June 2020 Draft Amended PRIIPs RTS: Significant Change for Autocallables? Part 1

June 2020 Draft Amended PRIIPs RTS: Significant Change for Autocallables? Part 1
In a previous article, we described the changes in the draft amended PRIIPs RTS applicable for structured products. As we mentioned, this amended RTS was not supported by EIOPA’s board though it did receive the support of ESMA and EBA. While the future of this RTS as a whole is uncertain, still, we have decided to analyze its content. Even in the case these changes are not approved, there is a chance to see some of these amendments in the form of Level-3 Q&As.
In this article, we focus on the amendments related to autocallables. These products are known by various names in different countries including Kick-outs in the UK, Express Certificates in Germany, Austria, and Italy, and Autocall in Nordic countries. We limit the scope of this article to the changes in performance scenarios. In a future article, we will address changes relevant to cost disclosure.It is noteworthy that the ESAs have decided to dedicate special instructions for a specific financial product. Perhaps this is due to the many questions raised by market participants regarding this product type or because of their popularity in recent years.We must also point out that autocallables are not always considered as distinct product type. Rather, in some markets and countries, autocallability is a product feature. For example, a digital product (i.e. paying income based on a yes/no decision) might have an autocallability feature built in. We understand the ESAs meant to apply the new requirements on any product with an autocallability feature.

Executive Summary
The body of this article expects, on the part of the reader, a certain amount of technical knowledge of the PRIIPs RTS, autocallables and statistics. For readers lacking this foundation, we have summarized our main findings:
  • The new requirements in the amended RTS mean a major change compared to the current RTS.
  • The new requirements will demand a significant development effort.
  • The new requirements lead to several shortcomings in the performance scenarios table such as loss of comparability with other products.
  • On the hand, the new performance scenarios table might be easier to understand. This should be verified with potential investors (i.e. consumer testing).
We believe it would be beneficial to discuss our findings with the relevant regulatory bodies (ESAs, NCAs) before legislative decisions are taken.

New Methodology in Detail
As mentioned in the executive summary, whether the ESAs intentionally meant that or not, the new requirements for autocallables mean a major change compared to the current active RTS. Some amendments are generic, for all products, and affect autocallables as well. Other amendments are specific for autocallables. In order to demonstrate the extent of those amendments impact and their implications, we will begin our analysis by utilizing a sample autocallable product.

Sample Autocallable
For the analysis, we picked a relatively simple and popular product: a 5-year EUR denominated autocallable product, observed annually. In case the S&P 500® price index increased at an annual observation date (compared to where it was at the launch of the product) the autocall product matures repaying full capital plus 7% coupon for each year since issue. At final maturity (i.e. after 5 years), if it did not mature early, there are 3 scenarios:
  • If the index is equal or above its initial level (where it was at the launch of the product) – it will repay full capital plus 7% coupon for each of the 5 years.
  • If the index is below its initial level and above or equal 50% of its initial level – it will repay the full capital (with no coupons).
  • If the index is below 50% of its initial level – it will repay the capital reduced by the decline of index.
To summarise, in professional terminology:
  • 5-year EUR autocall
  • Underlying: S&P 500® price index (Bloomberg: SPX Index)
  • Autocall trigger: 100%, annual observations
  • Risk barrier: 50%, checked at final observation date (i.e. European)
  • Memory coupon: 7%
Scenario Analysis
Running the 10,000 bootstrapped scenarios (with the 5-year historical drift as of 24 July 2020) results in the following distribution of redemption scenarios:

In other words, at RHP the Unfavourable and Moderate Scenarios show a value of EUR 10,700 (early maturity after one year), while the value of the Favourable Scenario at RHP is EUR 12,100 (early maturity after three years). For the sake of simplicity, we will disregard the Stress Scenario.

In other words, at RHP the Unfavourable and Moderate Scenarios show a value of EUR 10,700 (early maturity after one year), while the value of the Favourable Scenario at RHP is EUR 12,100 (early maturity after three years). For the sake of simplicity, we will disregard the Stress Scenario.

So what is the “Significant Change” in the amended RTS? Let’s begin with the Intermediate Holding Periods (IHPs).

Intermediate Holding Periods
Since the amended RTS requires RHP/2 IHP to be included only if RHP is 10 years or more, we will focus only on the 1Y IHP.

