New obligations on the OTC derivatives market
The guidelines of the Polish Financial Supervision Authority enter into force
Legal Alert (25/2016)
Investment companies and banks whose scope of business includes activities equivalent to broker services are obliged to implement PFSA guidelines concerning provision of broker services on the OTC derivatives market, i.e. outside the organized market (regulated market or alternative trading system), by 30 September 2016. The said guidelines apply to both trade orders placed by clients and portfolio management services provided by investment companies.
They concern the fulfilment of a number of disclosure obligations to investors, in addition to showing good practices in OTC derivatives offering and advertising.
The guidelines have been issued as a result of private investors' growing interest in financial instruments. Private investors frequently do not understand how leveraged financial instruments work and do not realize their complexity or the related risk of losses.
The Polish Financial Supervision Authority made it clear (which is not common in such documents) that the OTC guidelines are a collection of interpretations of binding laws. In particular, they create obligations in the following areas:
1. OTC financial instrument marketing/advertising
As promotional and advertising activities may lead to the entry into a contract with a client, the PFSA is of the opinion that they should be subject to regulatory limitations.
Frequently, marketing activities are carried out online (also in social media) and, as such, they are addressed to an unspecified group of recipients. Therefore, investment companies should remember that due to the distribution channel used, such information may be received by individuals with limited investment knowledge and no experience in investing in financial instruments (in particular, OTC).
Advertising and promotional materials should be clear to each individual from the potential recipient group. Special attention should be paid to the presentation of content encouraging investment as compared to the information concerning the related risks (e.g. not omitting the risk aspects, clarifying the importance of leverage for the investment, not misleading the investors about the nature of the investment). Where the advertising material refers to past yields, such information should be representative, i.e. in particular, concern the actual clients of the investment company and present a sufficiently long period of time.
2. Limitation on cash bonuses given to clients
The guidelines suggest that the use of incentives to encourage clients to invest more in OTC instruments should be limited where the vision of such a benefit (e.g. bonus) may be a decisive factor for the entry into a contract or an increase in the investment.
According to the PFSA, in particular, virtual deposits granted to clients or prospective clients may increase the leverage level and thus violate the maximum leverage rules (under last year's amendments to the Act on Trading in Financial Instruments, the maximum leverage is 1:100).
3. Control of the operations and remuneration of introducing brokers
Additionally, the guidelines address the issue of supervision of the acquisition of clients by third parties acting for or on behalf of an investment company.
Such supervision should be "complete and reliable", i.e. apply also to advertising and information activities carried out by third parties (to include telephone calls and meetings with prospective clients) as well as verification of whether a third party offers investment advice where it is not authorized to do that.
To this end, in the agreement with a third party, an investment company should reserve the right to control and verify the quality of third-party services and determine how clients should be acquired.
4. Collection of client information for purposes of analyzing the suitability of the investment
Investment companies should make an effort to ensure that the highest possible number of clients grant their consent for an analysis of whether investments in OTC instruments are suitable for them considering such factors as the client's knowledge and investment experience.
The questionnaire ought to include questions regarding the client's knowledge of the OTC market and basically, it should not allow self-assessment.
Clients should be informed that a failure to conduct the analysis rules out the possibility to assess whether the product is suitable for them.
5. Provision of complete and reliable information to investors and prevention of conflict of interest
The client should realize that he/she will invest in a derivative instrument as opposed to the underlying instrument and be provided with detailed information concerning the key aspects of such an investment (to include swap points, rollover and its effect on open positions). The said information should be organized and its presentation ought to make the client aware that the information is important (e.g. crossing a field to confirm that specific information has been read is necessary for entering the next stage of contract conclusion via the Internet).
The investment company should make sure that such information has been read by the client, also if the contract is entered into on a remote basis.
Additionally, the guidelines impose the obligation to provide clients with information on the standard processing time for orders from their receipt in the IT system of the investment company. This is particularly important considering that even small fluctuations in underlying instrument prices may have a considerable impact on the value of the investment due to the leverage mechanism.
Regulated entities are obliged to regularly publish information concerning their clients' performance on the OTC derivatives market on their websites.
With a view to preventing conflict of interest, investment companies should construct their remuneration policies applicable to their own staff and the entities responsible for client acquisition so as to motivate them to secure the interest of clients. In particular, remuneration should not be largely conditional on the value of payments made or transactions entered into by clients. The PFSA has suggested that systems based also on quality criteria (such as client satisfaction level) should be introduced.
6. Regular audits and documentation reviews
The OTC market broker service terms and conditions and contracts made with clients will have to be audited at least once a year.