Aug 3, 2015

Part I: Explanation of PRIIPs Methodologies for Structured Products

In this Part I video blog: PRIIPs Methodologies in Focus, Tim Mortimer, Managing Director for Future Value Consultants and Keith Styrcula, Chairman and Founder of the Structured Products Association join Jim Jockle, CMO of Numerix to discuss the debate surrounding the four Packaged Retail and Insurance-based Investment Product (PRIIPs) methodologies being considered for determining structured investment product risk ratings.

With the imminent August 17th deadline approaching, it remains to be seen which methodology will win out as the regulatory standard for determining the risk ratings under the PRIIPs framework. Will it be a quantitative or qualitative methodology? Can a simple risk rating actually create more transparency?

Weigh in and continue the conversation on Twitter @nxanalytics, LinkedIn, or in the comments section.

Video transcript:

Jim Jockle (Host): Hi welcome to the Numerix Video Blog, I’m your host Jim Jockle. Today we have two guests joining us: Keith Styrcula, Chairman and Founder of the Structured Products Association and joining us from London Tim Mortimer, Managing Director for Future Value Consultants. Good morning gentlemen.

Keith Styrcula (Guest) and Tim Mortimer (Guest): Good morning Jim.

Jockle: OK. So, the battle has begun. And, while usually sleepy and quiet during the summer, we are now pushing an August 17th deadline to nominate which methodology will win out as the regulatory standard for determining the risk ratings under the Packaged Retail and Insurance-based Investment products, or more widely known as the PRIIPs framework. So gentlemen, you know, I think traditionally the place has been held in the market as the credit rating being the world’s shortest editorial, but yet we now have an introduction of a new one for structured products as it relates too, from the regulators. So, Tim, let me start with you. And, there are four methodologies that are in contention for the top spot – perhaps you can just start with a brief overview of the four options and methods and then we can jump in from there.

Mortimer: OK. Thank you. The first of the four methodologies, is looking at coming up with a quantitative scale based on five groupings. This has quite a lot of detail and a look-up table approach where product categories and characteristics are used to determine which of the five categories the product risk could fall under. Having looked at it, this has certainly got a lot of merit to it. Although for certain product types, it may be, depending on where the market goes in the future, it may not be clear which of the five categories  a given product should  fit into.

The second one is one that’s actually has been used in the UK for all of 2015 so far, been adopted this year. And our company is actually the sole calculation agent of this methodology. This takes a combination of the historical volatility of the underlying asset and the bank-provided delta sensitivity to the market, on day one. Put those two numbers together, and come up with a risk rating from that methodology.

Method three doesn’t actually have a whole lot of detail in the paper right now. But, it’s going to be some kind of forward-looking simulation based off the methodologies used in the German market for calculating a distribution of returns and then generating a risk number based off of that methodology. And method four is a two level indicator. The first one is extremely broad and general. And the second level of indicator is used to provide a bit more granularity. That’s also quantitative, so it’s a bit like option one. So those are the four methodologies.

Jockle: Thank you Tim. So, let’s jump into a little bit of the debate. I think…there was a recent article in Structured Products Magazine, and did a survey. Of those polled, about 60 percent clearly want a quantitative approach in the way that we continue to move forward. Keith, let me turn to you. Perhaps, give us some insight, you work with a lot of the manufacturers and distributors of the products, why would the quantitative versus the qualitative really take the lead here?

Styrcula:  Well, it is interesting, and I’m not certain that that’s the case.  But, what I do believe is that if Tim’s methodology, for example, is something that can be broadly applied to the US structured products market, then it’s something that we should adopt. Or that we should look into. Even before the SEC starts adopting some of the PRIIPs regulations that we are already seeing being put into place in the EU. More transparency is always better. That speaks for itself. I do worry sometimes that some of the additional regulations will chill some of the development in the marketplace. That seems to be the largest concern. Again, if there is a quantitative plus qualitative approach to disclosing more risk, that is something I think that we, as an association, would applaud.

Jockle: So, let me just stay right there with you for a second, Keith. Having been to many of the Structured Products Association conferences over the years, education has been first and foremost kind of a key barrier to product issuance in the US, in an ongoing theme. In terms of trying to distil down to a simple risk rating, is this going to create more transparency? Because I want to get to you Tim in just a moment as it relates to the complexity behind, driving these ratings. So, will this achieve the intended purpose of better transparency and better understanding as it relates to the product for investors?

