MiFID II - Guidelines on complex instruments
On 30 November 2015, the ESMA published its Final Report on Guidelines on complex debt instruments and structured deposits.
The purpose of these guidelines is to specify the criteria for the assessment of
- debt instruments incorporating a structure which makes it difficult for the client to understand the risk involved and;
- structured deposits incorporating a structure which makes it difficult for the client to understand the risk of return or the cost of exiting the product before term.
These guidelines also clarify the concept of “embedded derivatives”.
ESMA expects to promote greater convergence in the classification of “complex” or “non-complex” financial instruments or structured deposits for the purposes of the appropriateness test/execution-only business in accordance with Article 25(3) and 25(4) of MiFID II.
These guidelines apply from 3 January 2017.
Instruments embedding a derivative
An embedded derivative should be interpreted as meaning a component of a debt instrument that causes some or all of the cash flows that otherwise would result from the instrument to be modified according to one or more defined variables.
In comparison to the list of examples that ESMA considered as embedding a derivative in its consultation paper, only inflation-indexed bonds have been removed. Such bonds are mainly used by retail investors as a hedge against inflation. Convertible and exchangeable bonds, indexed bonds and “turbo” certificates, contigent convertible bonds, callable or puttable bonds, credit-linked notes and warrants remain within the non-exhaustive list of debt instruments embedding a derivative.
Instruments incorporating a structure making it difficult for the client to understand the risk
Any of the following (non-exhaustive):
a) Debt instruments, the return of which is dependent on the performance of a defined asset pool;
b) Debt instruments, the return of which is subordinated to the reimbursement of debt held by others;
c) Debt instruments where the issuer enjoys discretion to modify the cash flows of the instrument;
d) Debt instruments lacking a specified redemption or maturity date;
e) Debt instruments having an unusual or unfamiliar underlying;
f) Debt instruments with complex mechanisms to determine or calculate the return (new*);
g) Debt instruments structured in a way that may not provide for a full repayment of the principal amount;
h) Debt instruments issued by a special purpose vehicle;
i) Debt instruments with complex guarantee mechanisms;
j) Debt instruments with leverage features.
Structured deposits incorporating a structure making it difficult for the client to understand the risk of return
It concerns structured deposits where (non-exhaustive):
a) More than one variable affects the return received;
b) The relationship between the return and relevant variable or the mechanism to determine or calculate the return is complex;
c) The variable involved in the calculation of the return is unusual or unfamiliar to the average retail investor;
d) The contract gives the credit institution the unilateral right to terminate the agreement before maturity (new*).
Structured deposits incorporating a structure making it difficult for the client to understand the cost of exiting before term
It concerns structured deposits where the exit cost is (non-exhausitive):
a) Neither a fixed sum;
b) Nor a fixed sum for each month (or part thereof) remaining until the end of the agreed term;
c) Nor a fixed percentage of the amount deposited.
* Was not included in the consultation paper.