Kerstin Rummler, BaFin
Structured financial products: Price transparency to enhance investor protection
Investment services enterprises increasingly offer structured products to retail clients. In order to enhance investor protection, it is important that prices are determined in a clear and transparent way.
The European Securities and Markets Authority (ESMA) has therefore published an opinion listing certain aspects investment services enterprises should take into account when manufacturing structured retail products. According to the opinion, the value of such products should, for example, be determined consistently with the methodologies used by the manufacturer to value its own proprietary portfolio in its annual financial statements. That way, ESMA intends to avoid double standards in the valuation of such products.
Structured retail product
ESMA believes that, in determining the value of financial products, companies should use either the concept of “fair value” recognised in accounting law or the concept of “intrinsic value”. The concept of “fair value” is described in IFRS 13 as the price of a financial instrument that would be received in an orderly transaction between professional market participants. The concept is supposed to ensure that the disclosed value is as objective as possible. The second recommended concept includes summing up the value of each of the components of the product, such as the embedded derivatives. In addition, ESMA is of the opinion that the internal value determined according to one of the above-mentioned concepts should be disclosed to potential buyers of the product.
Initial reactions in Germany
In Germany, the German Derivatives Association (Deutscher Derivate Verband) has been dealing with price transparency. In the context of a Fairness Code, the association’s members have undertaken to determine the value of the structured retail product as a so-called Issuer Estimated Value (IEV) and to inform their clients accordingly. This value may, for example, be included as a voluntary and additional disclosure in the information sheets that investment services enterprises have to provide to their clients under the Securities Trading Act (Wertpapierhandelsgesetz – WpHG) when providing investment advice.
The IEV is a US concept. In the USA, these values determined at the time of emission are usually disclosed in a prominent place in the securities prospectus, such as the cover page. The IEV is generally determined using the “fair value” concept and is therefore close to the price professional market participants would pay. The IEV is determined on the basis of models for the determination of the prices of the various product components and hedging and funding costs. Each issuer of structured products will probably use its own assumptions when determining the IEV, for example as regards the volatility of the underlying, future interest rates or the development of an issuer's creditworthiness. This may lead to different issuers estimating the value of the same product differently. That is why this value is called the “estimated” value: it is an approximate value determined by way of calculations that strongly depend on the assumptions used.
The IEV nonetheless enables retail investors to understand better how the price of the structured financial product is determined. By comparing the IEV with the actual sale price, the investor can easily see which basic costs are included in the price of the structured product. The difference between the sale price and the IEV comprises, among other things, the operational costs for structuring the product, costs related to IT infrastructure necessary for trading the product, as well as the expected profit. Retail investors can thus compare the costs of products and, moreover, assess whether the costs are appropriate in relation to the expected profit.