Cicero Policy Briefer

Issue 27, August 2008

The substitute products debate: more heat than substance?”

By Chris Jackson

The disclosure requirements placed on providers of retail investment products have become an increasingly important policy debate. With the newly published UCITS reforms outlining the Commission’s work programme on the development of key investor documents (KID), we can expect to see much more on this issue in the next six to nine months. However, UCITS is only one part of what is a rather fragmented jigsaw.

The EU’s historical pattern of regulating retail investment markets on a product basis through various pieces of legislation, including MiFID, UCITS, the Life Directives and Prospectus, has helped to create a divergent regime of information disclosure (not to mention other variations in conduct of business rules, such as the requirements covering inducements or the suitability test on MiFID business) across life products, investment funds and structured products. A good example of how different products are captured by fragmented regulation is illustrated in the table below.

The current discussion surrounding fragmented regulation of so-called substitute products addresses an important need; namely to both assess and, if needs be, address the potential market distortions created by differentiated product-based approaches to the regulation of product disclosure. There are perhaps two key questions to be resolved. The first issue is whether there is actually a problem at all. The second issue is a subsidiary: assuming that there is a problem, does it require an EU response or can it be better resolved by regulators working to fix problems within their own national market? The European Commission’s open hearing on substitute products in July produced little momentum, or indeed consensus, on how to make further progress in this area.

On the first point, there are those in the industry who argue that there is, in fact, little evidence to suggest that consumer behaviour is influenced by the varying disclosure requirements attached to products. Whether distributors themselves are influenced over what products to offer clients is more open to debate. Certainly, other factors will be more persuasive in the minds of both consumers and distributors. Certainly, the tax treatment of those underlying investments held in life and pensions wrappers has historically been much more generous than is the case with investments held in OEICs and unit trusts. While tax incentives might not encourage people to save, they certainly do influence the flow of savings between different types of products.

This is especially true where the consumer is receiving financial advice—after all, the adviser would be failing in his or her duty to the client to not make them aware of important tax differences and make recommendations accordingly. Note how the UK saw massive sums flow into the newly created (if somewhat short-lived) Pensions Term Assurance product almost entirely because of differentials in the tax treatment when compared with other existing products. Tax relief does matter.

Whether the same can be said for product regulation and disclosure requirements is a moot point. The higher level of fiduciary care under MiFID does raise concerns over regulatory arbitrage: is there any real distortion in the marketplace in favour of unit-linked life policies covered by the less strenuous Insurance Mediation Directive? Answering that question rather depends on which member state you operate in. Speaking at the Open Hearing on behalf of the FSA, Dan Waters made clear that the UK regulator has always taken a balanced approach in transposing EU legislation in this field, and that the UK is prepared to ‘gold-plate’ some directives in the name of creating a balanced and level playing field between products.

MiFID offers potential to address some of these concerns. It was designed to be implemented horizontally across different types of investment products. This is currently allowing the French to address some of the concerns over substitute products as part of their MiFID transposition process. Regulators can already take action to redress imbalances in the regulations should they wish to. However, this can only be really effective within their own borders. Regulators in different member states may (and do) take different approaches, giving some credence to the concerns of those such as David Wright, the DG of the Commission’s financial services policy directorate, that the current fragmented approach risks creating barriers to cross-border retail markets.

In essence, both Waters and Wright have legitimate concerns, and any solution to this issue will be a mixture of both the national and EU authorities taking concerted action. Some response at the EU level is needed—if only to ensure better coordination and cooperation between regulators. Fundamental changes to the current legislative approach can probably be ruled out. Equally, the member states need to take action too. Waters was clear in his assessment that there are a host of other factors which come into play beyond product regulation and product disclosure which regulators—such as the FSA—need to address if consumer choices are not to be unduly influenced or distorted when choosing products. This inevitably shone the spotlight on the FSA’s own work in the area of the reforming retail distribution. The need to align the interests of distributors with those of the investor—largely though tackling issues such as commission bias, which the FSA hopes to do with its proposals for ‘consumer agreed remuneration’—will play an important role in any outcomes.

Chris Jackson can be contacted on +44 (0)20 7665 9530 or click here to email.