June 2020 Draft Amended PRIIPs RTS: What’s inside for Structured Products?

In a letter sent by the ESAs (the European Supervisory Authorities, i.e. EBA, EIOPA and ESMA) to the European Commission, the ESAs have included a draft amended PRIIPs RTS. As the letter points out, this amended RTS was not supported by EIOPA’s board though it did receive the support of ESMA and EBA. So while the future of the RTS as a whole is still uncertain, we do believe that as far as Structured Products are concerned, we should not expect too many changes to this RTS going forward. Therefore, we have decided to start analyzing its content and summarize the main changes.

We reviewed the differences from the current active PRIIPs RTS (including the Q&As) and not from the latest Consultation Paper, as we would imagine most readers are interested in the expected changes from their current PRIIPs KID implementations.

In this article, we will focus on the changes applicable for Structured Products. The changes listed below are not an exhaustive list though we believe these to be the most substantial changes. RTS amendments that appear to simply be minor wording corrections have been ignored.  

SRI

 An important change has been applied to the SRI calculation criteria. The amended RTS allows manufacturers to increase the SRI if they feel it “does not adequately reflect the risks of the PRIIP”, while asking the manufacturer to document “such an increase.” We think this addition is a result of the UCITS exemption expiry. Usually, UCITS SRRI are higher than PRIIPs SRI. The ESAs would like to eliminate the confusion caused to investors when a UCITS instrument falls into scope for PRIIPs and their risk indicator is suddenly reduced. Subsequently, we suspect this change might be less relevant for structured products.
 As far as structured products are concerned specifically, there are only several minor changes to the SRI calculation criteria:   

1. VEV buckets: it wasn’t clear for a specific bucket whether the range is included or not. For example, MRM class 3, VEV range of 5% - 12%. Are 5% and 12% are included or not? The new RTS clarifies it is greater or equal to 5% and lower than 12%.

2. In the VEV formula (ANNEX II, point 17 for Category 3 products), the 1.96 has been moved out of the square root:    

However, it is important to mention that the 1.96 was already out of the square root in the delegated regulation (published 8 March 2017) and in the PRIIPs flow diagrams, and it just looks like a typo in the version that ended up in the official journal. Therefore, it is safe to assume most manufacturers are already in line with the amended RTS.

3. In the SRI narratives (ANNEX III), the amended RTS adds several clarifications regarding when each narrative should appear. Manufacturers will need to verify they are in line with those instructions. Still, we have discovered several noteworthy typos in the amended RTS. For example:
                           

Performance Scenarios

 While the SRI determination for structured products is relatively untouched, the amended RTS suggests numerous changes to the performance scenarios calculation and presentation. Some of those changes warrant a closer look. We intend to further elaborate in a set of dedicated articles. For the time being, here is a summary of the changes:
 
1. Category 2 methodology has completely changed. The Unfavourable, Moderate and Favourable Scenarios are no longer based on Cornish-Fisher expansion. However, since there are only a few Category 2 Structured Products (such as Actively Managed Certificates tracking a portfolio), we intend to further elaborate on this topic in a dedicated article focused on funds.
 
2. The ESAs decided to leave as is the historical drift and abandon the methods they suggested in order to deal with the pro-cyclicality problem (e.g. risk premia for equities). Instead, they allow manufacturers to use percentiles lower than 10th, 50th and 90th for the Unfavourable, Moderate and Favourable Scenarios when they believe the scenarios are too optimistic. There are several challenges with this change:  

• From the legal perspective, it is transferring the responsibility to treat too optimistic scenarios to the Manufacturer.
• From the technical point of view, it is unclear how to quantify “inappropriate expectations”. It is simply too underlying and payoff dependent.
  
• Another technical issue: it is not a trivial task to lower the percentiles and reach an appropriate expectation. Not to mention there is simply no guarantee of finding one.  

3.  In the Consultation Paper, the ESAs suggested to replace the Stress Scenario with a Minimum Scenario. However, in the amended RTS the ESAs decided to keep the Stress Scenario, and to require, in addition, the minimum scenario. In the Minimum Scenario, the minimal value in monetary terms should be specified. And for structured products with an RHP longer than a year it gets a bit more complicated, as the minimum is only guaranteed at maturity and not in all Holding Periods. In this situation, the amended RTS requires further narratives.  

4. Intermediate Holding Periods (IHPs) – the ESAs decided to keep 1Y IHP as of today (i.e. for RHP longer than a year) and discard RHP/2 for products with an RHP less than 10 years. For products with a 10-year RHP or more, there will be three Holding Periods, similar to the current RTS. Another change in IHPs is tricky to spot. The ESAs do not describe this change in chapter 4 (where they list main changes, feedbacks and considerations), but readers are expected to realize this change by manually comparing the amended RTS with the active RTS (a simple doc compare won’t help here, too many differences in performance scenarios annexes). For Category 3 products, the ESAs give up the active RTS requirement to “choose underlying values consistent with the 90th, the 50th, and the 10th percentile levels… and use these values as the seed values for a simulation to determine the value of the PRIIP.” Instead, the amended RTS requires values at IHPs to be “consistent with the estimation at the end of the recommended holding period”. This “semi-hidden” change that is just merely embedded within the RTS is rather a significant one. Sorting the 10,000 scenarios just by their RHP and choosing their respective scenarios at IHPs would lead PRIIPs with callability (either autocallability or issuer callability), for example, to show values at IHPs not at an ascending order (e.g. Favourable 1Y IHP can be in many cases lower than Moderate 1Y IHP).  

