Complex investment markets bring high returns, but also involve equally high risks. There are no requirements for providing comprehensive information on many of them, however a person needs professional knowledge and skills to make an investment decision. The new Russian law requiring information disclosure to both retail investors and financial consumers in general and setting restrictions on selling complex products to non-qualified investors that was adopted by the State Duma on 19 May 2021 is aimed at strengthening the protection of individuals in financial markets. However, it simultaneously establishes new rules for operations which would change the structure of the securities market.
In all jurisdictions with mature financial markets, access to financial instruments of various complexity is provided based on the classification of investors into qualified and non-qualified ones, a system that has been in place from the 1930s as a result of the innovations in the US securities market. Specifically, the USA allowed only so-called accredited investors to invest funds in complex instruments that are not publicly traded: investors could be considered accredited if they had at least 200,000 US dollars in annual family income or one million US dollars in net assets, not counting their primary residence. Since 2020, investors may be qualified as accredited if they prove they have sufficient professional knowledge. Accreditation allows access to the markets for direct investment funds, hedge funds, startups, and private securities, annual investments in which are more than twice as much as those in the public securities market. The European Union applies similar rules: a qualified investor should have steady and significant amounts of transactions with financial instruments, work experience in the financial sector for at least one year or financial assets totalling at least 500,000 euros.
In Russia, beginning from 2013, individuals are classified as qualified investors if they possess substantial portfolios of financial instruments (financial assets or transactions with financial instruments in the amount of at least six million rubles), work experience in financial institutions for at least two years, and have professional education or a qualification certificate equivalent to the one issued to a financial institution’s employee. Thus, only wealthy people or financial experts were previously recognised as qualified investors allowed to access complex investment products.
However, the soaring demand from retail investors in the securities market in 2020–2021 and the practice of the distribution of complex products have shown that inexperienced non-qualified investors are most vulnerable to misselling. As assessed by the Bank of Russia, qualified investors numbered approximately 200,000 people as of the beginning of 2021. Meanwhile, the number of individuals with brokerage accounts on the Moscow Exchange exceeded 11 million people and continues to grow. The new draft law stipulates additional conditions for selling financial products to non-qualified investors. The key requirements are that a seller should properly disclose information, while investors should comprehend the specifics of instruments they purchase and their inherent risks. Financial institutions will be allowed to sell certain types of complex products to non-qualified investors only after the latter pass a test proving that they know the specifics and risks of a particular type of instruments. It should be emphasised that a successful test will not give a person the status of a qualified investor in the sense provided for by the law, but will allow access to the types of instruments, the knowledge of which has been verified.
The scope of the tests is described in the standards of the self-regulatory organisations of brokers, the National Association of Securities Market Participants, and the National Finance Association and is approved by the standards committee under the Bank of Russia (link in Russian). To a certain extent, the requirements are similar to the conditions in the US market, where individuals to become accredited should pass exams put forth by the Financial Industry Regulatory Authority, the self-regulatory agency of Wall Street. As said by trainers, the Russian tests are to verify learning outcomes, that is, to measure the knowledge and skills acquired after completing a training programme. These tests check the elementary knowledge of how to identify a financial instrument and be able to make an investment decision with regard to it.
Those who fail to pass the test after the first attempt will have a chance to try once again – the regulation allows a person to take the test several times after acquiring the necessary knowledge either by self-studying or at specialised courses. Currently, the Moscow Exchange, supported by the Bank of Russia and the Financial Literacy Development Association, is developing one of such modular training programmes for retail investors.
Investors who fail the test will get a clear signal first and foremost for themselves: they do not have sufficient financial sophistication for such a complex instrument and, therefore, may be unable to manage their investment in such a way as to receive returns. Moreover, such investors are exposed to high risks of being deluded by unfair sellers or ‘advisers’ from the Internet or telegram channels. Nonetheless, an investor who fails the test but insists on purchasing a complex product will still be allowed to do this based on the right of the so-called final word. However, the amount of such transaction will be limited to 100,000 rubles. In making such a decision, a person will be at least aware of accepting high and uncontrollable risks.
The tests may be conducted remotely by a broker servicing the retail investor. The self-regulatory organisations of brokers and the Bank of Russia will carry out monitoring to make sure there is no conflict of interest in the broker’s activity. The Bank of Russia publicly notifies the market that it will be closely monitoring how tests are organised in order to ensure compliance with good faith principles. Taking the tests, retail investors should be very prudent and not delude themselves.
According to the law, the testing will start earlier – on 1 October 2021. That said, some types of organisations are currently making promises online that anyone who wishes to would be granted the status of a qualified investor for a fee, even if an investor actually does not conform to the established criteria. I would say that, after the law is adopted, a lot of individuals might receive tempting offers from unknown persons proposing assistance in passing the tests and luring people into the trap of easy money.
