Robert Jeanbart is division CEO SIX Financial Information.
With 10 weeks to go before PRIIPs is slated to enter in force, the financial industry must continue with compliance preparations in the face of uncertainty about the implementation timetable.
While recent votes by the European Parliament raised the possibility of postponement, the regulation has so far not been formally delayed by the European Commission.
Moreover, regardless of any delay, the regulation’s fundamental obligation has not changed. Firms must still prepare to produce and hand out KIDs for PRIIPs that are sold in the European Economic Area.
PRIIPs are packaged retail and insurance-based investment products. Typically marketed to private individuals, this type of investment combines exposures to multiple underlying assets and entail a degree of investment risk and costs.
Firms will need to invest significant effort to establish the partners, data connections and processes that will allow them to be compliant with PRIIPs’ investor protection obligations. Meanwhile, preparation for MiFID ll regulation will also demand resources in 2017.
1. Background to PRIIPs: the regulatory context and recent developments
The regulation for Packed Retail and Insurance-based Investment Products (PRIIPs) is the first hurdle in the European Union’s investor protection calendar.
The regulation aims to help retail investors better understand and compare investment products. PRIIPs affects institutions across the financial industry, including banks, wealth management firms, portfolio managers and insurance institutions.
PRIIPs is intended to lead to greater transparency in a market that is estimated by the European Commission to generate up to 10 trillion euros annually in the EEA.
However, it adds complexity to an industry already undergoing significant restructuring from the all-encompassing MiFID II package of reforms.
The PRIIPs Level 1 law is formally scheduled to enter in force on 31 December 2016. However, on 14 September the European Parliament rejected draft Regulatory Technical Standards proposed by the European Commission, i.e. the detailed Level 2 legislation that outlines how the law should be implemented.
The rejection vote means that the RTS as currently drafted will not enter into force, introducing uncertainty into the ‘how’ and ‘when’ of the PRIIPs timetable.
Many industry voices are calling for postponement. As yet, the European Commission has not enacted the legislative procedure that would formally delay PRIIPs.
For the time being, firms must still prepare for compliance by 31 December 2016, subject to other developments.
The unusual legislative situation makes it difficult to predict what will happen in terms of the ‘how’ and the ‘when’ of the legislation. The ‘what’ (to improve transparency for retail investors) is undisputed, however, underlining the regulation’s importance on the European Union’s legislative agenda.
Postponement therefore offers little prospect of breathing space – firms who delay preparations would risk having to prepare simultaneously for PRIIPs and MiFID II during 2017 and a delay would not significantly alter the fundamental obligations of the regulation.
2. The scope and obligations of PRIIP: what does compliance look like?
Under PRIIPs rules, institutions (including non-EU domiciled banks, derivative exchanges and insurance companies) that sell retail investment products to any retail investor domiciled in an EEA country will be required to ensure that consumers receive a 3-page document, the Key Information Document (KID), that outlines the investment’s risks and costs.
The Key Information Document (KID) must be made available to a retail investor before a sale can take place.
Acting as a kind of quick reference guide to the PRIIP, KIDs must follow strict design and content guidelines, be produced using correct legal terminology in at least one official language of each country where the product is marketed and be regularly reviewed and updated.
The responsibility for creating and maintaining the document lies with the product manufacturer or issuer.
Meanwhile, distributors must ensure that their client receives the documents in the pre-sale phase, via retail advisors or directly through an execution-only online environment (e.g. mobile online banking application).
This means that any financial institution actively advising EEA residents or providing execution-only services to them needs to alter their processes to provide access to the KIDs in time for the transaction to be concluded.
The regulation is extremely wide-ranging. In scope are any investment products for retail clients that are “packaged” with at least one underlying asset (e.g. structured products, OTC derivatives or securitised derivatives) as well as insurance investment products. Many millions of instruments are affected, requiring financial institutions to manage a huge volume of regulatory documents.
The PRIIPs regulation is challenging due to the new interdependencies created between the issuer (who must generate PRIIP-KIDs) and the distributor (who must hand them out). Finally, banks who are already occupied with other regulations like IRS 871(m) face a juggling act to get PRIIPs implemented while simultaneously preparing for MiFID II and the Automatic Exchange of Information standard during 2017.
