Europe’s PRIIPs: When Being Clear Isn’t All That Easy

Fund managers, banks and insurance firms can now breathe a collective sigh of relief, but not for long.

The European Commission has just announced that it has postponed by one year the implementation date for new legislation requiring financial firms to more clearly explain the risks and rewards of some investment products that fall under the umbrella term of PRIIPs. Financial firm still have to wait for the EC and other regulatory agencies to reach an agreement on how to amend the language of the technical rules on how the European measure should be followed and only hope the disclosure requirements aren’t as challenging as the original rejected ones.

“We were facing a unique situation in which the primary legislation could be implemented without the technical rules ironed out first,” says Nicola Le Brocq, regulatory and compliance market strategist for data aggregation and regulatory reporting firm Confluence in London. “Usually, the European Securities and Markets Authority (ESMA) issues technical rules and has sufficient time to tweak them before legislation is set to take effect.”

If the EC had not postponed the effective date for the measure, commonly known as PRIIPs to January 1, 2018 it would have become effective on December 31, 2016. That was too short a timetable for the European Commission and Parliament to work out their differences on how the final technical nitty-gritty rules for its implementation should be written.

So what? Without the final technical rules, European legal experts worried that financial firms could have been held legally responsible for any shortcomings in writing three-page key investor documents (KIDs). Specifically, that the regulators might have frowned on the results of  a best-faith effort to disclose as much as possible to investors about their products based on existing guidelines.

PRIIPs is short for “packaged retail and insurance-based investment products,” reflecting the types of investments it covers. The range is so extensive that financial firms categorize PRIIPs products by what they aren’t– namely traditional investment funds covered under UCITS, bank deposits, or variable annuities. Falling under the category of PRIIPs are structured products, a unit-linked or profits-policy issued by an insurance company, or an investment product where the amount repayable to an investor is subject to fluctuations because of exposure to the values of reference assets. That means structured notes, derivatives, hedge funds, and funds of hedge funds.

In September, the European Parliament rejected the technical rules created by ESMA and approved by the EC on the grounds that investors could misunderstand the information presented in the KIDs. All agree that financial firms that produce PRIIPs must clearly describe in plain English everything investors need to understand before they invest in these products.

The question is just how the metrics explaining the potential risk, costs and rewards should be calculated and presented. Lawmakers are concerned they wouldn’t be clear enough and so were 23 out of 28 European Union member states. Delaying the implementation date for PRIIPs gives the EC more time to iron out new technical rules and have them passed by the EP.

So what should creators of these products do while waiting in limbo for the new regulatory technical rules? “We are recommending that financial firms start preparing with what they know,” recommends Mario Mantrisi, a senior advisor to Kneip, a regulatory reporting specialist based in Luxembourg. “Even with a postponement of the effective date for PRIIPs, any changes to the existing rules will likely be evolutionary rather than revolutionary.”

Keeping Tabs

Data management and reporting experts point out that, as manufacturers of PRIIPs, large banks, insurance firms and fund managers may have underestimated the work of complying with the new European measure. Since the rules governing PRIIPs affect such a wide range of products, banks and their subsidiaries will be affected as manufacturers of some products and distributors of others. So might asset managers which create products for insurance firms, as well as those which manage hedge funds and funds of hedge funds.

Manufacturers must complete an inventory of all affected products and distribution channels even before they start drafting the KIDs. They must also establish automated procedures to trigger updates to the KIDs throughout the lifecycle of the products. Then once the KIDs are created, they must translate them into multiple languages and forward the KIDs to distributors, such as retail advisors or other banks.

Even execution-only on-line platforms, which don’t rely on advisors, must produce KIDs as long as they sell PRIIPs to retail European investors. Since insurance companies may rely on share classes created by asset managers, those managers will have to provide the insurance companies with the data they need. Fund managers that sell funds invested in other funds will also need to collect data from multiple underlying fund managers in a standardized format.

Asset managers have to hope that the insurance firms they work with will accept an industry-developed European PRIIPs Template (EPT) for data transmission and frequency of updates. The EPT was created by a working group of asset management firms, including the European Fund and Asset Management Association, and insurance companies as a standardized data exchange format.

How hard will it be to gather and distribute the information? It could take a village of sales, marketing, trading, risk management, compliance and external legal advisors working together. Let’s not forget the data managers and last but not least translators.

“The manufacturer will have to prepare a KID in the language of each country in which a European retail investor might live. Even if the product is sold to only one European retail investor, all investors must receive a KID,” says George Bollenbacher, director of the regulatory practice for financial services consultancy Capital Markets Advisors in New York. “Any selling agreements will have to include language indemnifying the manufacturer if the distributor doesn’t give a European retail investor the KID because the legislation calls for the manufacturer to carry the legal liability.”

