The FCA sets out plans to reform the UK’s PRIIPs regulation

This blog was published on 02 September 2021.

At a Glance 

• The FCA has proposed a number of changes to the UK’s PRIIPs framework. These are:
  • Clarifying the scope of which corporate bonds are considered a PRIIP.
  • Scrapping performance scenarios and replacing them with narrative descriptions of the factors likely to affect a PRIIP’s future performance.
  • Allowing firms to upgrade the SRI score for a PRIIP if they judge this is too low and ensuring a minimum SRI score of 6 for Venture Capital Trusts.
  • Keeping the existing ‘slippage’‑based methodology for transaction costs but making amendments to rules relating to anti-dilution, debt securities and index tracking funds to mitigate some of the adverse side effects of these rules.
• While some of these changes are smaller adjustments, the FCA has sought to address the key concerns with the existing PRIIPs framework, namely the misleading performance scenarios and issues with transaction costs reporting.
• Replacing the performance scenarios with narrative descriptions of the factors affecting a PRIIP’s performance will improve the quality of information available to end investors and ensure they are not misinformed by misleading scenarios. However, by shifting from a prescriptive, quantitative framework, the FCA is putting the onus on firms to make some tricky judgments about the factors that will affect performance.
• Given the criticism levelled at the slippage methodology and the reporting of negative transaction costs, some may be surprised to see the FCA defend and keep the methodology. This said, new rules relating to anti-dilution should remove some of the cases where firms ended up reporting negative transaction costs.
• Firms will also need to make a number of systems and process changes within a short timeframe, as the FCA aims to implement these rule changes by 1 January 2022.
• Our overall assessment is that these proposals are positive, both for the firms that produce KIDs and the investors that use them. This said, firms that distribute PRIIPs across both the UK and EU will likely have to produce a separate KID for each market, adding to their overall regulatory burden.

Introduction

The FCA has published a consultation setting out proposed amendments to the UK’s regulatory framework for PRIIPs. The proposals cover the scope of PRIIPs, performance scenarios, SRIs, and transaction costs. The intention behind the proposals is to minimise investor harm by ensuring that investors can make effective decisions based on the information provided in PRIIPs’ KIDs.

This blog sets out the key proposals and their implications for firms.

Scope of PRIIPs

The FCA is amending the definition of a PRIIP in order to clarify which corporate bonds are considered a PRIIP.

The FCA says that the present lack of clarity has meant issuers have either taken on the cost of producing a PRIIPs KID for products where they were not required to do so, or curtailed access for retail investors. Whilst more evidence is required, it appears as though this has resulted in a reduction in overall volume of low denomination issuances of debt securities, which has consequences for liquidity and choice in secondary markets.

To address these concerns, the FCA has clarified that:

• A debt security should be regarded as a PRIIP if the overall return to the investor is materially determined by price movements or performance of assets other than the debt security itself, including reference assets and indices or benchmarks relating to assets or a class of assets.
• Debt securities with fixed coupons are not PRIIPs even if the coupons are subject to pre-defined changes.
• Incorporation of a put or call option that allows investors to demand early repayment or to convert the debt security into one or more shares, does not make the security a PRIIP (unless the exercise of the option is connected to the performance of other assets).
• A debt security will not be a PRIIP simply by virtue of having a perpetual term or because of a subordination in creditor hierarchy.
• It is not necessary to assess whether the features of legacy products (issued before 1 January 2018) make them PRIIPs.

In practice, these changes are likely to provide some helpful clarity to the issuers of corporate bonds and reduce costs for those bond issuers that were producing KIDs on a precautionary basis for products that were not actually in scope.

Performance Scenarios

The current PRIIPS rules obligate PRIIPs manufacturers to include a range of performance scenarios in the PRIIPs KIDs. The scenarios set out hypothetical future performance of the PRIIP across different market conditions; stress, unfavourable, moderate and favourable. They are calculated using historical data and methodologies provided in the RTS. There has been ongoing stakeholder concern that these performance scenarios can produce misleading future illustrations, particularly for alternative investment funds and investment trust companies. 

The FCA has decided to scrap performance scenarios and replace them with a narrative description of the factors that are likely to have a material impact on future performance. It has also proposed that firms should choose a relevant benchmark or index and provide an explanation of how the PRIIP is likely to compare in terms of performance and volatility. The FCA is seeking views on the factors that should be included as part of this narrative section.

The methodology for calculating the performance scenarios, as well as how they are presented to investors, has been one of the most controversial issues surrounding the PRIIPs regulation. As such, eliminating this potential source of confusion for retail investors (and hence potential source of regulatory risk for manufacturers) is likely to be beneficial for both parties. However, PRIIPs’ manufacturers will have to consider carefully the additional information which they must now include, and unless the FCA is explicit about the factors that must be covered in the narratives, there is a risk that like-for-like comparability between products will be diminished.

Firms must also consider what will be the most relevant benchmark for comparison to their PRIIP. Whilst in some cases selecting a benchmark may be simple, in others this may be a more complex task. Firms should document the process they used for benchmark selection and be ready to explain why they have selected a certain benchmark instead of others (especially where the selection of a certain benchmark may flatter a PRIIP’s comparative performance).