3. Why are KIDs such a challenge for the sell-side?
The regulation makes manufacturers responsible for KID generation, a change in principle compared to the existing German Product Information Document (PIB). PIB rules allow the buy-side to create PIB documents independently.
By contrast, under PRIIPs regulation, the buy-side must knock on the sell-side’s door to ensure compliance and avoid liability issues.
To produce compliant KIDS, manufacturers must juggle a variety of inputs that include EU-mandated standardised text containers and plain-language legal terminology.
Creating the templates is a complex affair: firms must account for all financial instrument types and procure translations in the language of every country they want to sell in. These requirements place huge demands on internal resources and may be uneconomical for seldom-used instruments or if a negligible proportion of clients speak the target language.
What is more, manufacturers must constantly create updated versions of the documents as risk and performance scenarios change over the product’s lifetime. Each material change triggers a new KID with re-calculated risk and yield indicators.
Firms must secure an adequate supply of data to perform these complex calculations: the regulation explicitly requires 10,000 simulations to calculate the scenarios.
Finally, manufacturers must either store KIDs or produce them on demand, conduct ad-hoc revisions in response to every material change in the product, and make the KID available to retail investors throughout the lifecycle of the PRIIP.
4. The challenge for retail advisors on the buy-side
Meanwhile, retail advisors must always be able to get hold of documents for the products they want to sell or they will not be legally allowed to conclude the sale.
Consequently, retail banks must set up uninterrupted access to retrieve KIDs from the manufacturers and replicate the process for every manufacturer whose products are on their shelf. Alternatively, they can use industry-wide hub solutions to reduce the number of connections necessary.
Since PRIIP-KIDs are updated continuously in response to lifecycle variations, simply downloading them periodically will not ensure compliance. Banks need to make sure their retail advisors can retrieve updated documents for every product, quickly and efficiently. Delays impact an advisor’s ability to make a sale and increase the risk of non-compliance.
Advisers also need to archive and track every download, for audit and dispute purposes. Two concepts have evolved to accommodate this requirement:
• Pre-generation: Where the manufacturer generates the document at the beginning and continuously monitors the events that would require an update; immediately that this occurs, an updated version is created and made available
• Generation on the fly (on demand): Instead of monitoring all the events, a document is generated every time it is required
According to the regulator, both approaches are acceptable. Of course, both approaches have pros and cons.
While the pre-generation approach may prove cheaper initially (as functionality already built up to deal with UCITS-KIIDs could be re-used), generation on the fly is probably better placed to deal with the characteristics of this genre of financial products.
Additionally, this approach is likely to be better at responding to the nature and life cycle of structured products and the time-to-market when new instruments are issued.
5. Industry is under-prepared for the complexity of PRIIPs compliance
All this means that PRIIPs creates a significant challenge for financial institution.
To produce compliant KIDs, firms must set up and test sophisticated processes with multiple partners, including data vendors, document management software providers, risk calculation specialists, translation agencies and legal advisors.
Alternatively, firms can develop these processes in house, requiring a redeployment of scarce internal resources. Either way, comprehensive end-to-end testing and bug fixing must be conducted to ensure all the moving parts work together, consuming further time and resources.
Banks may also have underestimated PRIIPs’ scale and complexity. This is likely due to the sheer volume of in-scope products and cases when a KID must be produced, for example even in execution-only online banking platforms where no retail advisor is present.
A lack of regulatory clarity further complicates the situation. The European Parliament view was that several aspects of the RTS would harm the spirit and aim of the Level 1 regulation to such an extent that the entire package should be rejected.
This raises a question mark over the specifics of PRIIPs’ scope and implementation.
In the midst of uncertainty, correctly implementing new compliance processes is also important for longer-term restructuring as banks prepare for the even larger challenge of MiFID II.
6. The need to outsource complexity
Consequently, firms will need to rely on a web of partners to outsource the intricate, costly and time-consuming processes necessary to achieve compliance.
Data vendors like SIX Financial Information, who specialise in helping financial firms understand and react to regulatory compliance obligations are well placed to support manufacturers and distributors in this cumbersome task.