The European Securities and Markets Authority (ESMA) announced the issue of an Opinion entitled "MiFID practices for firms selling complex financial products" [ESMA/2014/146] dealing with the importance of adherence by firms with the requirements governing selling practices of complex investment products as regulated by the Markets in Financial Instruments Directive (MiFID)1 and MiFID Implementing Directive2.

ESMA's Opinion centres on the fact that various asset classes, market segments and investment strategies which traditionally were solely available to the professional investor, have, through complex investment products, been made readily available to the retail consumer. Furthermore, firms' compliance with the MiFID selling practices in relation to these products has not kept to the expected standards.

Although the term 'complex product' might prove to be a relative one across the spectrum of investors, ESMA has proceeded in its Opinion, with a classification of the instances when products should generally be considered as being 'complex' namely when:

  1. they are derivatives or embed a derivative; and/or
  2. 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
  3. they use more opaque indices that are for example set up by the product manufacturer, rather than using standard market indices; and/or
  4. they have a fixed investment term of a number of years with barriers to exit (which 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
  5. they have returns/pay-off structures involving multiple variables or complex mathematical formulas; and/or
  6. they include capital protection that may be conditional or partial, or that can be withdrawn on the concurrence of certain events.

ESMA also listed specific products which by way of example should be considered as complex products, namely: contracts for difference (CFDs); binary options; turbos; exchangeable, callable, puttable, convertible, perpetual, and/or subordinated bonds; warrants; derivatives relating to underlying securities, currencies, interest rates, yields, or commodities; credit linked notes and asset-based securities.

ESMA warns that "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's Opinion further tackles the following aspects:

  • Organisation/ internal control: ESMA further advises that firms should have in place adequate internal controls for products and service development when providing both retail and professional clients with investment services in complex products to avoid any detrimental practices towards the client;
  • Suitability: In this regard, ESMA points out that before a firm decides to advise clients on complex products, it first should apply a high level of due diligence to evaluate such products. ESMA also refers investment firms to the Guidelines published in 2012 on "Certain Aspects of the Suitability Requirements "with regards to 'complex or risky products'. In this regard, firms should enquire into, inter alia:

    1. the prospective client's risk appetite and investment objectives;
    2. the prospective client's perceived time-frame for the investment (particularly when dealing with an illiquid product);
    3. the prospective client's ability to fulfil foreseeable future commitments should he incur losses equal to or exceeding his capital through the investment;
    4. the potential client's awareness of the fees and costs involved;
    5. the potential client's knowledge and experience in transacting similar complex products in accordance with Article 37 of the MiFID Implementing Directive. Such an assessment should not be conducted by means of a simple self-assessment exercise by the client himself. Moreover, should a client not provide the required information or the firm is of the opinion that, based on the information submitted, the product is not appropriate for the consumer in question, the firm must inform the client accordingly. Should the investment firm proceed to give access to the consumer in question to the product notwithstanding, it should clearly specify that the client is unlikely to appreciate the risks involved in dealing in these complex products.
  • Appropriateness: In this regard, ESMA maintains that when assessing appropriateness, firms should consider all elements and features that determine the complexity of a product and the risks involved and should assess the knowledge and experience of the client in the context. Thus firms that choose to implement a standardised process to assess appropriateness must not use it simply as a self-certifying process but must ensure that the client has understood the risks of the product.
  • Disclosure (including marketing communications): With regards to disclosure, ESMA advises that when communicating the key features and risks of complex products, particular attention should be given to ensuring that the communication is fair, clear and not misleading. Reference is also made to MiFID which provides that the disclosure of key features and risks involved in such complex products should be given fairly and clearly and should not be misleading in any way. This means that potential benefits and returns should be explained as simply as possible whilst avoiding jargon. In particular, it should disclose the total costs and charges involved including exit charges as well as the application (or otherwise) of any national investor compensation scheme should the provider default.
  • Ongoing monitoring: ESMA's Opinion further recommends that the firms' compliance functions should take a risk-based approach to determining the focus of the monitoring and advisory activities of the sales function. ESMA's position with regards to on-going monitoring by firms is that "the more complex the product, the more scrutiny the firm's compliance function should apply."
  • Execution of client orders: In this regard, ESMA maintains that in accordance with MiFID firms should 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 order.

ESMA's Opinion is also accompanied by an Information Note entitled "Risks of investing in complex products" aimed at providing investors with information concerning complex products. Both documents can be accessed from the ESMA Website. Moreover, the public is urged to access the Authority's sister website, http://www.mymoneybox.mfsa.com.mt/ for further information on the subject.

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Footnotes

1 Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments amending Council Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/EC of the European Parliament and of the Coun-cil and repealing Council Directive 93/22/EEC

2 Commission Directive 2006/73/EC of 10 August 2006 implementing Directive 2004/39/EC of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.