Retail certificates: A German success story

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1 Financial Market Special EU Monitor 43 March 19, 2007 Retail certificates: A German success story Market trends, regulatory framework and outlook The German market for retail certificates has become a firmly established market for investment products in its own right. In 2006, the volume of derivative securities outstanding grew by 37% to EUR billion (2005: EUR 80 billion). We expect this strong growth trend to continue in 2007, with the volume in circulation rising by about 30% to approximately EUR 142 billion. In the mid term, we consider a trend growth of 15-20% p.a. feasible. Our forecast is mainly based on three assumptions: strong growth in new customer business, high innovation by issuers, and a positive trend on the financial markets. An important driver for this positive development of the certificates market is the well-suited regulatory framework, consisting of four main components: rules on prospectus requirements when issuing certificates, rules regulating trading on the stock exchange, rules on distribution (which will be regulated in more detail by the MiFID), and additional voluntary self-regulation through the Derivatives Code. The Derivatives Code is a further step towards greater investor protection since it increases transparency in the certificates market. The Derivatives Code should be elaborated further on a continuing basis in line with market, product and regulatory developments. An essential prerequisite for this success story made in Germany to continue in the mid term is not only strong innovation from product providers but also a suitable regulatory framework. Hence, the German government s announcement back in September 2006 that it does not intend to tighten the level of regulation in the certificates market any further is to be welcomed. Author Raimar Dieckmann Editor Bernhard Speyer Technical Assistant Martina Ebling Deutsche Bank Research Frankfurt am Main Germany Internet: Fax: Managing Director Norbert Walter Market volume outstanding: Forecast for 2007 in billion EUR % Q1/05 Q2 Q3 Q4 Q1/06 Q2 Q3 Q4/ e Sources: DB Research, Derivate Forum

2 EU Monitor Introduction Total market volume outstanding in billion EUR Retail structured investment products ( certificates 1) are a major success story for Germany s financial market. The volume of derivative securities outstanding grew strongly by 37% to EUR billion in 2006 (end-2005: EUR 80 billion) 2, reaffirming the sustained growth trend which has been in place for some years. Surveys reveal that already more than 6% of German private investors hold certificates in their portfolios 3. The German market for retail certificates has also established itself internationally as the biggest single market. Certificates made in Germany are selling successfully as innovative financial products in other European countries and in Asia. In this study we describe how the German certificates market works and what the success factors are. We have set three main focuses. Firstly, we give a general overview of the market and an outlook for We then discuss the product characteristics of investment certificates, the secondary market and the issuance of certificates. Finally, we look at the regulatory environment for certificates and discuss the role additional voluntary self-regulation can play in the certificates market. Q1/05 Q2 Q3 Q4 Q1/06 Q2 Q3 Q4/ The market for certificates Source: Derivate Forum 1 Volume outstanding by product class Leveraged products 1.2% Investment products 98.8% Source: Derivate Forum 2 The market for retail certificates consists of investment products and leveraged products. The main investment products are guarantee certificates, bonus certificates, partial protection certificates, express certificates, discount certificates, index certificates, strategy certificates and equity-linked bonds (reverse convertibles). Leveraged products consist of warrants, knock-out products and exotic options. The focus of this publication is on investment certificates (for an overview see Fig. 11, p. 16). 2.1 Market volume in Germany The certificates market witnessed strong growth of 37% in The volume of derivative securities outstanding rose by EUR 29.6 billion to EUR billion. According to calculations by the German Derivates Forum 4, the market is dominated by investment products, which make up 98.8% of the total market volume outstanding, while leveraged products account for only 1.2% (for details regarding the classification of products see Section 3.2) The term retail certificate is used here to refer to all structured investment products offered to private investors. This includes certificates as well as warrants and knock-out products. Estimate of total market by Derivate Forum e.v. (German Derivatives Forum). See Deutsches Derivate Institut. Derivate Forum e.v. is an association of nine banks: ABN Amro, BNP Paribas, Deutsche Bank, Dresdner Bank, DZ Bank, Goldman Sachs, HypoVereinsbank, Sal. Oppenheim and WestLB. Figures as of November See Derivate Forum. 2 March 19, 2007

