The European Supervisory Authorities (ESAs) seek comments by 29 January on draft rules on the presentation and underlying methodologies of the risk, performance scenarios and costs sections of the PRIIP KID (Packaged Retail Investment and Insurance-based Products, Key Information Document).
The rules build on the previous two consultations and the results of a pan-EU consumer testing exercise, but remain unclear in a number of important areas. In particular, the underlying methodologies are technically incorrect or confused in places, as evidenced by comments made at the ESAs’ Open Hearing on 9 December in Frankfurt.
The timetable is very tight: the rules may not be final until the autumn of 2016, only three months ahead of the implementation deadline. For PRIIPs whose underlying investments are not traded on major, liquid secondary markets and for funds, given the intricacies of the proposed calculation for transaction costs, it is doubtful that this is operationally achievable. Also, there is a risk that the end result will not be fully aligned with the MiFID II costs and charges disclosures, and this disconnect will be exacerbated by any difference in the implementation deadlines.
The draft Regulatory Technical Standards (RTSs) prescribe the KID template, the presentation and underlying methodologies of each of the risk, performance scenarios and costs sections, specific rules for ‘multiple option’ PRIIPs (e.g. unit-linked insurance contracts with options for the underlying investment funds), and rules on the provision and review of the KID. At the ESAs’ Open Hearing, officials emphasized that they want feedback but stressed that the boundaries and timeframe are dictated by the Level 1 Regulation.
The KID template set out in the RTS is straightforward. However, at a maximum of only three sides of A4-sized paper, providers will need to consider carefully how they can fit in the required statistical information and ensure that any narrative is succinct yet meaningful.
For the presentation of risk, the ESAs have opted for a single seven-point scale, similar to that in the UCITS KIID, but combining market and credit risk. They say that testing showed that consumers could not understand how to interpret two separate indicators, even when shown below one aggregate indicator. Liquidity risk will be covered by narrative. The key issues are: the confusing text on the calculation of market risk; that credit ratings appear to be hard-wired into an RTS; and the simplistic way in which market and credit risks scorings are to be combined in order to produce one risk number.
For market risk, the draft rules separate the PRIIP universe into five categories, with some types of PRIIPs potentially falling into three. Two of the categories dictate specific numerical risk classifications (e.g. derivatives are all assigned to risk 7, along with PRIIPs where investors could lose more than their original investment and diversified funds with relatively high VaR numbers). Otherwise, the underlying calculation is VaR but with two different variants, and there are other permutations for PRIIPs for which market or historical data is not available.
A credit risk figure must be calculated when the return of the investment depends on creditworthiness of the manufacturer or another party bound directly or indirectly to pay the investor. Generally, investment funds will not need to calculate a credit risk figure. The calculation for all other PRIIPs is to be based on external credit ratings, converted to a six-point scale. The draft RTS includes a list of current credit ratings agencies (CRAs), begging the question what happens if CRAs are authorized or de-authorized by ESMA.
The two risk indicators are them combined to create one single indicator, in accordance with a simplistic matrix. Two options are given for the contents of this matrix, both of which would group various combinations of market and credit risk into the same overall figure. In particular, many combinations will fall into a combined risk of 5 or 6.
For performance scenarios, the ESAs have opted for three to be shown – unfavorable, moderate and favorable – but with the underlying assumptions for the three scenarios largely left to the discretion of manufacturers. The scenarios will be shown graphically, each with only three time points (1 year, 3 years and 5 years or recommended holding period), and with prescribed narrative, including a warning that the scenarios are a simplified representation of possible outcomes.
The RTSs for the cost section are the most extensive and include specific provisions for investment funds, insurance products and other PRIIPs. In contrast to the suggestion that consumers cannot interpret two risk indicators, it is proposed that the cost section should comprise 20 figures spread over two tables. There are entry and exit costs, recurring costs (e.g. management fee and underlying transaction costs) and incidental costs (e.g. biometric risk, performance fees and carried interest). They are expressed in monetary and percentage terms based on an investment of €1,000 (or €15,000 for insurance PRIIPs) showing the effect on return by ‘Reduction in Yield’.
For banking products, entry and exit costs are based on the spread between product price and fair value. For funds, the proposed calculation for underlying transaction costs assumes that manufacturers have ready access to the so-called ‘arrival’ prices required by the proposed methodology. Absent the increased market transparency that MiFID II heralds, it is not clear how these prices are to be determined, especially for fixed income.
Multiple Option PRIIPs (MOPs) can follow one of two approaches: a separate KID for each option; or a generic KID for the MOP with separate information about each option. A common type of MOPs are unit-linked insurance products that offer a range of underlying investment funds. Where those funds are UCITS or national retail funds that produce the UCITS KIID, the fund providers will, in effect, have to produce PRIIP KIDs, despite the fact that the Level 1 Regulation allows UCITS and funds to continue to use the UCITS KIID until end-2019.
KIDs must be provided by all PRIIP manufacturers by January 2017. Although the implementation of MiFID II is expected to be delayed until, say, January 2018, and although there is a close relationship between the costs and charges disclosure required by MiFID II and to those in the PRIIP KID, there is no indication as yet that PRIIP KID implementation will be likewise delayed. Therefore, firms will have to produce KIDs with perhaps only three months between the technical rules being adopted and the deadline.