Supervision and regulation of the structured products market in Norway

Presentation (ppt)

Oversight
Structured products have challenged the Norwegian legislation and supervision on three different occasions over the last years.

The first occasion was the compound products, constructed and sold by banks, mainly to retail investors. The main part of these products is a bond or a deposit and the remaining part a call option on an index. The losses where limited to the derivative part of the investment. These products where sold mostly from 2001.

The second occasion was the so called Terra-case. Terra Securities was a Norwegian investment firm which in the summer of 2007 sold Collateralized Debt Obligations (CDO) and Credit Default Swaps (CDS) issued by Citigroup, to some smaller Norwegian municipalities. Kredittilsynet withdraw the firm’s licence because of misconduct following huge losses suffered by the municipalities.

The third occasion was the appearance of structured products which to some extent replaced the compound deposit or bond based products previously mentioned. These products have no risk modification elements imbedded, and the investor could loose almost the entire investment.

These three occasions represent three different kinds of structured products, but had when sold in the Norwegian market, some significant common features:

They were not sold in a regulated market, but in a non-transparent, shady market.
They were offered to non-professional investors.
They are more risky and costly than regular investments, with less or almost no liquidity.
They reflect the market strength of distributors in relation to producers and misuse of investor’s thrust.
They were part of, or an effect of the increased use of the securities market caused by securitization and innovations after 2001. In other words, they are elements in the current financial turmoil.

In this speech, I will mainly talk about why and how the intermediaries, who at the same time acting as advisers and distributors, have been able to misuse confidence in the market. In addition, how they up front were able to “confiscate” some significant parts of the investor’s investments. In the end I will talk about regulatory and supervisory measures against such behaviour.

A decisive key for understanding the problems and the challenges, is to understand the market strength of distributors, and the impact of this strength.

It is evident to Kredittilsynet that there has been and probably still is a “marriage” between the producer and the distributor. In this “marriage” it is the distributor who is the strong partner. This “marriage” has a severe, negative impact on the investor.

A large part of the structured or compound products has been constructed in such a complicated manner, and has such a complicated cost structure, that it is impossible for the common investors to understand the risk and the cost involved. The products lack sufficient transparency. These products have been sold based on the investor’s confidence in the distributors as investment advisers. The circumstances in which these products are sold based on this trust give the distributors an immense and unique power. This power over the investors gives the distributor power over the producer, consequently different producers compete for delivery of products to the distributor. If a producer is unwilling to pay a large kick back, the distributor will have an incitement to choose another producer. In a well functioning market we may presume that there at all times will be a correlation between expected return and expected risk. Thus it is unlikely that complicated structured or compound products should be more attractive than an ordinary portfolio consisting of shares and bonds. When the distributor misuses his position to reserve him the right to a considerable remuneration, it will lead to higher cost of the product. It is therefore reasonable to presume that the expected return for the investor will be reduced equivalent to the amount he pays the producer or the distributor.

After this opening, it is important to emphasise that Kredittilsynet is not opposed to structured products in general. Under certain conditions it is very rational for an investor to reduce his risk of loss by investing in derivatives including call options. Our reservations are related to costly products, mainly caused by the greed of some distributors. I will later give you a more profound analysis on this issue.

How has it become possible to convince the investors about the “excellent qualities” of the products?

The fundamental task when evaluating alternative investment opportunities is to form an opinion on what kind of investments gives the best risk adjusted return. To estimate expected return and the volatility is difficult, because the estimates are generally based on historical data. The problem is that historical data have uncertain predictability about the future. The selection of time series will influence on the estimates.

The selection of appropriate time series is theoretically difficult and statements based on financial theory will contain considerable uncertainty. This uncertainty about selection of appropriate time series might have as consequence that the distributors choose to market products with favourable growth over last tree to five years. This problem is important to understand since it explains the reason why some products have been sold instead of others.

Measurement
Investment advice became subject to licensing requirements according to the Securities Trading Act which came into force 1st November 2007 as an implementation of MiFID. It was an adequate measure considering the cases that have come to light in the securities market over the recent years. Particularly the selling of structured products like compound products consisting of a bond and a call option on an index illustrated the problems associated with poor investment advice. Investigations undertaken by Kredittilsynet at the end of 2007 proved that most of the hold to maturity-products per the third quarter of 2007 had generated no surplus value compared to risk free investments. This was the situation for the equity financed as well as the debt financed investments in such products.