3 Retail certificates: A German success story Turnover in investment and leveraged products in billion EUR Leveraged products Investment products Forecast is based on three factors High net inflows of funds expected 0 Source: BÖGA 3 Market shares in 2006 Turnover in % Deutsche Bank ABN Amro UBS Société Générale Goldman Sachs Commerzbank Citi Sal. Oppenheim Dresdner Bank Others Source: Deutsche Bank 4 Turnover 6 in investment products and leveraged products both on and off the exchange has also risen strongly in recent years. Turnover surged 76.8% from EUR 261 billion in 2005 to EUR billion in was therefore a record year for turnover in retail derivatives. However, the BÖGA statistics need to be qualified for two reasons: firstly, the total exchange turnover is double counted and, secondly, transaction chains are not eliminated in the figures. In all, 136,259 investment and leveraged products were in circulation at the end of Of the total, 72,788 were leveraged products and 63,471 were investment products 7. Another point is that the relative weight of investment products and leveraged products in terms of turnover reversed for the first time in Before then, because leveraged products are more frequently traded, turnover had always been higher in leveraged products than in investment products. This changed in 2005: with a volume of EUR billion in 2005 investment products overtook leveraged products (EUR billion) for the first time. The trend continued in While turnover in investment products and in leveraged products was more or less on a par in the first half of the year, investment products took the lead in the second half of All in all, more investment products (EUR billion) than leveraged products (EUR billion) were traded in Two factors have been mainly responsible for these rapid rates of growth. Firstly, during the bear market in the first years of the decade stronger investor demand emerged for financial products that offered a favourable risk-return profile as well as a capital guarantee. Secondly, structured products have grown more attractive with the positive trend on the financial markets since 1993 because, by using structured products, investors can base their investment strategies on a much broader spectrum of underlyings. Currently, there are about 35 issuers competing in the market for retail certificates. Deutsche Bank is the market leader in terms of turnover, with a share of 22.8% at the end of 2006, followed by Commerzbank (17.0%) ABN Amro (12.4%), and Sal. Oppenheim (6.6%). More issuers are expected to enter the market in Market outlook for 2007 The vigorous growth trend should continue in the German certificates market in We expect the volume outstanding to grow by about 30% to EUR 142 billion. We consider a trend growth of 15%-20% feasible in the mid term. Guarantee, bonus and express products will continue to be the dominant types of certificate (based on volumes in circulation) in On the supply side, the competition among product providers is expected to intensify further. There will probably be more than 40 issuers operating in the German certificates market by the end of Our forecast is mainly based on three factors: First, we expect strong growth in new customer business. Certificates are finding interest among broader sections of the investing public and should therefore attract considerable net 6 7 Turnover figures have been taken from the BÖGA clearing system. BÖGA publishes the so-called total exchange turnover (all executed securities transactions in Germany). However, this does not include transactions which banks settle internally, in other words transactions with internal entities (business units/subsidiaries). The figures published for total exchange turnover are double counted, in other words they include both the buy side and the sell side of trades. See Deutsche Bank. March 19,

4 EU Monitor 43 Innovation by issuers remains strong Positive development of the financial markets Investment products by category Based on volume outstanding as of November 30, 2006, in % Hedge fund certificates Other Guaranteed certificates Bonus/partial protection certificates Discount certificates Reverse convertibles Express certificates Outperformance/sprint certificates Index certificates Basket/theme/strategy certificates Source: Derivate Forum 5 inflows of funds. This trend will be reinforced by a large number of maturing products, and investors will be looking to reinvest the cash. As certificates have performed well, the rate of reinvestment in certificates is likely to be high. Owing to the market s enormous growth in recent years, more cash will be available for reinvestment from maturing products in 2007 than ever before. Second, our outlook is based on the strong innovation by product providers. This will continue in 2007 and lead to the introduction of further products, especially in two areas. On the one hand, certificates with novel product characteristics that can be tailored still more specifically to investor needs. For instance, possible developments here could be the introduction of actively managed certificates, the introduction of certificates with reduced issuer risk (through the creation of so-called compartments), or combinations of different types of certificate. On the other hand, the spectrum of investment approaches will be widened further with the introduction of new underlyings. The third assumption is that the equity markets will continue to develop positively in 2007, and thus provide further growth stimulus for the certificates market. We expect certain types of certificate, such as guarantee, bonus and express certificates, to profit particularly from this. Discount certificates could also witness a further growth surge as, in view of the low interest rate level, they are establishing themselves partly more and more as an alternative to low-yielding bonds. 3. Product classification 3.1 Structured products as the generic term In economic terms, certificates are structured financial products which classify as derivatives. As a rule, issuers construct ( structure ) certificates from different financial instruments (e.g. underlying and option) so as to create specific product characteristics. These are tailored to the respective market expectations and risk-return profiles of specific investor groups. The term derivative is used as a collective term for financial instruments and products whose price is linked to the value of an underlying asset. The underlying can be individual shares, indices, currencies or commodities for instance. 3.2 Product categories: investment products vs. leveraged products The market for derivative securities is dominated by investment products (see Section 2.1). In the investment products group, investment certificates are the biggest category, accounting for 97.6%, followed by reverse convertibles (1.2%) and hedge fund certificates (1.2%) (as of November 2006). Among the investment certificates, guarantee certificates predominate, accounting for 42.1% of the volume in circulation. In second place are bonus and partial protection certificates (19.7%), followed by express certificates (12.3%) and discount certificates (9.1%) 8. Investment certificates document the holder s participation in the development of the value of the respective underlying, such as a 8 Figures as of November 30, See Derivate Forum. 4 March 19, 2007

5 Retail certificates: A German success story Leveraged products with low market volume Advantages of certificates: Low buying and selling costs Complex investment approaches can be realised cost efficiently Liquidity assured on any trading day by continuous market making Permanent bid and offer quotes by issuers Broad product spectrum allows matching to individual risk-return profiles Comparatively long trading hours through off-exchange trading platforms Longer-off-exchange trading hours Exercise ratio: fraction of the underlying evidenced by a certificate share or an index, and are issued for a limited or unlimited term. The risk profile of the investment products is essentially comparable to the risk of a direct investment in the given underlying. However, additionally, certificates are exposed to an issuer risk. Generally speaking, investment certificates are suitable for instance for optimising or diversifying portfolios for investors with a medium to long-term investment horizon. The securities grouped together under the leveraged products category make up 1.2% of market volume and, owing to their riskreturn relationship, primarily address investors with a more speculative investment strategy. They can also be used by conservative investors for instance to hedge positions. The leveraged products include warrants, knock-out products and exotic products. The main feature of leveraged products is the leverage effect on the underlying since far less capital has to be invested than with a direct investment. 3.3 Advantages of investment certificates The use of investment certificates offers investors a great many advantages. Firstly, investors can profit from easy access to more complex financial products at comparatively low cost. For instance, if investors want to track an index they can either buy all the shares included in the index or invest in an index certificate. Investing in certificates can also be cheaper than investing in investment fund units since there is usually no upfront sales charge or annual management fee (exception: actively managed certificates). Secondly, with certificates investors can pursue a broad spectrum of investment strategies to which only professional investors generally had access in the past. Thanks to the diverse product characteristics and payout profiles which certificates offer, investors can profit from rising, stagnating or falling price trends. Thirdly, retail investors can optimise the risk-return profile of their portfolios as they can realise a very broad spectrum of investment approaches by using certificates. In this way investors can often achieve a lower risk exposure compared with a direct investment. Investors can also benefit from longer trading hours than in exchange trading thanks to the off-exchange trading platforms provided by many issuers. Selected products of leading issuers for instance can be traded off the exchange from about 8 a.m. to 10 p.m. Certificates can be traded easily and transaction costs are low since there are no special requirements that have to be fulfilled to buy certificates, such as margin accounts for trading on Eurex. Finally, investors benefit from certificates being listed, with published prices. It is therefore easy for investors to monitor the value of most certificates, in contrast to many other investment products such as life insurance. With more complex certificates, however, their value depends on a great many factors and is based on advanced financial valuation methods, so their performance might not be as readily transparent for the investor. 3.4 Characteristics, investment strategy and risks The main parameters of certificates are the underlying, the exercise ratio, the maturity and the payout terms. The exercise ratio reflects the fraction of the underlying evidenced by a derivative security. In practice, smaller exercise ratios predominate, such as 1:100 for instance. An index certificate linked to the DAX with an exercise ratio of 1:100 would have a value of EUR based on a DAX of 6,000 March 19,

