structured products:
are you aware of what
is in your back book?
december 2014
background
The sale of structured products in firms’ back books
have once again been thrust into the limelight, following
the fining of two high-profile retail firms1. Although
these firms are big industry players, the FCA is keen for
the industry as a whole to sit up and take note when
they issue fines and final notices. Therefore, the past
sale of structured products is not just a potential issue
for the larger firms, but one for any firm, even small
intermediaries, that have previously recommended these
products as part of a client portfolio.
Critics suggest that structured investment products
are risky investments that are highly complex and are
unlikely to be understood in any depth by the average
adviser, let alone the unsophisticated investors who have
often ended up as the consumer. Conversely, many view
them as a vital option for risk-averse investors who have
little capacity for loss and argue that there are good and
bad options, as with any financial product.
Consumer detriment is usually uncovered years after the
event, and so we are yet to confirm conclusively whether
problems are still occurring and whether legacy issues
have yet to be uncovered. This means that unsuitable
sales of structured products may still be lurking in firms’
back books.
Notional value
Although the FCA does not seem to be proactively
engaging in any interventionist activity, firms should be
proactively examining past business to make certain that
the past sale of structured products is not an area of
concern for them.
This white paper provides an exploration of the risks of
structured investments and outlines where issues and
failings have occurred in the past to provide advisers
with food for thought when considering whether they
need to consider reviewing any past business.
Risks and rewards
Structured investments, also frequently referred to as
Guaranteed Equity Bonds or Protected Investment
Bonds, are an investment where the returns are based on
the performance of an instrument such as the FTSE 100.
There are many varieties but, commonly, there are two
underlying investments, one for capital protection and
another to provide investment growth.
The diagram below illustrates how a structured
investment is generally arranged:
Provides
investment
growth
Equity
Option
Zero Coupon
Bond
Issue date
1
Provides capital
protection
Maturity date 3 years
FCA http://www.fca.org.uk/news/fca-fines-credit-suisse-and-yorkshire-building-society-for-financial-promotions-failures
Structured Products: Are you aware of what’s in your back book?
3
The combination of features available generally appeals
to investors wanting to guarantee their initial investment
yet also gain an element of growth. Structured
investments may be especially attractive in today’s
market due to low interest levels generating little return
for traditional savings vehicles and low yields from many
investment products.
On paper, structured investment products sound
highly attractive with most being able to boast capital
protection as well as investment growth and flexibility;
but as with any kind of investment, there is a gamble,
delivering risks as well as rewards for investors.
Detriment may have occurred in past business where
these risks were not made clear, or where they were not
understood by both adviser and client.
As with any investment,
there is a gamble delivering risk as well as
reward for investors
Capital protection
In a structured investment, often a proportion of the
initial capital is protected by investing it in a fixedinterest security, such as a zero coupon bond. With a
fixed price at maturity, the investor can expect this part
of the investment to be guaranteed. This is not always
the case however, some products known as SCARPs
(structured capital-at-risk products) will lose capital
Structured Products: Are you aware of what’s in your back book?
protection if the investment element falls below a certain
percentage e.g. 60%, resulting in investors losing capital
as well as investment growth.
Most structured investments are distributed to market
through a financial adviser, bank, building society
or insurance company. In the majority of cases the
distributor is not the product provider, rather the
provider is another company that is simply using the
third party to sell to the product. These companies are
referred to as counterparties and if they fail, investors
lose their capital. The collapse of Lehman Brothers (the
counterparty) at the beginning of the financial crisis
brought it home to investors that the ‘capital protection’
element of these products was vulnerable. To further
compound this risk, counterparty failure is not covered
by the Financial Services Compensation Scheme (FSCS)
so if the counterparty goes bust, investors have no
chance of obtaining compensation, unless they have
been a victim if mis-selling.
Advisers should ensure when reviewing past business
that the extent of capital protection was clearly
explained to customers, using illustrative aids to ensure
that counterparty risk was made clear to the customer
and was documented.
Potential return on investment
The remainder of the capital can then be used to
pay requisite charges and distribution costs and be
invested for growth, usually on the performance of an
underlying asset or index such as the FTSE 100 or S&P
500. Although the gains will not be as high as investing
directly in the stock market, this element provides the
investor with potential growth. Obviously, investors could
also be at risk of making no gain at all.
It is also important to note that whether investors win or
lose, administration and adviser charges still apply, which
can eat into the gain, the capital or augment the loss
further, and this must be clearly illustrated to the client.
4
Flexibility
Due to the wide range of options and products available,
the investor has the option to match their market
exposure to their attitude to risk, allowing an element of
control over the balance of risk and reward.
On the other hand, investors are invariably locked
into a structured investment for a fixed-term, where
redemption penalties can be high. Investors also lose
out by not being able to take dividends, which can be a
significant part of an investment. This lack of liquidity can
be attractive for some investors and there are potential
tax advantages to be gained, such as qualification for
capital gains tax rather than income tax.
Structured investments are also designed to pay out at
a fixed date. This means that if, on maturity, the market
is not favourable, the investor cannot wait for more
agreeable times, they have to take what is paid out on
that date. Once again, it is imperative that the client is
made aware of both the risks and rewards of investing in
a structured product.
Although many structured investments are designed
to protect against fluctuations in the market, they do
not protect against catastrophic events such as those
occurring during the financial crisis. In these events,
financial firms considered stable by the consumer have in
the past failed and could do so in the future.
Counterparty failure is therefore a real risk and there
have been well documented instances of this in the past.
Advisers should have explained to clients the risk of
counter-party failure and to mitigate this risk should have
used one or more of the following three guards:
•
Invested only in products where the credit rating
of the counterparty was BBB (investment-grade) or
above;
•
Carried out effective due diligence on the
counterparties;
•
Spread the risk over a multitude of counterparties
or a range of Structured Investments backed by
different counterparties.
Market risk
Structured investments rely on the volatility of the
markets to produce the expected return. Of course,
markets can go down as well as up and so there is
vulnerability as with any kind of investment.
Structured investments commonly use a barrier level,
below which investors stand to lose out financially. This
means that if the index used e.g. FTSE 100 drops below,
say 50% of its initial level, then investors will lose all or a
proportion of their capital. Although the likelihood of the
FTSE falling below 50% is slim, it is not an inconceivable
event and if the barrier level is set higher, at 75% for
example, the risk is much higher.
Structured Products: Are you aware of what’s in your back book?
Counterparty failure is a
real risk and there have
been well documented
instances in the past
5
Structured Investment Issues
There have been some well documented problems with Structured Investments over the past 15 years, leading to consumer
detriment and regulatory intervention:
1999-2006
Eurolife/Nvesta
Capital Secure
Bonds
Counterparty
Failure
1999-2003
Precipice
Bonds
Mis-selling
Considering where firms have gone wrong in the past and
the common themes that have emerged from the above
cases is a good place to start when considering where
issues may have occurred in past business.
Complexity
Structured investments are often regarded as complex due
to the number of different product options and the way in
which they are structured. The term ‘structured products’
is a wide catchall and to the unsophisticated investor it can
be difficult to distinguish between what are mainstream
retail derived products and the more complex structures
designed to hedge risk in and out of complex investment
arrangements.
There have been concerns in the past that structured
products have been discounted due to miscomprehension
and there is potential for mis-selling should they have
been misunderstood and recommended to clients
2005-2009
2007-2008
2007-2009
Lehman Brothers
Credit Suisse UK
Counterparty
Failure &
Mis-selling
Counterparty
Failure &
Mis-selling
Inadequate
Systems &
Controls
Keydata
unsuitably. This was a key issue in the Keydata scandal
whereby the FSCS ruled that the product was largely
mis-sold by advisers, reasoning that any competent
adviser would realise that Keydata was a high-risk and
complex product.
With this in mind, when assessing past business it is
imperative that advisers are certain that they received
the level of information and/or training needed from the
provider to enable them to describe complex product
features clearly and make them understandable to
investors. The information provided for advisers should
have been more comprehensive than the financial
promotions intended for investors. Moreover, firms
should ensure that suitable training and competence
procedures were in place to ensure that advisers were
aware of structured products, their advantages and
risks. Ultimately, where advisers did not understand the
features and structure of a product, they should not have
recommended it.
2008-2010
6
Santander UK
Credit Suisse
International
Disclosure
Breach
Misleading
Promotions
Understanding whether there was adequate
comprehension of products can be difficult to assess
retrospectively, and so, to remove doubt, advisers
should initially consider reviewing a sample of cases and
examining adviser training records to assess the level of
competence.
Target market & distribution
In the FSA’s review of structured product development
and governance2 in March 2012, they discovered that
firms were unable to articulate a clear strategic purpose
in the manufacturing of structured products and placed
too much emphasis on commercial factors. In adherence
to TCF Outcome 2: Products and services marketed
and sold in the retail market are designed to meet the
needs of identified consumer groups and are targeted
accordingly, providers should ensure that they are
designing products that meet an identified need and
distribute them through appropriate channels.
2
Structured Products: Are you aware of what’s in your back book?
2009-2012
2009-2012
Yorkshire
Building Society
Misleading
Promotions
2013
Lloyds Bank
Mis-selling
It is thought that lack of targeting places a
disproportionate responsibility on those distributing
the products, potentially allowing the products to be
mis-sold to unsuitable consumers. With the responsibility
of ensuring that structured products distributed by
the intermediary market land in the hands of those
consumers for which it is suitable on advisers, it is
imperative that advisers obtain a clear brief from the
provider outlining who the intended target market is.
Advisers should ensure that they truly understand who
the product is intended for and that they feed back
to the provider if they find that investors are not able
to understand the product features or if they seem
inappropriate for the target market.
In the high-profile Keydata case, the distributor Norwich
and Peterborough Building Society (N&P) was found to
have sold to older consumers approaching retirement
who were looking for, and should have been advised,
low risk products. This is despite the product being
FCA http://www.fca.org.uk/static/pubs/guidance/fg12-09.pdf
Structured Products: Are you aware of what’s in your back book?
7
deemed high-risk. More recently Lloyds Bank has been
reported to be paying thousands in compensation to
the ‘vulnerable and elderly’ customers to which it sold
complicated structured investments. Both these cases
demonstrate the necessity of clearly designing products
for a particular market and articulating it clearly so that
products are not available to whom it was not intended.
Advisers should investigate whether the structured
products they sold in the past were targeted towards a
specific consumer group and review a selection of past
cases to determine whether they were indeed sold to the
correct consumers.
Systems and controls
In a 2009 review3 the FSA found systems and controls
failings in the quality of advice of structured products,
stating that firms failed to:
•
Consider the individual features of structured
investment products and their suitability for different
customers
•
Ensure advisers were competent enough in their
understanding to advise on structured investment
products
•
Ensure appropriate compliance monitoring and
oversight arrangements were in place.
Subsequently, Credit Suisse UK was fined in 2011 for
failing to establish and maintain effective and resilient
systems and controls overseeing the advice suitability
of structured products, resulting in a £198.2m consumer
loss.
Since then there have been no reported failings in
oversight of advice suitability however this does not
mean the issues have been entirely remedied. Firms
should consider testing systems and controls around
sales practices against specified outcomes to ensure they
accurately identify unsuitability risks.
A review of past business will also provide insight
into how effective firms’ systems and controls were
at the time, particularly around the sales process and
3
unsuitability. If failings in systems and controls are
uncovered, this could signify there may have been
failings across the board.
Firms should test systems
and controls to ensure
accurate identification of
suitability risks
Suitability
As suitability continues to be an issue for the industry,
in the past nowhere was this more evident than with
structured investments. In the review into the suitability
of advice of structured investment products, conducted
in 2009, the regulator found that 46% cases were
advised unsuitably. The reasons stipulated for this view
were:
•
Failing to meet the customer’s needs and
circumstances.
•
Exposing the customer to an inappropriate level of
risk including over-concentration of assets in a single
product or product type.
•
Failing to meet the customer’s tax needs.
Two areas of concern that crop up frequently in
investment advice across the board are matching
attitude to risk (ATR) with investment recommendation
and portfolio diversification.
In the FSA’s assessment of Credit Suisse UK, they said
there was ‘little to no evidence’ of how attitude to
FSA http://www.fsa.gov.uk/pubs/other/qa_structured.pdf
Structured Products: Are you aware of what’s in your back book?
8
risk was met, highlighting a number of damning cases
where customers’ risk profiles had been increased for no
apparent reason. Advisers need to ensure that they are
clearly establishing the risk that a customer is willing to
take, taking into account their capacity for loss as well as
their attitude to risk. If firms are using risk-profiling tools
they should recognise their limitations and ensure there
are effective controls to identify and mitigate arising
risks.
Many of the IFAs that sold Lehman Brothers backed
structured investment products were found not to have
taken into account customers’ financial circumstances
and objectives and recommended products that did not
match ATR. There have clearly, in the past, been issues
with advisers misunderstanding or underestimating
a structured investment product’s risk, leading to
unsuitability. Firms should ensure that they have a
clear view of a structured investment’s risk-rating and
document comprehensively how that matches the client’s
risk profile, taking into account the risk of the underlying
investments and the additional features as well as
counterparty risk.
The regulator stipulates that ‘Advisers should always
seek to diversify a customer’s investment portfolio.’4,
considering both product and portfolio concentration.
If an adviser has deemed a structured product to be
a suitable recommendation for a client’s need and
circumstances, they should reflect on the concentration
of this product as part of the portfolio. The regulator
has only set guidelines rather than prescribed rules as
to what proportion of a portfolio should be allocated to
structured products, it is widely accepted that no more
than 25% should be invested in this way and no more
than 10% in a single structured product. In the Lehman
case, unsuitable advice given by the IFA distributors was
attributed in part to the excessive concentration of one
structured product in the investment portfolio. With any
portfolio, whether containing structured products or not,
spreading the risk is imperative and a basic component
of financial planning.
There is potential that this could be a common issue in
structured product past business. Therefore, firms should
review a sample of past cases to determine whether
customers were recommended a product that matched
ATR and whether their portfolio was sufficiently diverse.
