OTC Derivatives: How are they affected by the new PRIIPs RTS?

The ESAs established the PRIIP KID regime with the goal to present information on financial products to retail investors in a clear and standardised manner. The presentation and content of the KID document as well as the methodology for the calculations and presentation of risks, rewards and costs were specifically developed to create a better understanding. Now, with a lot of industry feedback the ESAs act on their responsibility to review the PRIIPs RTS.

The new RTS focuses on proposals for appropriate performance scenarios and revised presentation, aiming at avoiding inappropriate expectations from the retail investor. Revisions to the summary cost indicator  and better presentation of the costs support the understanding of the different types of cost structures. In addition, the presentation and narratives have been adjusted on multiple occasions across the document.

Since the Key Information Document (KID) was introduced in January 2018, the ESAs have received industry and consumer feedback. In October 2019 the ESAs provided a consultation paper on a draft RTS on changes in presentation, content, review and revision of the KID. Further research and the review of various methodologies resulted in a new RTS draft which was approved by ESMA and EBA during June 2020. In February 2021, the RTS was approved by EIOPA. The European Commission is now adjusting the implementation timeline to July 2022 and is planning to publish the amended RTS during Q4 2021.

While many issues and exact requirements remain open, we have analysed the effects of the changes on OTC Derivatives and summarised the main changes.  

SRI
As OTCs always have an SRI of 7, they are not directly affected by the SRI calculation changes. Therefore, the new RTS allowing manufacturers to increase the SRI if they feel it “does not adequately reflect the risk of the PRIIP”, adds no further responsibility to OTC manufacturers. In addition, the VEV buckets have been slightly amended as well as the VEV formula. Both adjustments clarify what most manufacturers have been using anyways. Both changes do not affect OTCs. Relevant for OTCs are the narrative changes accompanying the SRI:    

• 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:  

Note: as this is the official RTS screenshot, the SRI is shown as “5”. Nevertheless, the SRI “7” rule for OTC is still in place.

• Especially for OTC, there is now an additional paragraph mentioning, that the SRI narrative explanations should be adjusted to reflect the specific features of the PRIIP. As an example, the absence of an initial investment amount needs to be considered. Since more specific adjustments can be found in the Q&As, it seems like the content of the Q&As (April 4th, 2019) regarding OTCs have found their way into the RTS and thus becoming mandatory. Due to the new paragraphs requiring manufacturers to adjust narratives to OTC derivatives’ terminology, we do not expect to see additional adjustments for new narratives (from the new RTS) to be published within Q&As. Those adjustments should be performed by the manufacturers (for example, the new narratives for the new Minimum Scenario – more information available below). 

Performance Scenarios
While the SRI section for OTCs 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. 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.    

2. 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. Usually, for OTC derivatives there are no guarantees. There are two typical cases: (a) the minimum is zero, for products such as options. For those you will need to say there is no minimum (b) there is no minimum, for products such as forwards and swaps. For those you will need to add another clause that claims you might need to pay more to cover losses.

3. 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.  

4. Monetary unit rounding – the amended RTS requires 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 interest rate environment, 10 EUR rounding, especially for 1Y IHP, is not negligible. Two examples for specific pay-out conditions might be Coupons with precisions lower than 0.1% or Caps and Floors with precisions lower 0.1%. Perhaps, these are the cases the ESAs mean “misleading”.  

5. 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/

6. The ESAs finally clarified what formula should be used for the “Average return each year” for forward contracts, future contracts, contracts for difference, or swaps. It is simply: “(Net profit or loss / Notional Amount)^(1/T) – 1” if T>1. A footnote shall indicate that the potential return is calculated as a percentage over the notional amount. In case the Net profit or loss of the KID is negative, this formula is not well defined. As the RTS does not provide another solution, we print “N/A” in the KID as any other calculation would be misleading for the retail client and it would deviate from the RTS specifications.

Now that the calculation formula has been clarified, 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.

Still, we are left with the usual open questions: what about OTC options? Instructions are also missing for which Notional Amount should be used if an OTC has more than one Notional (e.g. leverage TARFs or accumulators, Amortizing swaps).  

7. 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. For OTCs, the terminology should also be adjusted where appropriate to reflect the specific features of the PRIIP, such as to refer to the notional amount of the PRIIP. 


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

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 changed as specified below.

“Costs over time” table:

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

“Composition of Costs” table will include three columns:

The cost item name – performance fees and carried interests will be combined to one line, but these cost items are irrelevant for OTC.

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”. However, these are just sample narratives, and the Manufacturer can decide which wordings to use. For example, for OTC derivatives, in the exit costs it is useful to explain they are applied only if the investor exits early.

Instead of RIY at RHP (which is kept only for IBIPs, i.e. insurance-based investment products), for other product types, including OTCs, the third column should show costs in EUR if the investor exits after one year (or RHP if it is shorter than a year).

This poses a challenge to long term OTCs (e.g. 10Y IRS) as the costs are usually charged upfront. While investors typically hold classical OTCs until maturity, assuming an exit after one year will show the full cost charged upfront plus the early exit fee charged after one year. This is not a fair representation of the costs of those products. 


Q&A is now RTS, so check your OTC KIDs
In a few cases the exception in the wording for OTCs have found their way into the regulation. While not all details and separate narratives are included, the RTS now mentions at multiple places the use of “Notional” instead of investment. Therefore, implementations and current KIDs not up to the Q&A standards need to review their setup.

Topics to discuss | What’s still unclear
Even though the timeline is not finalised yet and the RTS not approved, still, it looks as the RTS will be approved as is (except for the 6 months delay). There are additional open questions and therefore industry alignment is necessary.

In case of the Performance Scenarios, the responsibility has shifted to the manufacturer to decide if a scenario is too optimistic and might be misleading. The decision when to use this mandate, the exact quantification and methodology – they all should be aligned at the industry level to eliminate comparability issues.

As for the scenario description, there is no sample text in the RTS for Category 1 products. How elaborated these should be? Should they be product type dependentor general ones? Again, it would be preferable to have an industry consensus.  


Where to find further material
The above information is based on the original PRIIPs regulation, current RTS, latest Q&As and the final draft for the PRIIPs KID RTS. For more information and current discussions, please join our LinkedIn PRIIPs RTS Preparation Task Force or get in touch with us. We are happy to arrange in depth sessions with our PRIIPs experts and provide you with additional material. As the timeline moves along, we will continue to publish articles on this topic and provide further insights.