Germany: BaFin plans to prohibit the marketing, distribution and sale of retail credit-linked notes (Bonitätsanleihen)

BaFin's product intervention powers

Based on a new product intervention tool introduced with the German Retail Investor Protection Act (Kleinanlegerschutzgesetz) as section 4 b of the German Securities Trading Act (WpHG), BaFin may restrict or even prohibit financial instruments or financial activities and practices if these present a significant investor protection concern or a threat to the stability or integrity of the financial system or financial markets. This provision explicitly establishes collective consumer protection as a supervisory objective. The German legislature pre-empts the European legislation: the Markets in Financial Instruments Regulation (MiFIR) will introduce the product intervention right for all EU Member States. Section 4b WpHG is based on the MiFIR product intervention provisions and serves to bridge the period until these come into force.

Which kind of products are affected?

Credit-linked notes (Bonitätsanleihen) are interest-bearing debt securities whose interest payments and repayment are contingent on the financial solvency of the underlying debtor, such as a company or a state. As long as the debtor does not experience a credit event, the investor receives interest payments that are usually higher than comparable government or corporate bonds. Upon maturity, the principal of the note is repaid at the nominal value. If a credit event occurs, future interest payments are forfeited and the investor receives a settlement amount lower than the notional amount or no amount at all. The calculation of this amount is based on a complex valuation process.

The Supervisor’s Concerns

According to BaFin's draft product intervention, the marketing, distribution and sale of credit-linked notes to retail clients raise significant investor protection concerns based on the following factors:

High product complexity

In contrast to other structured product underlyings (e.g. shares or indices), retail clients are typically neither familiar with underlyings like creditworthiness and credit risk, nor do they have access to the relevant information sources. However, in order to properly assess the risk-return profile of such products, the client needs to assess whether a credit event will occur in relation to the underlying reference entity. The circumstances of the occurrence of a credit event are crucial from the investor's perspective. This might, at best, be possible by analyzing the prices of the embedded credit default swaps – but such information is not available to the very great majority of retail clients.

Complexity also becomes evident with respect to repayment after occurrence of a credit event: the repayment amount is determined in accordance with an auction process initiated by ISDA or based on average market quotations – in both cases retail clients are unable to assess the possible repayment amount. This in effect prevents them from (i) gaining an idea of the product’s performance in such cases and (ii) as consequence, making appropriate investment decisions.

Complexity even increases with credit-linked notes linked a basket of multiple reference entities with "worst-of" structures.

Misleading product name and product descriptions

Despite what the German product name may suggest, Bonitätsanleihen are not bonds (Anleihen) in the traditional sense (e.g. a debt instrument issued with the purpose of raising capital by borrowing and paying interest in exchange). In contrast, with credit-linked notes the retail client takes on a role similar to that of a protection seller that assumes the risk of a credit event and provides protection for it – in BaFin’s opinion, the contractual relationship seems to establish insurance against default rather than provide bond capital. In addition, BaFin’s investigations of the respective investment advice given by banks to retail investors have shown that the explanations on how credit-linked notes work have been inadequate. This lack of clarity and confusion of roles (i) embedded in the product structure and (ii) not resolved by the marketing and distribution processes leads to misunderstanding on the part of retail clients who regard the product as an interest-bearing security.

Conflict of interest

Another reason for concern is the risk of a conflict of interest inherent in the product structure, because issuers may take the role of product provider while also having other kind of business relationships to the reference entities relevant to the performance of the credit-linked notes (e.g. with respect to lending or trade in reference liabilities).

Substantial market volume

Finally, a quantitative point: credit-linked notes are widespread in the retail client market, hence a large number of clients is affected. Market statistics published by the German Derivatives Association (DDV) reflect a significant increase in market volume recently (market share of 9.3 % in 2016 versus 7.4 % in 2015), which was confirmed by BaFin’s recent investigations conducted within German issuers.

Practical consequences and outlook

• If BaFin issues the General Administrative Act (Allgemeinverfügung) after the hearing, on the day following the public announcement the marketing, distribution and sale of certificates linked to credit-worthiness risks (Bonitätsanleihen) to retail clients will be prohibited in Germany.

• The order refers only to future activities: "Activities already concluded remain unaffected". However, it is explicitly stated that "related marketing, distribution and sales activities which are in progress must be ceased immediately" once the product intervention is effective.

• The core issue is whether the prohibition is a proportionate measure.

BaFin’s enabling provision requires that a prohibition be proportionate with respect to the risks identified, the level of expertise of the investors and market participants, and the likely consequences for the investors or market participants. When the BaFin considered these factors, the effective protection of retail clients was taken as the critical measure: in a nutshell, BaFin sees a "structural disadvantage" for retail clients in comparison to professional market participants, "in particular in terms of risk-bearing capacity and expertise". Given the severity of the measure it is to be expected that market participants will investigate whether milder measures could achieve the desired outcome and, as the case may be, will strongly advocate such a course.

• The question remains as whether this might be only a first step in BaFin’s intervening in the financial market using the new section 4b WpHG. It is to be hoped that the German supervisory authority can maintain and protect the important balance between a functioning and strong financial market and the interests of consumer protection.

Please click here to read BaFin's order relating to the hearing / General Administrative Act.