Topic Consumer protection BaFin plans to prohibit retail distribution of credit-linked notes
The Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht – BaFin) intends to prohibit the marketing, distribution and sale of credit-linked notes (Bonitätsanleihen) to retail clients for reasons of investor protection. To this end, BaFin today published a draft of its proposed General Administrative Act. Comments on the draft may be submitted in writing until 2 September 2016.
BaFin plans to prohibit the retail distribution of certificates linked to creditworthiness risks of reference entities. "Structured products linked to credit risks can be a useful investment alternative for institutional investors, but we do not believe they belong in the hands of retail clients," said Chief Executive Director Elisabeth Roegele, explaining the supervisory authority's move. "We are aware that we will pose challenges to the certificates industry with this step," said Roegele. "But precisely because the certificates market here in Germany is of great significance and its reputation and credibility are of central importance, we have to intervene with individual products". BaFin had significant investor protection concerns about credit-linked notes, particularly in view of the high degree of complexity of the products, she added. With credit-linked notes, the interest and repayment of the money invested depend on the credit risks of reference entities. Of particular relevance is whether a credit event relating to the underlying reference liability will occur – something which retail clients are not generally able to assess. They cannot tell how great the probability of repayment of the investment amount is and whether the assumption of credit risk is adequately compensated for by the level of interest promised. BaFin further views as problematic the risk of a conflict of interest inherent in the product structure. Issuers are, on the one hand, producers of the credit-linked notes which are sold to retail clients and, on the other, they also maintain business relationships with the companies whose creditworthiness risks underlay their products and they may act as lenders themselves. The standard contractual terms for credit-linked notes give issuers considerable leeway in this context. Moreover, the German product name is misleading and gives rise to investor protection concerns. Despite what the German name may suggest, credit-linked notes (Bonitätsanleihen) are not bonds (Anleihen) in the traditional sense. In fact, subjected to economic scrutiny, the role of the investor is not that of a (bond) lender: rather, the investor takes on a role similar to that of a protection seller who assumes the risk of a credit event. This confusion of roles gives retail clients the false impression that the product is an interest-bearing security.
In recent months, BaFin examined the extent to which credit-linked notes are being actively sold to retail clients and whether the risks involved are explained in sufficient detail to such clients. It found that issuers are producing credit-linked notes specifically for sale to retail clients. An assessment of advice documents showed that such clients generally do not receive an adequate explanation of how the products work.
With the prohibition, BaFin is making use of its product intervention power, introduced by the German Retail Investor Protection Act (Kleinanlegerschutzgesetz) in July 2015. Since then, BaFin has been able to restrict or prohibit the marketing, distribution or sale of certain financial products for reasons including investor protection (section 4b of the German Securities Trading Act (Wertpapierhandelsgesetz – WpHG)).
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