Complex instruments – Risk perception and retail investor access

Financial Article 14 by Vincent E. Rizzo - Jun 28, 2018

MiFID II allows investment firms, subject to certain conditions, to provide investment services that only consist of execution or reception and transmission of orders without assessing the appropriateness of the service or product for the client (so-called “execution-only” or “non-advisory”). One of the conditions for the application of the specific rule is that the services relate to products which are defined as “non-complex”.

At its simplest, regulation defines a “non-complex” financial instrument as one which is easy for a potential investor to understand and assess and which has no particular features or characteristics that puts this understanding or assessment into question. On the contrary, “complex” financial instruments are instruments which include a feature or characteristic that make it more difficult for potential investors to understand and assess in so far as risk is concerned. “Complex” financial instruments are therefore ineligible for retail investors unless they are capable of demonstrating that they have sufficient knowledge and experience to understand these features and characteristics.

By way of example, and in the interest of keeping this article as simple to understand as possible as well as relevant to the local context, the rules identify, amongst others, ordinary shares and plain vanilla fixed interest securities (bonds) having a fixed maturity date as “non-complex” financial instruments. On the other hand, “complex” financial instruments include bonds having an early redemption option (callable bonds), instruments embedding a derivative or presenting a structure which makes it difficult for the client to understand the risk as well as subordinated bonds amongst many others.

Over the past couple of years and with the onslaught of ever increasing regulation that is becoming harder to interpret, the market has had to adjust in an unprecedented manner. In the local context, there has naturally been no exception to this onslaught and we have also had to contend with formal regulatory “policies” and also informal understandings over and above regulation.

All this has indeed created an environment where investment services providers on the one hand and investors on the other are having to struggle with continuous adaptation while attempting to continue to provide a service in the main to the retail investor. Without a doubt, these investors cannot and do not follow regulatory developments as they unfold. Do you blame them?

In a circular addressed to the investment services industry dated 4 March 2014, the MFSA stated that securities’ regulators are concerned that “alternative and more sophisticated investment strategies” are being made available to retail clients and that this trend poses certain risks for retail investors as they may not be able to understand the risks involved.

While regulation no doubt creates a safer and more structured environment in which investors may indeed be “protected”, it also runs the risk, as, in my humble opinion, it seems to be doing, of creating an unwanted adverse scenario. A situation seems to have arisen where the monitoring of “risk” on one side is simply creating an unwanted and unfortunate shift of risk on the other. I will seek to explain this in simpler terms while adapting it to the local context.

Today, regulation effectively prohibits a retail investor from investing in a subordinated bank bond (“complex” instrument) unless the investor passes (literally) a rigorous test. This test takes the form of a lengthy questionnaire-type assessment that investment service providers need to provide to investors prior to an investment in this type of instrument. The answers provided by the investor are then assessed by the licenced financial intermediary who in turn assumes the risk and responsibility of determining whether the investor possesses the necessary knowledge, experience and expertise to invest in these instruments. This laborious process is time consuming and therefore costly, a cost which invariably would need to be passed on to the retail investor over and above the brokerage to be paid for acquiring the instrument. Realistically speaking, given the profile of most local retail investors, several investors are unlikely to pass this assessment. Effectively, this means that many local retail investors are unable to invest in subordinated bank bonds as a matter of fact. Explaining this to the investor after having gone through the assessment is not at all easy and few would accept the conclusion than an investment cannot be processed on their behalf even on a non-advised basis. The challenge goes one step further.

At this point, all these being equal, the retail investor could decide, out of lack of choice, to consider (and probably) invest in “non-complex” financial instruments since they are easier to understand simply because they are not burdened with “complex” features. Perhaps the cost of assessing investors is one of the factors that also leads them down this route.

The shift of risk though as I referred to earlier is in fact this ‘alternative’. In order to obtain returns and achieve the desired objective of an investment in financial instruments, has this burden partly created a demand for higher risk “non-complex” instruments? In reality, retail investors have easier access (effectively no barriers) to other financial instruments simply because they are “non-complex”. The difficulty and worry though, from my perspective, is that in all this process of “protecting” and “educating”, regulation has effectively provided retail investors with the completely incorrect perception that a “non-complex” financial instrument is less risky and therefore more appropriate. Add to this the ease with which one accesses these instruments relative to subordinated bonds (using my example above) and what you get is the perfect misconception!

Retail investors now also have the possibility of investing even in bonds issued effectively by start-ups or relatively small unknown issuers not having an adequate track record and almost certainly offering rates of return not commensurate to the risk being taken. In increasing instances, these bonds are not admitted to the main regulated market and are very illiquid. In the process, these same retail investors are having to shun bonds issued by large, regulated, dominant and strong banks simply because these institutions are issuing subordinated and therefore “complex” bonds. So much for risk vs return considerations!

I would not wish to be misinterpreted. I am not against regulation. On the contrary! However, regulators also ought to assess the potential counterproductive risks regulation may pose to the market as it adjusts to the realities at the time. There is somehow always a “way out” as it were, and the result may not always achieve the desired effect. The problem, as I see it, is the extreme to which we have now taken regulation in certain instances and the lack of conviction that the intended objectives are indeed being achieved. Complexity does not necessarily equate to risk. This is where educating as opposed to just regulating is highly needed. As is, the concern seems to be that retail investors are getting the wrong message.

Download as a PDF Print This Page Print This Page Disclaimer
Rizzo, Farrugia & Co. (Stockbrokers) Ltd, “RFC”, is a member of the Malta Stock Exchange and licensed by the Malta Financial Services Authority. This report has been prepared in accordance with legal requirements. It has not been disclosed to the company/s herein mentioned before its publication. It is based on public information only and is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. The author and other relevant persons may not trade in the securities to which this report relates (other than executing unsolicited client orders) until such time as the recipients of this report have had a reasonable opportunity to act thereon. RFC, its directors, the author of this report, other employees or RFC on behalf of its clients, have holdings in the securities herein mentioned and may at any time make purchases and/or sales in them as principal or agent, and may also have other business relationships with the company/s. Stock markets are volatile and subject to fluctuations which cannot be reasonably foreseen. Past performance is not necessarily indicative of future results. Neither RFC, nor any of its directors or employees accept any liability for any loss or damage arising out of the use of all or any part thereof and no representation or warranty is provided in respect of the reliability of the information contained in this report.