6 EU Monitor 43 Maturity: open end vs. limited term Legally certificated are bearer debt instruments Investment strategy and risks Product classification helpful points. Therefore, investors only need to invest a small amount of capital to participate in the performance of the underlying. The maturity specifies the point in time when the certificates are redeemed. A broad distinction is made between certificates with a fixed maturity and so-called open-end certificates. Open-end certificates generally have no maturity; however, if this is agreed in the conditions of issue, they can be called and withdrawn from the market by the issuer subject to a specified period of notice. For legal purposes, certificates are bearer debt instruments whose repayment terms are specified by the issuer in the listing and offering prospectus. As holders of a bearer debt instrument, investors bear the risk of the issuer defaulting and, in the event of bankruptcy, would be subordinated, with any settlement being made at the rate fixed by the administrator. As the leading issuers have very good credit ratings, the default risk is low for practical purposes. It should be noted that when buying certificates linked to an individual share or a basket of shares investors do not acquire any ownership title or shareholder rights and similar rights in relation to the company such as the right to a dividend. Certificates do not therefore generate any interest or dividend income which could compensate for possible losses upon maturity. In the case of certificates with a fixed maturity there is also the risk that any losses arising during the life of the certificate may not be recouped by the time they mature. This risk exists quite independently of the issuer s credit quality. Another point that should be noted is that, if certificates are linked to an underlying denominated in a foreign currency, the performance of the certificate is determined not only by changes in the value of the underlying but also by movements in the exchange rate. 3.5 Types of investment certificate The high level of innovation in the certificates market has led to enormous diversity, as reflected in the more than 136,000 products in circulation at the end of Given the strong rates of growth, the number of products available is likely to increase still further. In view of this product diversity it is helpful to classify the certificates on the basis of product classes and characteristics in order to make the products that are available in the market more transparent. Fig. 6 shows a broad classification of investment certificates based on their respective risk-return profile. 9 A broad guide to the characteristics of individual types of investment certificate can be found in Fig. 11 at the end of this report. This summarises the main product features of the commonest investment certificates. 9 It should be noted that not all certificates can be assigned in blanket terms to one type; Fig. 6 therefore needs to be seen as a rough segmentation. In this chart it has not been possible to reflect the specific characteristics of individual certificates. The focus of this study is on investment certificates. For a detailed discussion of the different types of investment certificate see for instance Harengel, Jürgen and Steffen Scheuble (2006), Alles was Sie über Zertifikate wissen müssen, and Pilz, Gerald (2006), Zertifikate. 6 March 19, 2007

7 Retail certificates: A German success story Product categories Reward Rolling discount certificates Discount certificates Guarantee products Partial Protection certificates Strategy certificates Index certificates Bonus certificates Express certificates Sprint certíficates Risk Source: Harengel, Scheuble 6 Value at Risk VaR as an objective, standard measure of risk Value at risk (VaR) is a method of measuring risk which states the estimated maximum loss on a security which will not be exceeded to a certain predetermined level of probability (e.g. a confidence interval of 99%) for a given holding period (e.g. 10 days) under normal market conditions. Example: A VaR (10 days) of EUR indicates that for each EUR 10,000 invested a loss in 10 days would be smaller than or equal to EUR with a probability of 99 percent. It is therefore likely with a probability of 99 percent that the investment would be worth EUR 9, or more in 10 days. VaR also for retail investors 3.6 Risk classification for investment certificates Assessing the risk of a certificate especially with more complex products is not always