The FSA is to get more involved at an earlier stage of product design and stress testing, rather than just at the point of sale, to try and avoid further mis-selling scandals.
Dan Waters, director, conduct risk, and asset management sector leader at the FSA, says the regulator's work on structured products and other investment vehicles identified a “significant risk of profound mismatches between retail products produced through the investment value chain and the needs of consumers who end up owning them”.
Speaking at the McKinsey Asset Management Conference, he emphasized the FSA’s commitment to getting involved earlier in the design stage of products rather than just at point of sale.
Waters says: “We have learned the hard way that a focus primarily upon regulatory intervention at the point of sale has inescapable limitations.
“To put it bluntly, there have been too many mis-selling scandals in the UK and we want to turn the page on that part of our history.
“We want to develop a regulatory approach that looks more deeply into the value chain – into product governance, design and oversight by provider firms, rather than simply waiting to see what happens after products have reached mass circulation to the retail public.”
He also called for providers to consider gaps in consumer needs rather than focusing on who could be sold the product and how to improve marketing.
Waters says: “Often, product design seems to be driven by benchmarking against competitor products, so there is a sort of built-in circularity and re-enforcement of entrenched practices.”
He highlighted the importance of stress and scenario testing to ensure firms identify the type of customer for whom a product or service is likely to be appropriate.
“This means being clear about what the product does, who it is for and certain key characteristics such as the nature and scale of risks presented.
“On stress testing, we have not seen firms adequately illustrate what they do to test products where it is appropriate to do so.
“Stress testing becomes important, for example where a product is geared or has pay-outs which are indicated or promised in the product’s description but which are not guaranteed. The provider should consider stress testing any product features which could lead to sharp variations in the product’s performance.”
“Stress testing should seek to identify how a product is likely to perform in potentially extreme market conditions, including, where appropriate, counterparty defaults and stressed liquidity scenarios.”
He reiterated the FSA’s interest in exploring the risks arising through providers’ direct contacts with distributors.
“In our view, it is incumbent on providers to explore and understand their distributors’ information needs and ensure, as far as possible, that distributors are getting the right messages about what particular products do and how they might reasonably be used.
“This may well include accentuating the negative, and not just latching on to the positive features of particular strategies.”
However, he says the regulator’s enhanced interest in product governance, design and oversight should not be seen as a step in the direction of increased retail product approval or design by the regulator.
He also highlighted potential concerns in areas such as the booming absolute return secor.
Waters says: “This may be especially challenging for those firms that do not have deep experience of working in the retail market, such as hedge fund managers, some of whom are getting on what is beginning to look like a UCITS III bandwagon.
“We would remind new UCITS managers that compliance with the UCITS framework will take considerable investment in systems and controls, and while asset managers may delegate various functions, they retain ultimate responsibility for compliance with the quite detailed requirements of UCITS III and, even more, under UCITS IV.”
There may be further regulatory risks as the drop in value of most asset classes has forced many investment houses to cut costs “aggressively” and there continues to be a high volume of M&A.
Waters says: “Both of these developments have increased the likelihood of certain risks from a regulatory perspective; particularly those related to the retention of key staff, IT integration, and ongoing management of a large number of outsourced service providers.
“It is important that firms recognise the need to retain a focus on client service and performance, and remember to treat customers fairly during periods of significant transition or integration.”
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