Summary Risk Indicators (SRIs)

The PRIIPs RTS sets out requirements for PRIIPs to be assigned a SRI; a standardised risk score between 1 and 7, based on a combination of the product’s market and credit risk classification. The RTS provides a methodology for assessing the SRI. The SRI must also be accompanied by a narrative.

The FCA says that stakeholders think SRIs deliver lower than expected risk scores when the PRIIP’s underlying or reference asset is illiquid. Some stakeholders also thought that SRIs did not to capture all the risks associated with some PRIIPs.

The FCA is therefore proposing that PRIIPs’ manufacturers which have allocated lower than appropriate SRIs can amend them and notify the FCA of the change, including details of why using the methodology set out in the RTS resulted in an understated SRI. In addition, due to particular concerns about the SRIs allocated to Venture Capital Trusts (VCTs), VCTs can no longer be allocated a SRI lower than 6. The accompanying narrative describing additional risk factors that are not captured by the SRI can now be up to 400 characters, up from 200.

Note that there is no reverse provision to reduce an SRI score where the manufacturer considers the value produced according to the methodology to be too high.

The intention behind the proposal is to allow consumers to choose a PRIIP aligned with their risk appetite and not one that may pose the risk of greater financial losses than they are prepared to accept. For PRIIPs’ manufacturers, the ability to amend SRIs and include more risk‑related information in a 400 character narrative suggests that the FCA expects a thorough risk assessment, so that investors’ understanding of the risks is as complete as possible.

Amendments to transaction costs   

Slippage

PRIIPs’ manufacturers are required to calculate and disclose the costs of buying and selling the PRIIP’s underlying investments, including implicit transaction costs such as ‘slippage’. ‘Slippage’ is the difference between the price at which a trade is executed and the ‘arrival price’ when the order to trade is transmitted to the market. While stakeholders have raised objections to incorporating slippage in transaction costs, the FCA believes that the slippage methodology is working as intended and is the best way to calculate transaction costs for most products.

The FCA notes that the rules require ‘slippage’ to be calculated across all transactions for a product over a three-year period ‘and [are] not intended as an accurate measure of transaction costs for each individual transaction.’ The FCA says that when these price movements are averaged out across such the three-year period, they should be near zero. However, the FCA has proposed targeted amendments to transaction cost reporting in certain specific contexts.

Anti-dilution

One of the amendments pertains to anti-dilution, which is where a fund passes on transaction costs to redeeming investors so that remaining investors do not unfairly bear the cost of transactions. The PRIIPs rules require firms to calculate the costs of all transactions done by a fund – and funds are permitted to subtract any benefit they receive from anti-dilution. However, the FCA has seen examples where the benefit of anti-dilution is more than all the transaction costs a fund has incurred, leading it to report negative transaction costs. Consequently, the FCA has proposed that any anti-dilution benefit must not be considered if and to the extent it would lead to negative transaction costs. KIDs should also carry information about the benefits of anti-dilution.

Anti-dilution practices often require complex calculation and monitoring. The FCA and BoE’s recent liquidity review of open-ended funds (see our blog here) stated that, whilst several funds use swing-pricing, the relevant calculations could be improved to take into account the ‘true marginal cost of fund redemptions’. The same review also suggests that disclosing information about swing pricing might benefit investors, on an ex-post basis. Whilst the KID is an ex-ante disclosure, other ex-post forms of disclosure are clearly of interest to the FCA and firms may want to consider how best to disclose information about anti-dilution, so that end-investors have a better idea of the costs and charges they are paying.

Debt securities

Another point of concern relates to the transaction costs for debt securities. The FCA is aware that many bonds trade infrequently and prices available from data providers may not reflect the most recent market movements. As such the FCA suggests that firms check the fairness of the price before transacting, and that the best evidence for the market mid-price of the bond will be the average of the best bid and best offer obtained when seeking quotes from multiple counterparties. The FCA states that this approach is likely to be accurate and will remove the possibility of firms calculating negative transaction costs for these transactions.

Firms will need to ensure they have the right capabilities to obtain the data on prices and make robust records of mid-price calculations. Firms which are not already doing so will be expected to obtain multiple quotes from counterparties prior to buying or selling an illiquid bond over-the-counter, and to take the average of the best bid and best ask price as the market price. Qualitative assessments of ‘fairness’ should also be recorded, in case there are future client complaints or supervisory visits.   

Index-tracking funds

The FCA thinks that slippage is not necessarily the best way of calculating the costs associated with index-tracking funds, as they may only transact in significant volume on a limited number of occasions (when there are changes in the index).

The FCA has proposed that index-tracking funds should use a spread model to calculate costs as opposed to slippage i.e. when calculating the costs associated with orders that initially entered into auction, the arrival price should be calculated as the mid-price immediately prior to the auction.

Next Steps 

The FCA has requested feedback by 30 September 2021, with the intention that any finalised proposals will come into effect on 1 January 2022.

This is quite a challenging timeline for firms as updating SRIs, providing narratives about performance, and making information about anti-dilution clear could potentially be time consuming. For firms that are also selling PRIIPs to the EU, any finalised proposals will have to be implemented whilst maintaining the ability to produce KIDs according to the EU rules, which are also in the process of being reviewed. Firms will need to ensure there is a robust in-house framework for keeping track of the distinction between the EU and UK KIDs and documenting the updates for each separately.