Regulatory changes and developement
Kredittilsynet has earlier issued a circular (No. 15/2006) containing guidelines on information to be disclosed in connection with the sale of structured products by investment firms’, guidelines on their investment advice service as well as documentation on the advisory service in connection with the sale of these products. In addition to the guidelines stipulated in this circular the general information requirements in the new legislation for the securities market (both the Securities Trading Act and the Securities Trading Regulations) should also be mentioned.

In 2006 Kredittilsynet also issued amendments to the Regulations concerning financial institutions’ sale and advisory service as regards structured products. A number of provisions in the new legislation for the securities market which focus on investor protection are given corresponding application when financial institutions sell structured products not covered by MiFID.  

Kredittilsynet’s circular to financial institutions issued on 12 February 2008 [No. 4/2008], defines precisely that investment advisers are obliged to classify their customers and assess whether the structured products are suitable for the individual customer. Kredittilsynet emphasised that to a lesser extent, it would be relevant for investment firms and financial institutions to actually give advice and sell complicated savings products in the form of structured products to retail investors.

Kredittilsynet expected that this circular would lead to a considerable reduction in the sale of structured products to the general public. A large number of investment firms and banks have stopped the sale and distribution of these products, particularly when the products have been debt financed. The latest volume numbers available to Kredittilsynet, (certainly before the financial crisis), confirm this assumption.

Supervision
In 2008 Kredittilsynet has given priority to monitoring how the investment firms practise the new, stricter requirements relating to investment advice, including advisory service and the distribution of structured products. This year, Kredittilsynet has conducted 10 on-site inspections in investment firms authorised to provide investment advice. The on-site inspections have revealed a series of infringements as regards the firms’ duties towards their customers pursuant to The Securities Trading Act. These 10 investment firms were selected on the basis of an assumption that as relative new distributors/advisers they were seeking an additional profit beyond the rather huge profits taken so far by the financial institutions. Some of these investment firms have earlier been distributors for banks, and have discovered how easily money could be earned by selling to unskilled retail investors. Thus Kredittilsynet considered it necessary to enforce the code of conduct towards these investment firms initially to prevent and stop an escalating misbehaviour in the market.

The infringements revealed, were primarily that the investment firms have not recommended the products that offer the best terms to the client, secondly that they have recommended products where the associated total transaction costs have served to significantly reduce the yield-potential of the investment. And, thirdly, the investment firms have included sales commissions that are unreasonable, relative to the value the investment firms have provided for the clients.

Consequently, the investment firms have recommended to their customers products based on which products give the best terms for the firm and not based on which products would offer the best terms for the client.

It is the opinion of Kredittilsynet that the infringements revealed, represent such an extensive misconduct of the position the investment firms are given through their authorisation to offer investment services, that they undermine the public confidence in the securities market as a saving alternative.

According to the Securities Trading Act the investment firms are obliged to ensure that the interests of the customers are taken care of. Instead of performing investment advice according to the requirements stated in the Act, the firms have given priority to methods of sale and marketing to their customers with their focus based unilaterally on self-interest. In the view of Kredittilsynet, the most effective way to monitor and ensure that the methods of sale and marketing of complicated saving products, including structured products, are in compliance with the law and the common perception of acceptable behaviour from a services provider is when Kredittilsynet enforce the infringements.

The public has paid attention to expensive and complicated products. There has been less focus on the composition of the portfolio. It is generally academically accepted (among financial analysts) that the strategic choice of the portfolio composition is the most important choice. The experience of Kredittilsynet after this year’s 10 on-site inspections of the investment advice firms is that these firms to a lesser degree have focused on the optimal portfolio compositions. For instance, recommendations for investments in long bonds are absent despite the fact that such a portfolio usually has little correlation to the equity-capital market.

It is the experience of Kredittilsynet that the enforcements seem to have had a preventive effect on the rest of the market, and that the development is turning in the right direction. 

Kredittilsynet has focused not only on the structured products themselves, but also on the requirement that the clients shall receive the best advice concerning the products, based on her or his financial situation and their risk level.

The objective of the provision concerning the conduct of business (in Art. 10-11) is among other factors to ensure investor protection and a certain minimum standard when providing investment services to the clients. The obligation concerning business conduct must be seen in the context that the investment firms are given exclusive rights to carry out investment services, and as a result of this have a position that implies special duties to care for the clients. The clients are entitled to expect the investment firms to protect their interests. These considerations are particularly strong when it comes to carrying out investment advice, and the investment firms shall give individual and personal recommendations to their clients. Then there is a particularly strong expectation that investment firms shall fairly and professionally ensure the best interests of the clients. The provisions concerning good conduct of business are worked out in more details in regulations to the Norwegian Act on Securities Trading (chapter 10).

