BaFin postpones decision on ban sales of credit-linked notes

Earlier this year in July, the German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsich“BaFin”) had started a public consultation on a possible ban on the sale of credit-linked notes to retail investors.

The public hearing process lasted until 02 September 2016 and was widely utilized by market participants. National and international issuers of structured products were gravely concerned that the planned decree might just mark the start of a much stricter regulation of the distribution of securities and financial instruments to retail customers in Germany. However, BaFin based its proposed order on a power recently assigned to the regulator by the German front-running in the transposition of the product intervention right stipulated in MiFIR. The regularly articulated concerns were that retail investors would typically not be able to cope with the high complexity of CLNs because of the relevant type of underlyings. Unlike for ordinary underlyings which are more familiar to retail investors, retail investors would generally not be in a position to evaluate the probability of a credit event occurring.

Today, BaFin announced that the relevant associations for structured products, namely the German Derivatives Association (Deutscher Derivateverband) and the German Banking Industry Comittee (Die Deutsche Kreditwirtschaft) have published ten self-binding principles for the issuing of CLNs (available only in German) that address the concerns of the regulator. As a result, BaFin has postponed any decision on the decree for six months’ time and will then evaluate whether the measures undertaken by the industry have improved the market situation.

The industry has agreed on the following ten self-binding principles:

1. CLNs sold to retail clients must be “simple”, ie that such CLNs will only be linked to the credit risk of one reference entity. Links to multiple underlying reference entities are only acceptable if they work to diversify the risk of the investor.
2. CLNs will only be issued to retail investors with a fixed interest rate.
3. At the time, the CLNs are issued, bonds or shares of the underlying reference entity must be listed on a regulated market.
4. Underlying reference entities will be selected with a high standard of care and must have an “investment grade rating”.
5. The retail investors must be provided with clear product information, in particular setting out the effect of “credit events” on his investment and the dependency of a redemption on the non-occurrence of such event.
6. CLNs must clearly be labelled as “credit-linked notes”
7. Issuers of CLNs may not use the notes to hedge an own risk resulting from loans granted to the underlying reference entity by the CLN issuer or affiliates.
8. CLNs must have a face value of at least €10,000.
9. When providing investment advice, CLNs may not be sold to retail investors that have indicated a very low risk tolerance (ie first two tiers of the risk evaluation).
10. When selling CLNs as part of the regulated services of investment advice, the advisor must apply a two-levelled approach: First, the seller must specifically consider the skills and expertise of the investors on the general structure and functioning of CLNs. On a second level, the investor must be specifically informed about the product and associated risks. In particular, the risks must be clearly set out in the documentation accompanying the investment advice.

BaFin has already announced that it will carefully evaluate for the next six months whether the implementation of the self-binding principles sufficiently protects retail investors. While the regulator acknowledges that the self-binding principles may offer a similar level of protection to retail investors as the contemplated ban of sales, they have also made it clear that they are willing to continue the product intervention process, if they are not satisfied with the voluntary measures implemented by the industry.