Derivatives and structured products’ complexity, current practices, industry habits and, regulatory attempts.

What makes a structured product complex? There is no standard definition of perceived or real complexity in the financial derivatives industry.

Some products may be labeled “complex” or “exotic” based on subjective criteria such as their lack of popularity. Inversely, one may oversee the complexity of frequently traded products simply because market participants got used to trading them: the force of habit. The gap between financial complexity and investor sophistication makes it essential to define product complexity.

1. Motivation to define complexity

The marketing of complex products gives retail investors access to asset classes, market segments, and investment strategies that were previously only available to professional clients. To make informed decisions, investors should understand the risks, costs, and expected returns of some complex products and/or the drivers of risk and return.

While the vast majority of structured products are considered by ESMA and other regulators as complex, measuring this complexity is key to determine if clients have sufficient financial knowledge and experience to understand the key features, benefits, and risks involved in a given investment.

Despite its importance, it is surprisingly hard to find a practical definition of complexity. It is even harder to establish a rigorous one. This is in fact posing a challenge for financial regulators. The latest regulatory alternatives mostly seem to focus on providing investors with more information about the products. However, increasing product information does not solve the problem as it may lead to information overload.

2. Regulators’ attempts to define and regulate complexity

There have been some attempts to define derivatives and structured products’ complexity in Europe through the International Organisation of Securities Commissions (Iosco) and a couple of national regulators, notably the French and Belgian Financial regulators. Iosco’s approach is based on the extent to which the product is understandable by retail investors; whether its valuation requires technical skills, and whether it has limited or no secondary market.

Let us take a look at two European regulators' methodologies. The Financial Services and Markets Authority (FSMA) has elaborated a framework based on four criteria:

1. Underlying value transparency

2. Strategy’s complexity: calculation formulas complexity and transparency regarding costs

3. Credit risk

4. Market value

On the other hand, the Autorité des Marchés Financiers (AMF) suggested three different criteria:

1. Count of the features in the payoff formula

2. Number of nodes in the decision tree (the decision tree describes the payoff distribution, depending on whether events provided in the formula occur or not)

3. The number of scenarios affecting the product’s performance

Comparing the FSMA and AMF methodologies, we first observe the difference in the number of criteria. We also notice that the FSMA considers values such as the Underlying and Market values as opposed to the AMF. Suggested criteria range from observed variables to risk metrics such as the “Credit risk” in the FSMA criteria. But can we mix up risk and complexity?

In the US, the Securities and Exchange Commission (SEC), does not wish to intervene in proscribing a given structured product based on the belief that investors should make up their own minds if they have access to “full and accurate disclosure to make their investment decision.” see this article for more details. This market democratization principle gets tricky when it comes to retail investors. Structured products sold in the retail market face enforcement actions by the SEC and the Financial Industry Regulatory Authority (FINRA). The Complex Financial Instruments Unit is an example of a “police” workforce protecting retail investors.

Meanwhile, Russia’s innovative approach has caused much debate. It involves dividing “qualified investors” and non-qualified investors, where non-qualified investors will have to go through a testing procedure to gain access to financial instruments and transactions. The testing phase is supposed to start in October 2021, let’s see how this goes. Find out more on this page.

3. Non-regulatory attempts to define complexity

While there are ways to express risk in both absolute and relative terms, this is more difficult when measuring complexity. There is no standard measure to express complexity as an absolute. Therefore, a meaningful rating for complexity needs to be calibrated against reputed and widely accepted as simpler or more complex products.

3.1 The checklist-based approach

Using a checklist to determine the complexity of a product is one of the most popular approaches. Different characteristics of the products are evaluated and allocated a score. The overall score will then determine the complexity of the product.

Common characteristics include: