Financial Innovation and Complexity in Retail Investment Products
In Europe, different cases of mis-selling have caused national supervisors to take a more proactive stance on “complex” products. However, supervisory intervention has been piecemeal, and the crucial link between the origination and distribution of retail investment products has not been addressed yet.
A working definition of complexity is hard to determine. Take for instance the Belgian case in 2011 where the local supervisor introduced a moratorium on “particularly complex” products. Complexity was then defined by a list of non-exhaustive criteria, including practices that were not complex per se but deemed potentially unfair or generally unsuitable for retail clients. Some examples from the Belgian Financial Services and Markets Authority (FSMA) annual reports include basing advertising on teaser rates or exposing an investor more to depreciation than to appreciation of an underlying asset.
Wide-ranging bans on the sale of products to retail clients are strong indicators of broader failures in the investor protection framework. These bans notably reveal the limited trust that supervisors place on the rules operating at the point of sale — the suitability and appropriateness tests under the Markets in Financial Instruments Directive (MiFID) — as they have failed to protect investors in the past.
Financial innovation tends to generate higher complexity. And while complexity does not necessarily entail more risks, it transforms risks in ways that unsophisticated investors are not familiar with (e.g., transforming market risk into counterparty risk). Innovative products can help complete markets, satisfying investor demand for certain exposures or features. However, firms can strategically use financial innovation and complexity to exploit unsophisticated investors.
A research piece by the University of Zurich’s Claire Célérier and HEC Paris’ Boris Vallée explores the drivers of financial innovation and product complexity in the retail market for structured products. In reviewing the scientific literature, the authors find evidence that innovation can be used to maximise information asymmetries, increase search costs, and internationally reset investors’ learning.
The authors also explore a wide dataset on retail structured products in Europe. Using lexicographic techniques, they find that complexity has not ceased to increase, even after the financial crisis and the repeated instances of mis-selling. And, using Monte-Carlo simulations, they conclude that more complexity is associated with higher markups and lower performance.
The attention that supervisors give to complex products appears to be somewhat justified; however, they might not be using the right tools. By focusing almost exclusively on distribution, Europe has largely forgotten the importance of investor protection at the origination stage. The International Organisation of Securities Commissions (IOSCO) is clear in this respect:
“Intermediaries should put in place and enforce written strategies, processes and controls in view to ensure that any financial products they intend to distribute, especially complex financial products, are suitable for the type of customers they intend to solicit… This includes policies and procedures that support the design of products appropriate for particular customers. For instance, products should not be designed so as to hamper intentionally the ability of targeted customers to understand the risk-reward profile.”
This concept of “suitability at product design” would explicitly place the responsibility on originators to design investment products in view of the needs and interests of their target market. This would complete the individual assessment of suitability undertaken at the point of sale and, if properly implemented and supervised, reduce the extent to which generally unsuitable products hit the retail market.
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