easy since it depends to a large extent on the type and functioning of the components of the given certificate. Moreover, issuers use different methods of risk classification and in some cases only do this upon issuance, i.e. not over the certificate s entire life. As a result, products are not directly comparable for the investor. So, from the investor s point of view it would be useful for the risk of a certificate to be assessed on the basis of a standard risk measure which is continuously updated throughout its life. Ideally, a risk indicator should integrate volatility fluctuations as well as market changes during the life of a certificate in the risk rating. The value at risk (VaR) approach provides such a dynamic and objective assessment of risk. VaR is a measure of risk which states the estimated maximum loss to a certain pre-determined level of probability for a given holding period under normal market conditions (see box). In practice, an objective and standardised risk assessment of this kind is already used by professional market participants. In collaboration with the certification firm ebs European Business School mbh, Derivate Forum has introduced a VaR-based risk rating system for certificates for retail investors. The VaR is calculated twice monthly for all certificates issued by the member banks, and is divided into five sub-risks. The VaR is calculated on the basis of a confidence level of 99% and a holding period of 10 days. Certificates are classified into five risk classes according to how high the VaR is, ranging from safety-oriented to speculative. This system provides investors with an instrument which allows a standardised and objective assessment of the risk presented by certificates. On the basis of VaR, investors are also able to compare the risk ratings of certificates of different issuers in a transparent and objective way. March 19,

8 EU Monitor 43 Risk classification Risk class VaR range, absolut* VaR range, %* Investor profile 1 0 < VaR < < VaR < 2.5 safety-oriented < VaR < < VaR < 7.5 less risk-tolerant < VaR < < VaR < 12.5 risk tolerant < VaR < < VaR < 17.5 more risk-tolerant < VaR < < VaR < 100 speculative *measured in terms of the proportion of the investment VaR is calculated here on the basis of an investment of EUR 10,000 = 100% Source: Derivate Forum Comparison with investment funds Generally speaking, investors can realise similar (and in some cases more or less identical) investment strategies with certificates or with investment funds. However, on closer examination of the two investment products it is found that there are not only productspecific differences but, in part considerable, legal, tax and riskspecific differences too. Differences Legal definition Growing convergence of business strategies With certificates, investors can generally fine-tune their investment strategy better through the choice of an appropriate certificate (except with actively managed certificates), while in the case of investment funds the fund manager selects the investments from a range of eligible assets according to the fund s overall investment strategy. The value of an investment fund unit is calculated by dividing the investment fund s total net asset value by the number of units in circulation. The process for determining the price of a certificate can be more complex, being based on advanced financial pricing models. From a legal point of view, certificates are bearer debt instruments which embody an issuer risk (see Section 3.4). Investment funds, by contrast, constitute a special asset pool carried separately from the investment company s assets. This asset pool is barred from liability and recourse for the investment company s obligations. While certificates are subject to a great many legal rules and regulations (especially the prospectus requirements and shortly the MiFID), investment funds are regulated at the EU level primarily on the product side by the UCITS Directive. The business strategies of certificate issuers and investment companies are showing signs of convergence. Some certificate issuers are increasingly offering investment funds as well under the UCITS framework (e.g. DB Platinum Fund), while more and more investment companies are tending to issue certificates (e.g. DWS GO) or to launch investment funds which invest in certificates (e.g. ZJ Zertifikate Select DWS). 8 March 19, 2007

9 Retail certificates: A German success story Certificates vs. investment funds: A comparison Comparison Certificates Investment funds Legal structure Obligation Separate asset pool Originator Issuer Investment company Investments Selected by customers according to their market expectations (except actively managed certificates) Investments selected as a rule according to eligible assets and the fund's strategy Pricing Complex price determination based on option pricing models Price calculated as total net asset value divided by the number of units outstandig Listing Regulated at the EU level by the Prospectus Directive Regulated at the EU level by the UCITS Directive Source: DB Research 8 4. How the certificates market works 4.1 Structuring certificates: the issuer side Investors buy certificates as a finished investment product. Before they are issued, however, certificates