Kredittilsynet has specified three important standards that are interpreted from the general business conduct obligations. The standards serve to clarify how the best interests of the clients and the integrity of the markets shall best be ensured. They are derived from the general obligation/ standard to give priority to the interests of the clients ahead of the interests of the investment firm. The standards, which are separate and independent, are as follows:

i) The investment firm must offer the best of comparable products
The investment firm must have sufficient competence on the available products in order to make comparisons relative to risk, expected yield, costs, liquidity etc. This comparison must be made relative to important general measurement criteria. The investment firm, by its nature as an advisor to the client and professional middle-man, is independently responsible to perform this evaluation. The investment firm has a duty to examine which products are available in the market, and which would offer the best terms for the client.

It has to be emphasized that the products might be comparable when it comes to main criteria such as risk, expected yield, costs and liquidity, even if the specific terms are not completely identically.

The OTC-markets are difficult to follow to a certain extent (less transparent), and the products that are offered, are often complex and difficult to understand, particularly for the non-professionals. It will then be difficult for the clients to obtain the necessary knowledge necessary to make a qualified assessment of the products that are offered as well as the quality of these products. When investment firms for example carry out investment advice, it must be expected that they focus on what will best serve the interest of the clients, the comparable products available in the market taken into account. The clients should be able to trust that the investment firms ensure that this main assumption is fulfilled and that they receive a qualified and professional advice.

ii) The transaction costs can not significantly reduce the potential yield of the investment     
The investment firm must ensure that there is a reasonable relationship between the total costs and the amount invested, so that the potential yield is reasonable compared with alternative investments, as seen from the client’s perspective.

When recommending products that contain major cost elements, typically when it comes to structured products, the potential yield of the investment are reduced, and the client’s possibility to achieve their investment aims might be severely reduced. Investment firms should avoid recommending to customers investments in financial products that are associated with high costs, given that the customer’s investment objective can be achieved at a lower cost. Even if the investment product (with regards to other elements than cost) is in accordance with the customer’s investment objective, such a recommendation could mean that the customer’s interest is not maintained in the best possible way. A number of financial products, including various derivatives and complex structured products, have such complex and comprehensive built-in cost elements that they for the most part, are unlikely to produce a return in accordance with the customer’s investment objective.

The upper threshold for the total costs associated with the product is a consequence of the investment firm’s direct relationship with the customer, its responsibility and requirement to ensure that the customer’s best interest is maintained. The customer’s best interest is not maintained if there are disproportionate costs associated with an investment. The absolute upper limit of the total cost prevails, even if the investment firm has in an adequate way informed the non-professional investor of the various costs associated with the product. This should be plain if it is obvious that the costs limit the expected return to only a theoretical possibility. Agreements based on such conditions prove that the customer has not understood the consequences of the information given. In other words, good business practice requirements limit the parties ability to enter into private contracts with regard to the conditions agreed upon for the investment services.

iii) The share of paid in capital that is received by the investment firm as fees, must be reasonable relative to the value added created by the firm
The demand for good business practice and that the customers best interest is maintained, means that the fees the investment firm receives cannot be disproportionately high (the firm can not take unfairly high fees). One must see the fees received as fair and balanced compared to the value added created, for example, in the case of the firm having taken risk associated with the investment or in the development of the product.

This requirement is connected to the role that the investment firm has in relation to its customer. When an investment firm act as an intermediary, then the firm shall act as a trustee for the customer. If a disproportionately high share of the customer’s investment, either directly or indirectly, constitute fees and/or costs then the trustee function is abused, and the customer’s best interest is not maintained.

The savings products are to a large extent distributed by investment firms that are acting as placement agents for other investment firms that produce the savings products. The cost associated with the product for the producer consists of two main elements; 1) the cost associated with the production and management of the product and 2) the distribution cost. In addition certain administrative fees may be incurred. The costs associated with the production and management of the products varies, and may depend on the complexity of the product. The distribution costs are to a much lesser extent dependent on the product complexity. Therefore, the share that the customer should reasonably pay for the distribution of the product should not vary according to product complexity. Both investment firms that distribute and produce must therefore ensure that these issues are addressed when entering into a distribution agreement.

Summary
I have in this speech concentrated on a specific feature in the distribution of structured products in the Norwegian market. The complexity of the structured products has made it possible for the distributors to get considerable power in the market; but the power has been used also in relation to other products. It is also important that this misbehaviour has been made possible because of the lack of skills in the retail market. It is a combination of these two circumstances.