According to the findings of the first behavioural assessment of the Bank of Russia released in April 2021, moderately complex tests are most efficient – they require elementary skills, that is, a person should know how to solve a problem using a single formula. To reliably determine an investor’s knowledge level, the test should include at least eleven questions regarding every particular financial instrument. If this behavioural assessment is carried out on a regular basis, this would help adjust and enhance the tests. In our opinion, the majority of retail investors with a long-term interest in the securities market will be able to pass the test sooner or later and become experienced investors.
Information disclosure and alterations in the market
The first thing any investor needs is timely, reliable and clear information about a potential investment instrument. To eliminate information asymmetries in financial markets, the draft law introduces new powers for the Bank of Russia entitling it to establish the requirements for the so-called Key Information Document (KID), or in simplified terms, a ‘passport’ of a financial product. A retail investor should possess clear and balanced information about the chosen financial instrument, its returns, costs and risks.
In foreign practice, the KID has been used for many years and has proven to be efficient. The UK first introduced a unified information disclosure requirement in 2009, and it was primarily related to structured investment products. Higher market transparency increased investors’ awareness, while also causing a redivision of the market. The issuers of financial instruments lacking in transparency and reliability who used to dominate the market yielded their positions to other players. The offerings of some risky and complex financial instruments became limited since many banks reviewed their interests in the retail market. Having reconsidered the situation, a range of large issuers inferred that retail sales were no longer part of their KPI.
However, the establishment of the first requirements for information disclosure did not streamline market practice instantaneously. In 2014, the UK’s financial regulator fined Credit Suisse and the Yorkshire Building Society for failing to ensure products were clear and fair, as well as for deluding potential investors through their financial promotions. The fines totalled 3.8 million pounds sterling. Nearly 84,000 customers invested a total of 797 million pounds sterling in a product linked to FTSE 100 share prices. Credit Suisse agents declared maximum possible returns, although the probability of such performance was close to zero.
After the first KIDs were tested, the information disclosure requirements were enhanced and expanded to the pan-European level. In 2017–2020, they were stipulated in two EU directives: the Regulation on key information documents for packaged retail and insurance-based investment products (PRIIPs) and the expanded Directive on markets in financial instruments (MiFID II). They establish the requirements for financial institutions issuing and distributing their products among retail investors.
In 2018, the EU and the UK made KIDs mandatory for financial products and instruments. KIDs provide a brief (three-page) description of the main characteristics of a financial instrument. The national associations of financial market participants and a number of information and analytics providers developed KID templates for the most widespread products. The trading platforms where exchange-listed instruments are offered and traded also presented their versions of KIDs. For instance, the Japan Exchange Group (JPX) selling its derivatives to investors in the EU prepared their standard descriptions.
In Russia, KID forms are developed by self-regulatory organisations as the standards for the protection of the rights and interests of individuals and legal entities receiving financial services. These forms shall be approved by the Bank of Russia. They combine both simple elements for an inexperienced newbie and complex ones for sophisticated investors. According to the new law, the Bank of Russia will be entitled to establish the form, ways and procedure for providing KIDs. Some KIDs for the securities market have already been developed by the self-regulatory organisation National Finance Association and the National Association of Securities Market Participants as their internal self-regulation standards. They have been tested within several focus groups of retail investors. In April 2021, the Moscow Exchange also developed and released KIDs on its financial instruments for the derivatives market section.
Among all the key metrics of KIDs, the risk rating (which is called a summary risk indicator in EU laws) and hypothetical performance scenarios are the most important ones. The risk rating is a hybrid assessment of a financial instrument measuring its credit and market risks. It is assumed that KIDs in Russia will use the combinations of colour lights and a quantitative scale showing an instrument’s risk rating. Furthermore, the Russian professional community is discussing (link in Russian) whether a risk rating should be assigned by a third party or by the financial product issuer.
In general, the development of common KID templates will take time. The Bank of Russia believes it unnecessary to reinvent the wheel and would rather rely on the EU and UK experience, adjusting it with account for Russian specifics. At the moment, it is only possible to note that the main points for discussion will include the description of hypothetical performance scenarios and their probability, the understanding of the baseline performance scenario and related risk, forecasting future performance based on information for past periods and its influence of procyclicality in financial markets, and the comparability of measures across various classes of financial instruments.
Overall, legislative innovations will result in temporary shifts in the securities market caused by structural changes in the demand for instruments. For instance, qualified investors accounted for as little as 8% of structured bonds (link in Russian) as of early 2021. There is a high probability of a decrease in the liquidity and capacity of the markets for complex and risky instruments, including over-the-counter products, unrated securities, perpetual bonds, etc. The reason for this is the requirement to disclose the results of investment and the restriction on selling complex products (link in Russian) to inexperienced investors until the start of mass testing. After millions of retail investors take the tests, who will apparently need to make several attempts, they will invest their funds in a market ensuring a totally new quality of information disclosure. In this market, investors should be more knowledgeable about financial products they invest their funds in.