Structured Thoughts: News For The Financial Services Community - Volume 4, Issue 7 May 2, 2013

Regulating Retail Structured Products - The IOSCO Toolkit

The regulation of retail structured products in established markets such as in Europe and the United States is not a new concept. Since the onset of the financial crisis and the collapse of Lehman Brothers in 2008 (and even in some cases, beforehand), several common regulatory themes have developed across a number of jurisdictions. These include the desire to eradicate irresponsible selling, rebuild investor confidence, improve transparency and simplify unnecessary complexity. However, the precise focus of different regulators and the techniques they use to regulate this market can be widely divergent. This has prompted the attention of the International Organization of Securities Commissions ("IOSCO").

IOSCO's Task Force on Unregulated Markets and Products established a Working Group on Retail Structured Products, consisting of (amongst others) the Financial Services Authority ("FSA") in the UK, the Securities and Exchange Commission ("SEC") in the United States and the Financial Services Agency in Japan. Their work, as well as the results of a survey conducted across the entire IOSCO membership, now forms the basis of a consultation report (the "Consultation")1 in relation to a possible 'regulatory toolkit' for retail structured products2.

The purpose of this toolkit is to provide guidance to IOSCO members in respect of potential regulatory responses when dealing with future market challenges. However, IOSCO expressly does not intend any of the "tools" to be mandatory, or necessarily even desirable, in all cases. As such, the toolkit seems to be only a discussion of the universe of regulatory approaches that could be applied to retail structured products.

The regulatory toolkit breaks down into five primary areas:

suggested overall regulatory approach to retail structured products (the "value-chain" approach); product design and issuance; product disclosure and marketing; product distribution; and post-sales practices. This update summarises the primary apparatus in IOSCO's toolkit for each of the areas outlined above, and reflects upon their consistency with existing and proposed regulations in Europe and the United States.

A Value-Chain Approach

IOSCO suggests that any approach to structured products regulation adopted by its members should take into consideration the entire 'value-chain' i.e., the relationships involved in the life of the product, from the issuance of the product to its distribution, to the investment by the end investor. "Issuance" is intended to include both the origination and manufacture of the product, while "distribution" incorporates the definition from IOSCO's final report on suitability requirements (the "IOSCO Suitability Standards")3, including "in broad terms the services of selling by the intermediary including marketing, selling, advising, recommending and, where relevant, managing discretionary accounts / individual portfolios, which results in holdings by customers of complex financial products".

In order to minimise the opportunities for regulatory arbitrage, IOSCO suggests that regulators consider taking a "horizontal" approach to regulation that is not determined by the base instrument (or "wrapper") of the product, nor the type of underlying reference asset for the product. This is an approach which, at least in Europe, has formed the basis of regulatory focus in this area since 20094, as is reflected in the current draft of the proposed PRIPs regulation5 and certain proposed changes to the MiFID Directive6.

IOSCO also encourages its members to consider aligning their activities and approach with those of other regulators, both within and outside their jurisdiction.

Product Design and Issuance

Investor Identification and Assessment

In IOSCO's view, product issuers could be encouraged or made responsible for the identification and assessment of types, classes and features of investors at whom they wish to target their structured products. Such information might also be disseminated (where possible) to distributors for their use, in order to help ensure that products end up in the intended hands. Examples of possible regulatory requirements include (but are not limited to) a requirement to thoroughly analyse investor needs (considering investor risk profile, tolerance for loss of capital, investment objectives and investment timeframe), to promote investment products in a way that can be easily understood and to consider the financial, experience and education of the target market7.

Having a detailed understanding of the recommended target market for particular products is intended to assist distributors when making required suitability assessments. If products are designed with a particular class of investors in mind, they are believed to be more likely to be suitable for a member of that class. It is worth noting IOSCO's view here, that financial intermediaries should be separately required (by rules drafted along lines recommended by the IOSCO Suitability Standards), amongst other things, to (a) distinguish between retail and non-retail customers when distributing complex financial products (Principle 1), (b) check that the structure and risk-reward profile of a financial product is consistent with a customer's experience, knowledge and investment objectives (Principle 5) and (c) have a reasonable basis for any recommendation, advice or exercise of investment discretion made to a customer when distributing complex financial products (Principle 6). The creation of target investor identification rules and rules relating to an assessment of suitability (on a generic basis only) by the product manufacturer for target investors are intended to dovetail with these principles applicable to intermediaries.

As with a number of other items in the toolkit, it should be noted that the investor identification and assessment recommendations of IOSCO are already integrated into the regulatory regimes of certain individual jurisdictions such as the UK. In March 2012, the FSA published finalised guidance (the "UK Structured Product Guidance") on retail structured products8, providing that "identification of a target market is crucial, not only for generating ideas for products, but for avoiding failures later in the value chain...consideration of the target market should permeate all aspects of the product development and distribution". In the U.S., FINRA has been quite active in ensuring that broker-dealers appropriately review these issues. The IOSCO toolkit appears...