4
At this stage, it is worth considering whether the
distribution of structured products through non-advised
sales channels is appropriate. Clearly, those products
that are complex and carry a high degree of risk should
only be distributed through advice from a qualified
professional. This largely occurs in practice, however
whilst those that carry little capital risk and are fairly
simple in structure may be appropriate to distribute
through non-advised channels, care must be taken to
ensure that these traditionally financially unsophisticated
consumers are provided with enough clear information
to enable them to assess the compatibility of the product
to their needs and circumstances.
Financial promotions & information
Financial promotions are identified as a particular risk in
financial services because of the complexity of products,
their long-term nature and the potential for considerable
detriment to consumers. Therefore, providing consumers
with clear, fair and not misleading information at every
stage of the purchasing process is imperative to ensure
that consumers are not becoming victims of mis-selling
and to enable them to make informed, sound decisions.
In response to the market trend of consumers seeking
higher yielding products than currently available, firms
responded by creating products that deliver higher
returns and marketing them as such. TCF outcome 5
stipulates: Customers are provided with products that
perform as firms have led them to expect, putting
in focus the need for firms to ensure their financial
promotions are fair and balanced and that unrealistic
expectations have not been fostered.
Since 2009 the regulator has witnessed significant
improvement in the quality and level of information
provided in firms’ financial promotions and the systems
and controls governing them. However they noted a
propensity to overstate the maximum rates of return
achievable and developed concern about the difficulty
for firms to explain complex product features in a way
that is fair, clear and not misleading. This is a concern
that has been echoed in the recent Credit Suisse
International (CSI) and Yorkshire Building Society (YBS)
sanctions.
FSA http://www.fsa.gov.uk/pubs/other/qa_structured.pdf
Structured Products: Are you aware of what’s in your back book?
9
CSI were found to have given undue prominence to
the maximum return of a structured investment to over
83,000 customers. This warranted penalty from the
regulator because their promotions presented unfairly
the information of the maximum return (of which the
probability of achieving was close to 0%) leading to
a disparity between what the customers were led to
expect and what was actually achievable. In addition,
they also failed to explain early termination charges and
conduct periodic review of their processes to ensure
compliance with regulatory requirements. CSI distributed
their products through third parties, typically building
societies on a non-advised basis, meaning that investors
were generally unsophisticated and conservative, unlikely
to understand structured products in general and the
likelihood of achieving the maximum return. The third
parties were not off-the-hook however, as is evidenced
in the penalty imparted on YBS, where they too gave
the maximum return undue prominence in their product
literature and financial promotions.
These examples demonstrate that both providers and
distributors are responsible for the way in which they
promote structured products. Firms should take care
to scrutinise the promotions and product literature
they receive from providers to ensure that it provides a
balanced view of the product and will not influence the
customer unfairly by placing emphasis on unachievable
outcomes. In turn, advisers should ensure that the
information they provide to customers from point of sale
through to post-sale, fulfils their information needs. This
Structured Products: Are you aware of what’s in your back book?
means highlighting the risks and disadvantages as well
as the reasons for recommendation or purchase. The key
is to ensure that a product ‘does what it says on the tin’.
As part of a review of past business, firms should review
their financial promotions, taking care to ensure that
the aforementioned issues are not present. Assessing
past financial promotions of structured products can
be a challenge if they have not been retained past the
required retention period.
As part of a review of
past business, firms
should look at financial
promotions
10
Summary
Structured products are often complex investments
that have the potential to yield a return higher than
traditional savings deposits, whilst offering a degree
of capital protection. It is easy to see why these are
an attractive option for the risk averse, conservative
consumer, however there are complicated associated
risks which need to be evaluated by independent
advisers who must consider these as part of their
appraisal of the whole market.
Although suitability, attitude to risk and portfolio
diversification remain continuing issues across markets,
advisers also need to take into account counterparty
risk, the complexity of added features and above all,
how this is communicated and explained to the investor
in a way that makes them understand what is generally
a complex product with many layers of management.
Advisers should ensure that these products are reaching
the target markets for which they were intended and if
there is any doubt as to the integrity or credibility of the
underlying counterparties that they choose to discount
them.
The sanctions against CSI and YBS demonstrate that
there may still be mis-selling or unsuitability issues in
firms back books. Advisers should be proactive now
to assure themselves that their past business does not
contain any skeletons by heeding the above advice and
reviewing a small sample.
If you think this could be an issue of concern for you, or
just to gain peace of mind that it isn’t, please discuss
with your TCC Intermediary consultant or get in touch
with the team on 0800 970 9757.
Structured Products: Are you aware of what’s in your back book?
11
Head Office
TCC Intermediary
The Consulting Consortium Ltd
6th Floor
10 Lower Thames Street
London
EC3R 6EN
Tel: +44 (0) 800 970 9757
www.tccintermediary.com
This document was produced by The Consulting Consortium Ltd © 2014