Keith: Well, obviously Jim there’s two schools of thought. More disclosure is better, or less disclosure is more succinct and can describe the product in a way that retail investors can more readily understand.  So, right now, most of the firms in the US lean towards greater documentation. We have the base prospectus, we have a pricing supplement, we have a product supplement, and we also have the free-writing prospectus. The free-writing prospectus would be something similar to the KID (Key Information Document) document that’s used in Europe, but the free-writing prospectus doesn’t have any space limitations. My understanding and Tim, correct me if I’m wrong, the KID document only has two pages, and if the product is a little bit more complex you only have a certain number of characters that you can fill in.  And so, I think the US approach with free-writing prospectus, it ain’t broke, so we don’t need to fix that.

Jockle: So Tim, let me turn to you for a second, in terms of the quantitative methods, these are challenging. Some of the debate has been for large manufacturers, you know this is just an additional step and they have the tools required that are necessary to run these kinds of calculations. Some of the smaller manufacturers and distributors are saying that this is going to be massive cost on us in terms of adopting new methodologies. This seems to be a little bit of a barrier as it relates to the VaR methodology. Perhaps you can give us some insights and thoughts as it relates to how complex will it be to distil you know, multiple Monte Carlo paths and what not into a simple letter indicator?

Mortimer:  Well. There are a lot of issues. And the paper, which is over 100 pages in length, that was published by the EU last month is very much a discussion paper, and there will be a further iteration after the responses are brought back in August. So there is still a long way to go, really. The first choice is whether it is qualitative or quantitative.  And, there’s two methodologies in each camp that have made the last four possible outcomes. I personally think the quantitative is the way to go. It’ s up to the manufacturer and distributor to calculate the number based on whatever methodology is adopted, and then present that to investors on a scale of one to five or one to seven, whatever is being used.  A risk number is part of the equation. It can’t tell you the whole story. Any methodology will have, perhaps, some weaknesses or inconsistencies now and again. But, it gives you a broad idea of what the product is all about. In terms of cost and effort for the calculation, the distributors and manufacturers will have until the end of 2016, at least, to get their systems ready to calculate this number. And, I don’t think with technology available either in-house or to outsource it, it shouldn’t be beyond the capabilities of people to get that number calculated reliably.

Jockle: So, Tim I want to stay with you just for a second.  And Keith I want to get your perspective on this as well.  You know right now, this is kind of a nexus in the industry. Is there a possibility that the wrong decision could be made? How important is this for the growth of the industry going forward?

Mortimer: Yes, it is possible. Like I said, there isn’t a lot of detail on at least two of the methodologies, so it remains to be seen what comes out next. And, any sensible methodology should give results that are pretty robust. Like I said there may be, you may be able to come up with two products that exist in the market and there risks look a bit out of line, but by and large, a sensible methodology should work for the vast majority of products, and that’s all that we can really hope for.

Jockle: And, Keith your thoughts?

Styrcula:  Well, I appreciate that Jim and I appreciate Tim’s thoughts on that as well. We’ve seen a concept called Estimated Instrinsic Value (EIV) that the SEC opposed in the Structured Products Industry going back a couple of years. There was a lot of panic among the manufacturers. How are we going to calculate this? There is no methodology that’s being given to us by the regulators, and we all are on our own to calculate that as an issuer. So, there was a lot of concern about it, but then everybody kind of came to an understanding that, hey, our law firm says this is kind of the consensus of how it should be done. And, just gradually, the law firms kind of led the way in the calculation of it, EIV. And, so now it took quite a while for everybody to kind of settle in, but now it’s adopted and it’s working well and it’s implemented. So, I can see the same thing with a risk rating, as long as everyone can come to an agreement on how to calculate that.

Jockle: So Tim, let me ask you, when I started with the comparison to the rating agencies. But, I think there is clear distinction between the two. This is being opposed by the manufacturers themselves to develop this. Is there, from your perspective, a role for independence? Or, should this be managed independently of the manufacturers themselves? Or is the outcome going to be a clear, repeatable methodology that will create a standard?

Mortimer: Yeah, I think the regulators, they have had previous iterations of both risk numbers and other calculations.  What the regulator would certainly like to do is to have a methodology which is reproducible. So, the manufacturer comes out with a certain risk rating and any independent or third party, in theory, even an investor with maybe a spreadsheet and a certain amount of data available would be able to reproduce the same number.  Now, it’s not clear whether the methodology that they are going to adopt, whether that would be very easy to take place or not. But broadly, these numbers should be reproducible, so that everyone can agree that the risk numbers that are coming out are correct, under whatever the methodology is. Whether companies go in-house or outsource that’s a decision they need to make along with some of their other technology and analytics requirements. But, at the end of the day, whoever calculates it, the manufacturer is responsible for actually that number.

To continue this conversation, stay tuned for the Part II video blog follow-up conversation surrounding PRIIPs Methodologies and Product Risk Ratings for Structured Investment Products.

On the Numerix Video blog it’s our goal to examine the topics that you want to talk about. Keep the conversation going on LinkedIn, and on Twitter @nxanalytics. Thanks for joining.

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