Following the European Council's (EC) adoption of the regulation on Key Investor Documents (Kids) for Packaged Retail Investment and Insurance-based Investment Products (Priips) Regulation, which will come into force in 2017 and recommends the use of a key investor information disclosure document (Kiid) through which all competing financial products have to disclose a risk rating, SRP provides an overview of some of the recent views provided by trade bodies and market players around this subject in the UK and Europe.
Christian Wollmuth, managing director at the German Derivatives Association
"We prefer downside risk measures (VaR, ELVaR, expected shortfall), since those dominate symmetric risk measures like volatility. Volatility is a good measure for symmetric distributed investment returns but not for asymmetric ones which can be observed in Priips (derivatives, structured products etc.).
"On the other hand, all downside risk measures are appropriate for such asymmetric distributions. However, it could be advantageous to choose a "popular" risk measure to be compliant with other regulations / market standards. For instance the VaR concept is already part of the Ucits and in Basel III regulation."
Zak De Mariveles, chairman of the UK Structured Products Association (UK SPA)
"The UK SPA Risk Ratings are two-dimensional, reflecting both the market risk and credit risk of a product. The market risk rating is calculated based on the volatility of the product, and ranges from 1 to 7 (similar to the SRRI rating commonly used by the fund industry), while the credit risk rating is based on the credit rating of the issuer or deposit taker of the product, and ranges from A to G.
"Up until now, while our members are very clear at describing key risks in their product literature, there has been no alphanumeric risk value assigned to each product, such as is available within the funds industry. These ratings not only give advisers the tools they need to be able to match products more closely to their clients' needs, but they demonstrate the high levels of transparency that our members are committed to providing."
Tim Hailes (pictured), chairman of the Joint Associations Committee (JAC) on retail structured products.
"On the subject of market risk, the JAC has pointed out that this is key for retail structured products and that there should be a single indicator determined by reference to historical volatility which should also include credit and liquidity risks.
"The disclosure of key risks in the Kid in accordance with the Priips Regulation should satisfy the above requirements in Mifid II. We note that the Priips Discussion Paper mentions that 'under certain circumstances' the investment firm could rely on the Priips Kid to provide Mifid II risk information. However, we consider that Mifid II requirements in relation to disclosure of risks should be satisfied where the requirements of the Priips regulation have been complied with."
Gary Dale, head of intermediary sales at Investec Structured Products
"Trying to put these incredibly diverse products into 'risk rated' baskets is a flawed practice and may potentially backfire on the very individuals we are trying to simplify the messages for, the consumers. Risk should be measured as the probability of loss and, from an investor's point of view, how much of their capital they are prepared to lose. Risk is an absolute measure, it can be quantified and understood and it should not be confused with volatility which is a relative measure usually around a fixed point or benchmark.
"Structured products by design have pre-defined upside and downside characteristics which cannot be altered once the product has struck, or started. The risk elements are absolute from the outset both in terms of any downside protection or upside potential which of course are asymmetrical by design. Structured investments carry asset risk and risk to capital in addition to counterparty risk whereas structured deposits, which also carry asset risk with regards to upside potential do not carry any risk to capital or counterparty risk where the deposit does not exceed the amounts covered by the Financial Services Compensation Scheme, currently £85,000 per eligible claim.
"Investors know exactly what the risks are for each individual product, however, it should be made very clear that even where the return profiles of two different products may be similar or the elements of capital protection appear the same, they will in fact be very different products where some of the characteristics may vary considerably. Categorising products, especially at a 'risk' level may prove to be incredibly misleading to investors."
David Stuff, chief executive at Cube Investments
"Although some providers have started providing historic back-testing data (a methodology with well-known drawbacks as a guide to future performance), we prefer to provide results on simulated and historic tests as well as providing descriptions of its calculations for each product launched.
"We also provide a volatility-based score consistent with the Synthetic Risk and Reward Indicator (SRRI) with which regulated collectives must comply as required by European regulators and has been mapped to the popular 1-10 risk scales used by many financial advisers.
"The risk indicator should be based on a model that calculates the overall distribution annualised returns you may get from a product and then calculates a deviation based on downside variance of that distribution... so basically looks at the downside risk and captures the volatility that matches that."
Graham Devile, managing director at Meteor
"We have been working on a risk rating model that is based on bootstrapping and a volatility play. We've tried to keep it relatively simplistic and straightforward for the end retail investor to be able to understand and for it to be intuitive. If you look at Esma's methodology, you have products that are very complex and risky with a rating of one which means the risk is very low.
"Because the data you are using can provide you with an outcome that assigns a low risk rating, it doesn't mean the risk is low. Our concern in this area is that regulators are now running for forward looking projections and it's very difficult to make any projections with any model or methodology. We need to provide investors with meaningful information but some of the regulatory requirements are going to create problems as investors may come back in five years claiming that risk projections were wrong.
"The risk rating requirements are flawed, but we have no choice. This is a dangerous route and it's not only about structured products. If you look at a structured product linked to indices, the return is tied to macro-economic situations whether a fund reacts to a fund manager's view. A structured product always tells you what happens if the underlying asset goes down in value but we don't see that same granularity in a fund which doesn't tell you what happens if the assets fall in value, or if the asset manager leaves.
We're facing a potential compliance galore situation with investors pointing at the forward looking scenarios to claim products were mis-sold on the basis of that probability. If you consider this in the context of different firms using different risk rating methodologies and probability scenarios the concerns are justified.
"The problem becomes more relevant if investors buy structured products on the basis of probability outcomes and risk ratings supplied by providers. The problem with using the delta supplied by banks is that we do supply the delta at the point of trade and the delta we get from the different investment banks are completely different. None of the methodologies we have seen are consistent. I don't think the industry will ever agree to a single methodology as banks have commercial interests."