undergo an elaborate product development process by the issuer. As a rule, issuers construct ( structure ) certificates from different financial instruments so as to be able to tailor them to the individual risk-return preferences of investors. Issuers have a wide range of financial derivatives at their disposal, from which they develop specific investment products for particular market phases and investment purposes on the basis of elaborate econometric calculations. We will describe this process in simplified form using the structuring of a discount certificate as an example. Example: Structure of a discount certificate When buying a discount certificate (see Fig. 11, p. 16), the investor purchases the underlying at a discount to its current market value, and can earn a positive return even in a slightly falling or sideways market. At the same time, the discount acts as a buffer against falling prices, thus reducing the risk compared with a direct investment in the underlying. In return, investors accept a limit on the maximum potential return from the underlying (this upper price limit is called the cap ). In its financial structure a discount certificate can therefore be regarded as a combination of two components: a zero bond 10 and a put option 11 (see Fig. 9). Viewed in this way, the investor buys a zero bond and at the same time sells a put option to the issuer. The discount represents the premium on the put option that is sold. In return, the issuer has the right to sell the underlying to the investor at predefined terms. As a rule, the issuer will exercise this right if at maturity the price of the underlying is below the cap. If the under- 10 A zero bond is a debt instrument without interest coupon. In contrast to conventional bonds, there are no regular interest payments. Zero bonds are therefore issued at a price well below their nominal value and are repaid at their nominal value upon maturity. 11 A put is a security with a limited maturity which grants the buyer, in return for the payment of a premium, the right to sell a specified underlying at a predetermined price (exercise price). As a rule, the buyer will exercise this right if at maturity the price of the underlying is below the exercise price. However, in practice the right is rarely exercised, i.e. instead of actually delivering the underlying against payment of the exercise price it is usual for a cash settlement to be made in the amount of the difference between the exercise price and the current price of the underlying. March 19,

10 EU Monitor 43 lying is quoted above or at the cap, the investor receives the cap as the maximum payout. Should the underlying be actually delivered, the investor can still earn a positive return if the current price of the underlying is higher than the price originally paid for the certificate. Example: Valuation of a discount certificate Long Position Zero bond Short Position 100 put options Present value of zero bond EUR 3, Value of option premiums EUR 353 Fair market price EUR 3, Hedging by issuers On-exchange vs. Off-exchange trading Role of the market maker Bid/ask spread Pricing As a general rule, issuers do not enter into any own risk positions when structuring the certificates they issue but neutralise them through matching hedges on the equities and futures & options markets. An issuer of a discount certificate, for instance, could hedge this by buying a matching number of shares and put options. In practice, all transactions are entered into the issuer s trading book and are hedged at the aggregate level. Therefore, as far as risk positions are concerned, the issuer always acts only as an intermediary between investors and the futures & options markets. Investors can subscribe to certificates when they are issued or buy them later in the secondary market, either on a stock exchange or through off-exchange trading platforms. Experts estimate that there is a roughly 50:50 split between on-exchange and off-exchange trading. As a rule, if investors subscribe to certificates, the issue price includes a commission, which the issuer usually passes on, either wholly or in part, to the distribution partners. However, the large majority of the investment certificates are purchased in the secondary market. Experts estimate that only a small single-digit percentage of all outstanding certificates are sold by subscription. 4.2 Secondary market As a rule, the issuer, or a securities firm which it engages, acts as market maker for particular certificates. The role of the market maker is to maintain continuous bid and ask prices for these certificates on or off the exchange. The market maker not only ensures that a certificate can be traded at any time. Its activities also considerably increase the liquidity of the given certificate and enables investors to sell their certificates in the market before they expire. The spread represents the difference between the bid price and the ask price of a security in the secondary market (bid/ask spread) and is paid by the investor as consideration for the service provided by the market maker. The spread varies according to the trading platform chosen and the type of derivative. The price determination process for certificates is based on generally accepted financial pricing models which calculate the 10 March 19, 2007

