Abstract
The investment in illiquid financial products introduces multiple profiles of criticality related to the perception of the effective profiles of risk and to the intermediaries’ distributive policies. However, the notion of illiquid product could be affected by some misunderstanding such as the tendency (which constitutes a simplification) to identify it to the trading venue, for which are illiquid only those products negotiated over the counter. In actual fact, it is necessary to estimate an instrument on the base of its characteristics, those of the issuer and the eventual market of negotiation. From a substantial point of view, this has some important implications regarding the regulatory profiles of investor’s protection. The Mifid in Europe set conduct rules to align the behavior of the intermediary regarding the objective to best serve the investor. The harmonization of the conduct rules passes from the implementation of level 3 measures. This paper examines the problem to the light of the implementation of level 3 measures in Italy.
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Notes
Recently, the Autumn Meeting of central bank economists in 2006 explored in depth this issue. For a better insight, see Hördahl and Packer (2007), Understanding asset prices: an overview, Bis Papers.
This phenomena is referred to as the credit spread puzzle (D’Amato and Remolona 2003).
It should be observed that empirical research on the determinants of credit spreads delivers uncertain results. Guazzarotti ( 2004 ) examines the determinants of variations in credit spreads on a portfolio of non financial institutions corporate bonds during the period 1999–2003. According to the findings, default risk explains 20% of volatility in credit spreads whereas liquidity and other market factors explain another 10%. Other research contributions examine the determinants of corporate bonds spreads. The Federal Reserve Bank of San Francisco (2004) analyzes the determinants of spreads on high yield corporate bonds. The research shows an interesting liquidity effect; in particular there emerges a tight relation between liquidity conditions, economic cycle and monetary policy decisions. During the 2001 recession a widening in high yield bond spreads was observed, followed by a subsequent convergence due to a more relaxed monetary policy, which resulted in better liquidity conditions.
According to the statistics published by the Bank of Italy, from 1997 to 2007 the weight of banking obligations on total financial investments of Italian families grew from 6.4% to 9.6% whereas the weight of insurance products grew from 9% to 15.4%.
See Communication n. 9019104 of 2 March 2009 on http://www.consob.it, adopted following the securities industry observations to the Consultation document issued by the Commission on may 26 2008.
In general terms, the observations to the Consultation document delivered by the Italian Banking Association (Abi) complain about a tightening of disclosure requirements, in addition to the obligations that regulation already foresees.
Consob level 3 guidelines cover segments without the scope of Mifid directive (placement at issue of structured bonds, Otc derivatives and distribution of insurance financial products); as a result of the adoption of Law n. 265/2005 on saving’s protection only in Italy such products are subject to the same rules set by the European legislation.
The Abi and the Italian Association of Capital Market Operators (Assiom) express this.
In particular the intermediary would be able to comply with disclosure requirements with a synthetic document containing complete and easy to understand information about the product.
It should be considered that Consob guidelines adhere to the principles of Ias fair value evaluation. The Italian Consob, in particular, aims to assure coherence between evaluations for accounting purposes and evaluation used in negotiations with clients. Adhering to accounting standards (and to the recommendations on financial intermediation) implies, however, some criticalities in particular market scenarios where liquidity is scarce. The reliance on market prices could turn out to a misleading assessment of the fair value of the financial instrument as well. More recently, Cesr (2008) issued a Consultation document containing guidelines on fair value measurement and related disclosures of financial instruments in illiquid markets.
Abi, in particular, object that it would be difficult for the client to understand all detailed information about price formation and costs. It could be answered, however, what is more misleading for the client, a great transparency or, otherwise, the habit to bundle all the relevant elements that contribute to the total disbursement. By the way, it is just a general duty to act fairly and transparently which would requires the intermediary to disclose all the relevant items for a proper assessment of the proposed operation.
On this round, associations (Abi and the Association of Investment Companies: Assosim) object that it would be turn out to an excessive burden a complete transparency over fair value and the likely disinvestments value. In particular the objections focuses on Otc derivatives for which a scenario analysis would be more costly.
The Italian Association of Asset Managers adhere completely to the Consob recommendations.
It should be considered that the Mifid extends the duty of best executions also to these instruments.
In this case the intermediary should adopt pricing methods coherent to those used when placing the product.
It should be observed that during discussions accompanying the adoption of Mifid a debate over benchmarking for best execution duties in the distribution of structured financial products emerged. In the light of difficulties in finding objectives benchmarks, such a solution was abandoned.
In particular, Abi fears a potential discrimination of the systematic internalizer compared with regulated markets and Mtf’s. In the Consultation document Consob laid down an obligation for the intermediary to request other parties for quotations in case of financial instruments not traded on regulated markets or Mtf’s. With this Consob seemed to presume that financial instruments traded on these platforms should be considered as liquid. In the issued guidelines the reference to particular trading venues does not appear. It would be the responsibility of the intermediary to request quotations in any case it recognizes the absence of an efficient and liquid market for a particular instrument.
See Abi and Assiom.
For example, upfront commissions, placing costs, structuring costs.
Due to the nature of what are generally understood as illiquid products the deliver of the investment service according to an execution only regime should not be available.
The Consultation document delivered by the Italian authority appeared to be more strict in assuming in advance as unsuitable for the typical retail client an investment in illiquid products (or otherwise containing derivatives items). As a matter of fact, this would have prevented intermediaries from operating in these instruments. Following objections from intermediaries’ associations Consob eliminated any reference to the retail client permitting intermediaries to sell illiquid instruments to clients, provided that they carry on a proper assessment of the comprehension of risks by the client.
As Consob observed, a synthetic suitability test in which the holding period is not distinguished from other profiles should deliver a misleading perception of the liquidity risk by the client.
References
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Polato, M., Floreani, J. Distribution of Illiquid Financial Products: The Case of Italy. Transit Stud Rev 16, 848–859 (2010). https://doi.org/10.1007/s11300-009-0114-x
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DOI: https://doi.org/10.1007/s11300-009-0114-x