What happens if the product is sold in the secondary market? If a retail seller were to sell the product back to the manufacturer — as might be the case in a fixed-income product before its maturity — the manufacturer would need to present a new KID to a new investor. However, it is unclear what happens in a transaction between two retail investors — whether the retail seller would have to present the KID to the retail buyer or whether the original manufacturer would have to do so.

Distributors aren’t off the hook when it comes to KIDs. They must set up procedures to always have KIDs for the products they want to sell, or they will not be able to conclude the sales. They will also have to keep up-to-date records about all of their past customers and make certain they don’t forget to distribute a new KID to any existing investor.

No Time for Brevity

With only three pages to fill, it shouldn’t take so long to compose a KID, right? Not exactly. The three pages must be presented in clear language and easy-to-understand charts that avoid financial jargon while remaining accurate and not misleading. Although manufacturers get one more page to work with than they would producing a KID than they would with a similar document for funds complying with the UCITS legislation, the extra wiggle room won’t help much. “Three pages sounds like a sufficient amount of space, but the KID isn’t designed to replace the offering documentation,” says Le Brocq. “It isn’t easy to squeeze in all the information about a complex product in three pages.” To ensure firms don’t try to circumvent the three-page rule by using small print, the EC has said that the text must be “easy to read” using “readable-sized characters.”

Offering a brief description of a product is hard enough. But explaining the risks and returns along with the costs is even more difficult. What is the risk? The potential that the manufacturer goes bust and won’t have sufficient money to make any payments to the investor or the investor can’t redeem its shares. What is the return? How much money the investor could earn. The operative word is “could.”

Based on the current technical rules for PRIIPs, manufacturers of PRIIPs must report future returns using three scenarios of favorable, moderately favorable and unfavorable. However, that idea has come under fire for being misleading and US-based global fund managers have lobbied the EC for change. “The calculations behind the scenarios are fundamentally flawed and there is a push for past performance to be disclosed in the KID to help the investor’s investment decision,” explains Le Brocq. “Since past performance is based on historical facts, it can be presented in a standardized way which shows how the fund is run and allows for easy comparisons between PRIIPs.”

Any projection of future performance is a bit of a sticking point for financial firms, who are not required to provide it for UCITS-eligible funds. European legal experts are concerned that an investor could ultimately decide to sue a bank or insurance firm for false advertising despite any warnings that past performance is not an indicator of future performance. Even if the investor doesn’t win the case, the financial firm won’t want to absorb any reputational risk.

One solution now being reviewed by the EC is to simply include only the past performance results without any future predictions as is the case with funds meeting the requirements of UCITS. That recommendation is being pushed by a group of European asset managers including Schroders & BlackRock, which criticized the EC’s decision to eliminate the mention of past performance results from the KIDs. Another option would be to include past performance results and some explanation of future predictions under separate categories but without offering any glimpse into returns for each category. Yet another would be to include a wrote projected future scenario.

Just as problematic is analyzing transaction costs. Unlike UCITS, PRIIPs requires that transaction costs — called composition of costs — be explained. Those costs must represent a lot more than just easily identifiable explicit expenses. such as commission fees. To include implicit costs, historic data prices from multiple front-end systems is required and not all information is easily available. Tracking down three years of historical bid and ask prices, opening prices, closing prices and mid-range prices could be difficult for fixed-income products. And what happens with products which don’t have a three year track record? A bit of subjectivity when extrapolating the figures could come into play.

Since complying with MiFID 2 also requires calculating transaction costs for each trade, it made sense for PRIIPs and MiFID 2 to be implemented at the same time with the same methodologies. Regardless of how transaction costs are calculated, financial firms will also need to document their methodologies to defend their decisions in the case of a regulatory challenge.

For banks and other financial institutions that think that devising the KIDs will be time consuming or cost-prohibitive, there is plenty of third-party assistance, but it comes without offering to take on legal liability for any errors. Kneip is offering a one-stop approach of collecting all of the data from the financial firm, crunching the risk numbers, formatting the KIDs and shipping them off to designated distributors.

Fund administrator Northern Trust has partnered with Kneip to provide a KID production and distribution service. Robert Angel, head of regulatory services for the product solutions group at Northern Trust in London, says that although his bank was anticipating a delay in the implementation date for PRIIPs, its product is ready to go. Zurich-headquartered data giant SIX Financial Information says it will also produce KIDs based on a combination of information from manufacturers and itself. SIX will rely on legal partners for language translation and send the KIDs to distributors through its own document hub. Confluence also is considering starting a PRIIPs production service.