5. Monetary unit rounding – the amended RTS required rounding the values to 10 EUR (or equivalent in other currencies), unless “it could be misleading to round the figures”. In these cases, the RTS requires rounding to 1 EUR. It is unclear what those “misleading” cases are. In addition, with the current low rate environment, 10 EUR rounding, especially for 1Y IHP, is not negligible.  

6. The amended RTS clarifies that intermediate cash flows, such as coupons, will not yield a return. This is in line with EUSIPA’s Recommendations 4.1.A and 4.1.C available at: https://eusipa.org/eusipa-rts-implementation-advice-published/  

7. The ESAs finally clarified what formula should be used for the “Average return each year”. It is simply: “(scenario value/ initial investment)^(1/T) – 1”. Therefore, all Manufacturers using non-compounded returns and other variations will need to adjust their implementation. For RHPs shorter than 1Y, the amended RTS explicitly states that the return should not be annualized, similar to what have been already published in the Q&As.  

8. The ESAs require adding a brief description (up to 300 characters) of the presented scenarios. There are a few more changes to the current existing narratives.  

9. Finally, for dessert, the amended RTS includes a special dedicated performance scenarios table for autocallables. The ESAs’ suggestion contradicts EUSIPA’s recommendation (available within the same link provided above) that is based on the active RTS requirement to keep consistency with percentiles 10th/50th/90th at each IHP. As mentioned above, the amended RTS replaces this demand with a requirement to be consistent with the value at RHP. We believe the ESAs’ suggestion requires further clarifications, as it will face several challenges, including:

• Losing the order at IHPs. In many cases, an autocallable’s Favourable Scenario at RHP is called later than 1Y IHP. With the common autocall trigger at 100%, this would typically mean a PRIIP value lower than 10,000 Euro at 1Y IHP. Assuming the Moderate was called at 1Y IHP, its value will be higher than the Favourable. This is counter-intuitive.
• It raises comparability issues, as the rightmost column for autocallable products represents the product value at the actual redemption date (which might be different for each scenario) as opposed to the product value at RHP as for all other types of products.

Costs

Similar to the performance scenarios section, the costs section includes plenty of changes.

Regarding the amendments on transaction costs, because, unlike funds, few structured products actually bear transaction costs (e.g. Actively Managed Certificates), we intend to further elaborate on this topic in a dedicated article focused on funds.

As for the presentation of costs, the ESAs decided to keep the two cost tables. Similar to the current RTS, the first is the “Costs over time” table and the second is the “Composition of Costs” table. Still, their contents have changes as specified below.

“Costs over time” table:

1. Similar to the performance scenarios table, RHP/2 should appear only for PRIIPs with a recommended holding period of 10 years or more.

2. The RIY concept is still used, but with a few changes: It has been renamed “Annual cost impact”. A simple description explains the concept in a narrative below the table, showing the return at RHP before and after the costs. The Moderate Scenario is used for the RIY calculation only for RHP and RHP/2 (if presented). For 1Y IHP, a net performance (i.e. after costs) of zero is used to calculate the RIY. This is mainly for achieving better alignment with costs presented in MiFID II. For RHPs shorter than 1Y, the amended RTS explicitly states that the RIY should not be annualized, similar to what has been already published in the Q&As. In this case, the RIY at RHP should be based on zero net performance and the label should say “Cost impact” instead of “Annual cost impact”.

3. New narratives below the table should appear, in the event the manufacturer remunerates the distributor.

4. A special “Costs over time” table should be drawn for autocallables (again, like in the performance scenarios, not for products with issuer callability) - The table should have only two Holding Periods: first autocall date and recommended holding period, i.e. final maturity.



1. In this table, it seems like the scenario to be used at the first autocall date, as the basis for the RIY calculation, is an early call scenario at this first autocall date. However, in some rare cases, this early call scenario might not be deterministic. For example, consider a Phoenix with a conditional coupon prior to the first autocall date and no memory. Was it paid or missed?

2. In addition, it seems that even if the first autocall date is less than a year, still the RIY should be annualized, since the non-annualization depends on the RHP to be less than a year. Therefore, this case might show an exaggerated RIY for short term first autocall dates (monthly, quarterly). Of course, maybe the ESAs just missed this specific case, and hopefully they can fix it.

3. Finally, under an autocallable's performance scenarios table, several new narratives should mention it is uncertain when exactly the product is expected to terminate and that it depends on how the market evolves.

 “Composition of Costs” table will include three columns:

1. The cost item name - performance fees and carried interests are combined to one line, but these cost items are irrelevant for structured products.  

2. Description – a flexible description of the cost. The RTS suggests a few wordings, usually including the raw costs. For example, for entry cost: “x% of the amount you pay in when entering this investment”.

3. Instead of RIY at RHP (which is kept only for IBIPs, i.e. insurance-based investment products), for other product types, including structured products, the third column should show costs in EUR if the investor exits after one year (or RHP if shorter than a year). This poses two challenges for structured products: (a) The minor challenge: since there is no special “Composition of Costs” table for autocallables, the costs in this table might not sum up to the “Total costs” presented at the first table (different Holding Periods: first table – first autocall date, second table – one year). (b) The major challenge: as most of the Manufacturer’s work is done at the launch of the product, Structured Products usually charge an entry fee. Apart from an early exit cost in the event the investor exited the product early, the entry fee is often the only cost charged by the Manufacturer throughout the entire life of the product. Showing costs at 1 year exaggerates Structured Products’ costs. Moreover, investors usually hold classical Structured Products till maturity and do not pay early exit cost. Costs at 1 year are then exaggerated twice. This presents these products unfairly.

In sum, at first glance, readers of the RTS (and maybe even the ESAs) might believe there are almost no changes in this RTS relevant for structured products. However, as we have demonstrated above, there are indeed numerous changes that often place structured products in an unfavourable light.


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