11 Retail certificates: A German success story Mistrades in ,000,000 transactions. 300 mistrade applications Source: DDI, intrinsic value of a given certificate taking account of other pricerelevant factors. As a rule, each issuer uses a particular pricing model. The prices quoted for comparable products may therefore differ from issuer to issuer. All the same, the competition among the more than 35 issuers assures an efficient pricing mechanism for standardised certificates, so significant price differences for standardised products cannot exist for long in the market. As a rule, the intrinsic value of a certificate should correspond broadly to the bid and ask prices quoted. Investors can also compare the certificates of different issuers on the Internet and buy the certificate which they consider to be the most attractively priced. However, the bid and ask prices quoted by the market maker can also differ from a certificate s intrinsic value in certain market phases. This is often the case shortly after their issuance. The issue price can include a premium on the certificate s calculated value which covers, among other things, the cost of the structuring and distribution of the certificate and any other administrative costs. Moreover, the market maker can modify the methodology it uses to fix prices at any time, and alter the spread between the bid and offer price, which depends, among other things, on liquidity and market sentiment. If trades are not executed at fair market terms, a party can file an application to cancel the transaction (mistrade application). If the certificates have been traded on an exchange, for instance on EUWAX, the application has to be filed with the exchange s management, which then decides whether the application is legitimate, i.e. whether the trade should be cancelled, on the basis of the mistrade rules. Deviations from fair market prices mainly arise as a result of technical errors or incorrect entries by the house bank or retail broker. In practice, mistrades are of negligible importance: in 2005, mistrade applications represented a mere 0.006% of all trades on the Stuttgart Stock Exchange. Over 99% of mistrade applications are filed by issuers. 12 On the Stuttgart Stock Exchange mistrade applications that have been accepted are also published on the Internet. This list shows that applications from issuers to cancel trades can also be refused and often are. So, all in all, it can be said that the market functions well despite the considerable product diversity and great many quotes. 5. Regulatory framework Great many legal norms At times, in public debate the impression is created that the certificates market operates outside the law. Quite the reverse is true: the certificates market is subject to a raft of statutory rules and regulations. In the main these derive from various EU capital market directives. For instance, the issuance of certificates is subject to the requirements of the EU Prospectus Directive, while the current rules regulating the trading and distribution of certificates are due to be fleshed out in more detail shortly by the MiFID (Markets in Financial Instruments Directive) which will come into force as from November 1, Other norms applying to the certificates market are regulated in the Securities Trading Act (WpHG), the Stock Exchange Act (BörsG), the Stock Exchange Listing Act (BörsZulG), stock exchange regulations and the German Civil Code (BGB). Thus, unlike the market for investment funds, the certificates market is not subject to product-side regulation. Rather, the legislator is pursuing 12 See DDI. March 19,

12 EU Monitor 43 EU Prospectus Directive sets regulatory framework European passport for issuing securities Prospectus requirements Role of the competent regulatory authority an investor protection concept which builds on several regulatory elements. 5.1 Issuance of certificates: Prospectus requirements The legal framework for issuing certificates derives in the main from the EU Prospectus Directive 13 which was translated into German law with the introduction of the Prospectus Directive Implementing Act 14 on July 1, The purpose of the Prospectus Directive is to reinforce protection for investors as well as market efficiency when securities are issued by harmonising the rules governing the drafting, approval and cross-border recognition of prospectuses within the EU. The new Securities Prospectus Act (WpPG) introduced in Germany in 2005 and the directly applicable Prospectus Regulation (ProspektVO) form the regulatory framework for the issuance of securities which are to be offered for sale to investors either by public offer or by being admitted to trading in an organised market. The Prospectus Directive introduces a European passport for issuers, which ensures that securities prospectuses approved by the competent authority in one member state are recognised in all other EU member states. The aim of this passporting process is, firstly, to guarantee that securities can be offered for sale (efficiently) across borders and, secondly, to eliminate the need for repetition of the prospectus approval procedure in different member states. In practice, the competent