Belgian Structured Investment Products Association
Thomas Wulf, Secretary General
BELSIPA agrees that market, credit and liquidity risk are the main risks for PRIIPs. The definitions for these three types of risks set out in the Discussion Paper are comprehensive and cover their main aspects.
BELSIPA would stress its general discomfort with a display of performance scenarios in any KIID as different likelihoods of a product’s assumed performance may be difficult to understand and weight against each other for retail investors. Depending on the individual risk perception of an investor, the overestimation of a loss or profit likelihood might frequently be the case and unduly influence the individual investment decision.
However we would like to underline that if ever performance scenarios are foreseen as part of a future KIID they should not be based on “risk-neutral” probabilities but instead use “real-life” probability scenarios, which entail, for example for equity underlyings and derivatives, a risk premium.
It should be noted that such an application of risk premiums in performance scenarios is also fully supported by research work undertaken on the level of single regulators, such as was recently published by ESMA (see ESMA Working Paper No. 1, 2015 “Real-world and risk-neutral probabilities in the regulation on the transparency of structured products” by Luca Giordano and Giovanni Siciliano).
BELSIPA takes the view that presenting summary indicators similar to features of non-financial products (such as energy efficiency labels for technical devices) is not an adequate means of communicating the risks of a financial product to retail investors. The main reason is that such “energy-style” labelling conveys, in its lower scale, the strong notion of a “good” (originally understood as environmentally friendly and energy saving) product and in its higher scale the opposite.
This however runs the danger to fundamentally irritate retail investors in financial products as they might choose a low risk product due to its “good” A-level classification (such as Eurozone sovereign bonds) but might overlook that a low risk typically leads to only low returns. With indicators which do not use formats that have already an established market reputation (which as mentioned energy efficiency levels have) this danger of irritating investors should not exist.
With regard to establishing a practical solution that is both easily understandable to the retail investor while bringing with it a manageable burden of changes to existing processes at issuers and distributors, we are convinced that the following is worth considering.
BELSIPA is of the view that market and credit risk can be integrated in one summary risk indicator, which should be based for market risk on a quantitative measurement and for issuer risk on a qualitative measurement, as set out below.
As for the market/performance risk, it would be a clear advantage to use a methodology already widely applied in the financial marketplace, such as for example the Synthetic Risk and Rewards Indicator (SRRI) foreseen in the UCITS directive for funds with its seven level risk scale. It should be tested whether this methodology and scale could generally be applied for also measuring the market/performance risk of packaged investment and insurance products other than funds.
As the SRRI methodology was however designed for funds, it does not account for issuer or counterparty risk when the structured product is a debt instrument. To ensure that this risk is equally considered a suggestion would be to use also a 1-7 level issuer risk scale for establishing the issuer/counterparty risk. Technically it will for this purpose be necessary to define qualitative criteria with regard to which of the current singular rating denominations used in the markets (e.g. the Moody’s, Fitch, Standard’s & Poor rating tables) are attributed to the numeric 1-7 levels. As final product risk the higher of the two risk scales, namely market risk on the one side and issuer/counterparty risk on the other, would represent the final risk level. The rationale of the above approach (to communicate the highest between SRRI and credit risk class) finds further justification in the nature of the SRRI methodology and its direct application to the main structured product categories available in the market (with or without capital protection) :
Products with no capital protection: for products with no (or partial) capital protection at maturity, the SRRI will by design reflect the worst-case scenario (1st percentile of return distribution which usually corresponds to losing most of the initially invested capital). As a result, the risk scale will already be very high (close to the maximum risk of 7), without even having to account for credit risk.
Products with capital protection: For a 100% to 90% capital protected product (most retail structured products), the SRRI will usually be low (typically between 1 and 3) because of the high level of protection. In terms of SRRI, the worst-case scenario for this category of products is redemption at par. As a result, the question of issuer default, however remote, is here more central as it constitutes the most damageable threat for the investor for losing a portion of the initially invested capital. As a result, and given the design of the SRRI, deteriorating its score in order to account for credit risk is economically appropriate for capital protected products.
BELSIPA would not include liquidity risk in above risk model as this risk is very difficult to quantify. It does not only depend on the availability of a counterparty able and willing to buy a product back from the investor but also, for example, on the question as of which level prematurely charged exit fees are considered to impact the decision of the investor to sell the product on the secondary market. BELSIPA would hence suggest to narratively disclose product features which potentially impact a product’s liquidity.