time.

Not surprisingly, it is the second measure on fees to distributors that has caused most impact, both in the UK and across the EU, where MiFID has similar proposals. MiFID covers investment banks, portfolio managers, stockbrokers and broker dealers, corporate finance firms, many futures and options firms, and some commodities firms. MiFID rules will cover not only UCITS funds such as exchange-traded funds (ETFs) but also exchange-traded notes (ETNs) and exchange-traded commodities.

"Planned changes to MiFID will involve a shift from advisors getting paid commission by the product provider towards a model whereby they are paid annually by the investor for advice and for sourcing the best products and best execution for the client," says Uwe Becker, head of investor solutions in Europe at Barclays Capital in Zurich.

As part of this process, providers are working on more cost-efficient platforms by using alternative wrappers to funds in order to address and enhance transparency on the costs and risks embedded.

"The RDR will bring about a sea change for the market, and a lot of what providers and advisors are doing now is looking to the future and redesigning their product ranges and delivery mechanisms ahead of the measures coming into effect in 2012," says Chris Taylor, a director in the wealth management sales team at HSBC in London.

The trend towards more products being listed on exchanges is related to the arrival of the RDR. It will be important for providers to have cost-efficient platforms with highly visible and liquid products, plus a wide range of pay-offs.

Deal performance reporting will also have to be improved, since more frequent and better presented performance reports to investors will form part of the overall drive for transparency in the market, and make products more attractive.

Individual investors will either simply buy products online or via their advisors, but they will be paying fees for advice and execution. Advisors will not be driven by provider commissions.

"Delivering a wide range of products in an efficient way will be critical and as commissions to advisors from providers are ended under RDR, many providers will be putting their products on platforms that are basically fund supermarkets, allowing investors or discretionary wealth managers to buy them direct," says Mr Taylor.

Jonathan Herbst, corporate finance partner and financial services regulation specialist at law firm Norton Rose in London

Technology boost

The changes sweeping through the fund and structured product industries are going to necessitate a big IT spend by providers, which is already under way. Technology providers say that whereas in 2009 many banks were holding off because of the crisis, 2010 has been a year when many internal bank committees have given the green light for new systems and software.

Broadly speaking, the German and Swiss banks already have highly sophisticated internal systems built up over the past decade. But across much of the rest of Europe there will be lot of outsourcing of the analytics needed to design a pay-off, create marketing materials and handle the onerous reporting requirements. Outsourcing is going beyond the supply of pricing tools.

"Key trends in the structured product market this year have been increasing regulatory pressure and a drive by product providers to reduce operational costs following the financial crisis," says Eran Elad, product manager at Modelity Technologies, which provides financial modelling and analytics to structured products providers and has offices in New York, Milan, Delft in the Netherlands and Tel Aviv.

Aside from the European Commission initiatives on new rules for tighter regulation of retail production distribution, regulators in individual countries, such as Commissione Nazionale per la Società e la Borsa (Consob) in Italy, have put forward a number of recommendations designed to allow retail investors to make informed investment decisions.

The key to the Consob process is a probability table that helps investors take a view on the relative outcomes of any given structured product when compared to a risk-free investment. The approach has so far been adopted by the insurance industry and the banks are following suit.

And in the US in December 2009, the Financial Industry Regulatory Authority (FINRA) issued a regulatory notice setting out obligations relating to sales of structured products. One of the main obligations is that in marketing or describing a product as offering principal protection, firms must ensure that their communications accurately and fairly explain how the securities operate. For example, firms must not overstate the level of protection offered or the investment's potential for growth. Promotional materials must be balanced.

More stringent requirements for salesforce training form part of these measures. To meet this need, Modelity has developed a product training module that allows an issuer to streamline the generation of interactive educational material and test staff at a product level, allowing sales force qualification for each product.

"Firms must train registered persons about the characteristics, risks and rewards of each product before they allow registered persons to recommend that product to investors," says Modelity's Mr Elad.

There is also growing co-operation on regulation between the US and Europe. In September 2010, the FSA and FINRA signed a Memorandum of Understanding to support more robust co-operation between the two regulators. The agreement will facilitate the exchange of information on firms and individuals under common supervision, support collaboration on investigations and enforcement matters and allow further sharing of regulatory techniques, including approaches to risk-based supervision of firms.

Uwe Becker, head of investor solutions in Europe at Barclays Capital in Zurich

Passport to sales

There is also a trend towards a pan-European market, whereas both ETF and ETN distribution has been very fragmented in the past, with each jurisdiction treated separately. Cross-border management of funds will become more common and jurisdictions such as Luxembourg and Ireland see a major role for themselves with regard to funds managed locally but distributed across Europe.

Under UCITS IV, master feeder structures may be created. In this case there will be at least two funds, and the feeder, generally in the country of the investor, will invest most of its assets into the master, which may be in another country. It may be considered that the management of most of the portfolio of the feeder is delegated to the master.

The passporting of products has been a controversial issue within the European structured products and funds markets over the past decade. Fund providers and hedge funds have often complained that countries such as France, Spain and Italy have used local regulatory clearance in order to protect the market share of their domestic providers.

"You often hear that Consob is very strict on new products and pay-offs. However, it depends on who is doing the selling, and an Italian bank is usually okay," says one analyst.

A streamlining of the notification process will reduce time to market and the administrative burden. It should also make it more difficult for individual countries to be able to use the process to delay and block entry of foreign funds and other retail financial products.

Given the alphabet soup of acronyms of the various new measures, how up to speed are banks and distributors of structured products? Certainly, their in-house legal counsel are being kept busy.

"Some are finding it extremely difficult to keep up on pan-jurisdictional distribution, with all these different proposals coming through at the same time," says one market participant.

"It is an interesting time because a lot of what people are doing now is looking to the future. Many products such as ETFs will be put onto third-party platforms for investors to buy direct and for discretionary managers to take from the platform," says one structuring banker.

The absence of provider commissions will take away a powerful distribution tool for structurers and the emergence of a more pan-European market will force providers to improve their cost-efficiency and improve the quality of information given to investors in order to make their products more attractive.