“The main objective of PRIIPS KID is investor protection by improving the comprehensibility of financial products and allowing their comparability. To attain these objectives, PRIIPS KID regulation has been articulated around the following requirements:
- Clear and concise description of financial products
- Use of the same indicators to compare financial products
- Use of alerts when changes occur in the behaviors of financial products
ESMA produced the Regulatory Requirements (RTS) on June 30th 2016. These RTS have been rejected by the ECON and the European Parliament. A quick fix has been circulated by the ESMA during September 2016. Finally, ESMA proposed improvements but not full adjustments to RTS on November 10th 2016. The final RTS are expected to be published and agreed in June 2017.
Given these elements, we propose in the following article the definitions of the practical meanings of the requirements and we propose the likely adjustments for the final RTS.
Comprehensibility of financial products
Comprehensibility of financial products relies on a key foundation, education. All investors should have at least a basic understanding of cash and derivatives financial products. The deep knowledge is good but not a pre requisite for retail investors.
Cash products have linear payoffs. If the price varies by one the retail investor equity varies by the same magnitude, one. Often, well-educated investors measure this variation by a technical word called delta.
The retail investor equity is measured by the cash used to acquire the financial products. In the common cash market, there is no leverage, which means that the retail investor must pay the full amount of the targeted financial product. However, some cash products require only a portion of equity to buy or sell, such as futures or CFD and in this case these products have leverage.
Derivative products can be simple or complex. Simple derivatives products cover vanilla options such as option to only get the upside variation of a product above a given level (call) or the opposite (Put). Complex derivatives capture other variations of the returns based on given events, often called triggers.
However, the most important rule to be understood by the retails investors is the risk appetite which determines their returns and consequently the variations of their equities. Since no free lunch can exist, they should bear in mind that the magnitude of the return of any financial product is function of its risk.
Lastly, all financial products’ returns are measured over time. Of course some products are perpetual because they do not have given maturities. Other financial products have different maturities and the only way to compare their returns is to measure them on equivalent yearly basis.
Comparability of financial products
The use of common standards to measure the forward equity of the investors and therefore to enable their comparability should be applied to all financial products. Among the common standards, we should cover:
- Nature of financial product,
- Forward looking to measure the investor equity accumulation, including intermediate observations,
Initial PRIIPS KID RTS
In the PRIIPS KID regulation, almost all the above criteria have been taken into account except taxes. The exclusion of taxes can be understood because the regulation is for the European area and all the countries have different taxes for the moment.
The produced RTS on June 30th 2016 draft the common guidelines to apply for all complex financial products sold to the retail investors: cash products, derivatives, structured products and insurance based-products. After analysis by the professional involved in each field of the covered financial products, it appears that some provisions of these RTS do not respect the above requirements, among them:
- Common standards: the RTS proposed different approaches for financial products which lead to confusion. For example, the treatment of insurance based products (MOPs) is not obvious and an educated retail investor can challenge the proposed treatment by stating that there is no difference in investment between a life insurance treatment and a fund of fund.
- Performances scenarios: the treatment of performances scenarios suffered from the use of observed past performances and consequently, supposed that the history repeats itself.
- Costs: the treatment of portfolio transactions costs is too complex to measure and could lead to confusion.
- Summary of Risk indicator: the classifications rules are not obvious and the exclusion of the impacts of the hedges that could be used could lead to wrong risk quantification and perception.
Proposed PRIIPS KID RTS
The proposed adjustments to the rejected RTS eliminate various weaknesses described above but require refinements to answer the key requirements listed above. In all cases and as a summary, it will be worthy to:
- Define common holding maturities for open ended financial products,
- Eliminate the treatment of insurance based products (MOP),
- Keep forward looking of the investors’ equities accumulations,
- Keep intermediate periods of investors’ equities accumulations,
- Use standard narratives to ensure the comparability of financial products,
- Use standards measures to alter the investors when a change occurs in their equities accumulations,
- Introduce the consistency with the other regulations such as MIFIID 2 and IDD.
All the views expressed in the present article are for discussion only.”
Luxembourg, November the 23rd
- Abder EL ADRAOUI (TALEO Reporting – Head of R&D)
Graduate of HEC, Paris in 1985, he has worked 6 years at Ernest & Young before joining the Banque Paribas as Head of Organization of Trading Activities in Paris for 4 years and in London for 6 years.
Among others, he has managed the Capital Markets department and ALM of the bank’s general inspection.
He became a consultant and entrepreneur in 2001 in London, Paris and now in Luxembourg since 2013.
He has set up dozens of projects for asset managers including AIFMD, FATCA, CRS and EMIR. He is specialized in Risk Management and has developed the required calculations for the KIID and KID.
Recently, he is Head of Research and Development at Taleo Reporting.
Taleo Reporting is a Reg Tech specialized in the creation of regulatory reports.
It covers: PRIIPs Creation / FATCA, CRS, QI / Solvency II: QRTs & Lookthrough / EMIR, TAF, MiFID II, MiFIR / Basel III (CRDIV), AIFMD, Form PF / Club Ampère…