On the 7th February of 2014, the European Securities and Markets Authority (ESMA) has delivered an opinion on “MiFID practices for firms selling complex financial products” (ESMA/2014/146). ESMA has observed that investment firms are offering complex investment products not only to professional clients, but also to retail investors, which “may not be able to understand the risks, costs and expected returns” of such products. A product should be considered “complex” when:
(i) they are derivatives, or embed a derivative; and/or
(ii) they are made up of one or more underlying financial instrument(s) that are difficult to value, or are combined in such a way so as to make it difficult to assess the risks involved and the likely performance scenarios; and/or
(iii) they use more opaque indices that are for example set up by the product manufacturer, rather than using standard market indices; and/or
(iv) have a fixed investment term of a number of years with barriers to exit (that are not clearly explained) - whether that is due to the lack of a secondary market, or significant penalties or losses on early exit; and/or
(v) have returns/pay-off structures involving multiple variables or complex mathematical formulas; and/or
(vi) include capital protection that may be conditional or partial, or that can be withdrawn on the occurrence of certain events.
For example, the following products should be considered to fall within the definition of complex products: contracts for difference (CFDs); binary options; turbos; exchangeable bonds; callable bonds; puttable bonds; convertible bonds; perpetual bonds; subordinated bonds; warrants; certificates; derivatives relating to underlying securities, currencies, interest rates, yields, or commodities; credit linked notes; and asset-backed securities.
Since “the more complex a product, the harder it is to demonstrate that retail clients have sufficient financial knowledge and experience to understand the key features, benefits and risks involved in an investment”, ESMA recommends that the National Competent Authorities ensure that investment firms meet some requirements concerning:
Organisation / internal control
They shall have in place adequate internal controls for products and services development when providing clients with investment services in complex products, in order to avoid detrimental practices toward clients.
Suitability
Before an investment firm decides to advise clients on complex products, it should first apply a high level of due diligence to evaluate those products; it should also carefully consider whether it is necessary to collect more in-depth information about the client, in order to consider which implications the investment will have for him.
Appropriateness
When assessing appropriateness, firms should consider all elements and features that determine the complexity of the product and risks involved and should asses the knowledge and experience of the client in that context. If, on the basis of the information provided by the client, a firm should consider that the product is not appropriate, it must warn the client.
Disclosure (including marketing communications)
The information used to advertise and disseminate complex products shall be “fair, clear and not misleading”. In particular, it should include disclosure of (i) the total amount of costs and charges applicable for the product, and (ii) the potential consequences of seeking to sell or exit early for the client. Moreover, it should explain the potential benefits and returns in the simplest way possible (e.g. avoiding jargon).
On-going monitoring (compliance risk assessment)
The compliance function within investment firms shall closely scrutinise the sale of complex products.
Execution of client orders
As required by the MiFID, firms must establish an order execution policy to allow them to obtain the best possible results for their clients taking into account price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order. Firms shall also take into consideration the characteristics of the financial instruments and the execution venues.