One simple fact to realize is related to the Favourable Scenario: the scenario that pays 3 coupons and is autocalled after 3 years. For this scenario to happen, the underlying index must be below 100% in each of the two previous annual observations. Usually, negative performance of the index means a negative performance for the entire product..

Now let’s compare the active RTS and the amended RTS in the paragraph that describes how to calculate IHPs for Category-3 PRIIPs:
ANNEX IV point 24 (c) of the active RTS says:

In other words, the active RTS requires the scenarios at the IHPs to reflect the 10th/50th/90th percentiles of the PRIIP valuation at each IHP.

However, the amended RTS says (ANNEX IV point 37):

Therefore, the scenarios selected for IHPs should be ones leading to the scenario shown at RHP.

This difference is not just a semantic change. Let’s have a look at the sample autocall. The performance of the underlying index in the 10,000 scenarios is distributed differently after one and five years:

As observed, at 1Y IHP only 6,616 scenarios are above 100%, while at RHP 8,131 are above. This is a reflection of the positive 5-year historical drift of the S&P 500® index.
Therefore, at 1Y IHP, for the Favourable Scenario:
  • According to the current RTS we should choose the 90th percentile. Assuming negative performance of the index means negative performance of the autocall, the Favourable Scenario at 1Y reflects an early call at 1Y, i.e. a value of EUR 10,700.
  • According to the amended RTS we should choose a scenario consistent with RHP, i.e. a scenario that will lead to an early call after 3 years. For a scenario to “survive” for 3 years, at 1Y the index should be below 100%. Meaning the Favourable Scenario will show a negative performance at 1Y IHP.
For the Unfavourable Scenario at 1Y IHP:
  • According to the current RTS we should choose the 10th percentile. As mentioned above 33.84% of the scenarios show a negative performance of the index after 1 year. Therefore, the 1Y Unfavourable Scenario will show a loss.
  • According to the amended RTS, “Figures for intermediate holding periods shall only be shown for scenarios where the PRIIP has not yet been called or cancelled before or at the end of that intermediate holding period” (ANNEX IV, point 17). Therefore, we should leave the Unfavourable 1Y IHP empty.
Performance Scenarios Table
Based on the analysis above, let’s see how the performance scenarios table changes from the current RTS to the amended RTS. To ease the comparison, even though needed, we eliminate the RHP/2 IHP in the current RTS. Below you can see the results consistent with the current RTS:

Investment EUR 10,000

* Early matured after 1 year
** Early matured after 3 years

In the table above each holding period (1 year, 5 years) is consistent with the requested percentiles. The investor knows, for example, that after one year, the positive case would be a 1-year early call. This also means that different holding periods in the same row can have different early maturities – in this case it happens in the Favourable Scenario.

Now, let’s see how the performance scenarios would look according to the amended RTS:

A few remarks on the table above:
  • 1Y Favourable: thee amended RTS doesn’t describe how a manufacturer should calculate an IHP value that is consistent with the RHP. We have looked at all scenarios that led to an early call after 3 years (663 scenarios of the 10,000) and chose the median product value at 1Y of those scenarios (and applied a 1% early exit cost). However, a rare scenario could be selected for the Favourable, having less scenarios. In this case, the value at 1Y IHP can fluctuate significantly due to the random nature of the bootstrap.
  • Having empty cells at IHPs and multiple different periods at the rightmost column requires infrastructural changes at the industry level. For example:
                o   The EPT (European PRIIPs Template) format will need to add the relevant information (i.e. when each scenario is called) and allow empty IHPs.
                o   o   Recalculation of costs for IBIPs (Insurance-Based Investment Products) that embed autocallables (MOP and non-MOP) requires further examination. This will be elaborated upon further in our following article that focuses on autocallables’ cost disclosure.
  • The holding periods in the new table are different from products with no autocallability. This means there could be comparability challenges with other products.
  • Still, the case can be made that this new format is easier for clients to understand. This would obviously require consumer testing to be determined conclusively.
The new methodology for autocallables requires significant efforts to implement. And yet, there are still some unclear specific details (especially regarding Intermediate Holding Periods) and a few drawbacks, in terms of comparability with other products. On the other hand, the new methodology might lead to a simpler performance scenarios table. This should be determined with proper consumer testing to justify such an implementation effort.

I would like to thank my colleagues Eddie Korol, Shai Corfas and Stefan Marcus for their contribution to this article.
Ayal Leibowitz

Chief Innovation Officer

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