Cicero Policy Briefer

Issue 20, January 2008

Substitute products and EU regulation

By Mark Twigg

The issue of regulating substitute investment products is currently a hot topic with EU policymakers. The term ‘substitute product’ alludes to the increasing trend towards a blurring of retail investment products so that over time the products offered by banks, insurers and fund managers have become less differentiated in the minds of consumers. Whereas once the investor could look to access different product types, satisfying different consumer needs, typically through different distribution channels, these days such barriers have been largely eroded.

Unfortunately, this pace of change has not been matched by the regulatory framework. EU legislation applying to different financial institutions still imposes different levels of product disclosure and different conduct of business requirements, mostly as a hangover from a bygone era when insurance and investment products had distinct features and were often distributed through distinct distribution channels. For example;

• The UCITS Directive requires that entry and exit commissions and other expenses be fully disclosed. This should distinguish between those fees to be paid by the unit holder and those which are paid out of the investment company’s assets. This involves disclosure of the total expense ratio (TER);
• The Life Insurance Directive, on the other hand, does not provide specific disclosure requirements with regards to cost governing unit-linked life insurance products.

In short, while the regulatory system retains a distinctly 'sectoral' base, such distinctions are increasingly meaningless in the marketplace. The blurring borderline between investment products and the opening architecture in EU financial distribution pose new challenges for the regulatory system. The failure to press ahead with meaningful regulatory reform will result in increasingly distorted markets in which the products purchased will come to reflect variations in sales regulation rather than the real needs of investors.

The UK may seem to be fairly well insulated from this danger, given that the UK has already imposed super-equivalence in its transposition of the insurance directives, specifically in order to create a level playing field between light-touch regulated insurance products and more heavily regulated investment products. However, to assess this danger in a purely UK-centric perspective misses the point, given that firms increasingly operate on a cross-border basis. While investment firms and insurers may be confronted with an even-handed regulatory approach when selling products within the UK, this might not be replicated when selling to investors in other EU states. And if the single market is to function effectively we need a more consistent approach across the whole European market place.

To this end, the EU Commission has given the industry a fair wind. The Commission rightly argues that the choice of investment products facing investors should not be influenced by manufacturers keen to package propositions so as to circumvent the burden of regulatory disclosure requirements either for themselves or intermediaries. In other words, the supply-side should not determine its product range on the basis of distortions created by an unlevel playing field in the area of sales regulation. At this stage, the Commission is yet to be convinced that a major problem exists in the market place. If there is a problem, now is the time for the industry to put its money where its mouth is, and make the case for change. That will mean presenting evidence outlining which investment products should be considered and which products can realistically be seen as offering direct substitutes.

The Commission outlines four further areas of interest, including;

• Product disclosure;
• Conflict of interest between manufacturers and intermediaries (a central issue within the UK's ongoing retail distribution review);
• Point of sale rules and the suitability requirements on advisors; and,
• Advertising and marketing rules.

Key among the Commission’s deliberations is whether any problems arising can be addressed through self-regulation. Certainly, it is a moot point whether the twin motors of market forces and market reputation can address any issues without a change in regulation. Equally, to change regulation will not, on its own, create a level playing field. Differences in tax treatment on investment products and insurance products are equally important given the significant role played by the tax system in helping to incentivise long-term savings and investments. There is much evidence to suggest that tax incentives do little to encourage savings, however, they do have a major impact on directing the flow of savings between competing investment vehicles. Traditionally, savings held in life insurance policies have benefited from more favourable tax treatment. Nonetheless, this is an important opportunity for the investment industry to make the case for more consistent regulation to be applied across Europe’s retail investment market. Firms need to respond to these points no later than 18 January; key next steps will then see a feedback statement published in March with the Commission set to publish an update in autumn 2008.

Mark Twigg can be contacted on +44 (0)20 7665 9537 or click here to email.

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