authority in the home member state notifies the competent authority in the other member state that a prospectus has been approved. This cross-border procedure between the competent authorities is generally to be welcomed, and functions more efficiently than the cross-border notification process for investment funds under the UCITS regulatory framework in this case the investment fund has to apply to the authority in the home state requesting that it notify the host country. The requirements regarding the content of prospectuses are regulated primarily by the Prospectus Regulation (ProspektVO), which stipulates minimum disclosures and prospectus formats. The Securities Prospectus Act (WpPG) requires additionally that prospectuses must present the issuer s financial position correctly and in a form which is easy to understand. Investors benefit from this harmonisation of the information contained in the prospectus at the European level. The competent regulatory authority (e.g. in Germany, the Federal Financial Supervisory Authority, or BaFin for short) does not check the accuracy of the content of the prospectuses but examines whether they are consistent (no contradictions) and comprehensible. The competent authority has ten working days to examine a prospectus. However, a problem is that this time limit is extended by a further ten days if the authority needs to make enquiries to clarify any matters. If there are a number of enquiries, a new ten-day time limit is triggered each time, so the approval of a prospectus can be considerably delayed. Prospectuses are valid for 12 months after their approval and publication by the competent authority. 13 European Parliament and Council Directive 2003/71/EC of November 4, 2003 on the prospectus to be published when securities are offered to the public or admitted to trading, and amending Directive 2001/34/EC. 14 The Prospectus Directive Implementing Act was promulgated on June 27, 2005 in the Federal Law Gazette, Part I, page March 19, 2007

13 Retail certificates: A German success story Role of the basic prospectus Assessment of the Prospectus Directive Complex documentation Transposition of the MiFID into national law The MiFID was passed at the EU level in April 2004 and is due to enter into force in the member states as from November 1, Although the deadline for translation of the MiFID into national law was January 31, 2007, it appears unlikely that the German Implementing Act will be passed by the Bundesrat (Upper House) before May If implementation of the MiFID in Germany is further delayed, this will leave less than five months until the MiFID has to be applied. In view of the high adjustment costs and extensive organisational measures this necessitates, such a short period of preparation appears inadequate. As a rule, derivative securities are issued using a basic prospectus according to 6 WpPG. Several types of certificate can be grouped together in one basic prospectus, with a supplement announcing the final conditions of an offering at the latest one day before the public offer. As with an incomplete offering prospectus, the basic prospectus enables the missing information to be published at the time of the offer or at the time of admission to trading without having to go through a renewed approval procedure. 15 In practice, the European passport functions relatively efficiently in many member states for instance in Luxembourg, Austria and Germany. By contrast, there are considerable shortcomings in the application of the single passport in countries such as Italy, Spain and France. These member states often make mutual recognition of prospectuses conditional upon further requirements which, in practice, present considerable market entry barriers and thus substantially obstruct the cross-border sale of securities. Another criticism relates to the extensive legal requirements which the legislator places on the prospectus. In practice, investors frequently find themselves faced with a lengthy legal document, extending to more than 100 pages at times, whose size and complexity is often out of line with market needs. The original objective of the Prospectus Directive to provide greater investor protection through more transparency is therefore unlikely to be accomplished fully in day-to-day practice. This might cause many investors to tend to rely on the termsheets 16 which are not legally binding. A negative aspect from the issuer s viewpoint is the higher cost of preparing the prospectuses, not to mention the cost of the approval process. 5.2 The implications of the MiFID for trading and distribution The purpose of the Markets in Financial Instruments Directive (MiFID) is to advance the integration of the European securities markets to better enable providers to operate on a cross-border basis and to strengthen customer protection rules. Among other things, the MiFID harmonises the obligations of banks to investors when conducting securities transactions on the European level. The MiFID will replace the Investment Services Directive which was introduced in Although most of the obligations already existed in essence in the past in Germany MiFID will elaborate them in more specific detail as it introduces a great many new rules. The best execution obligation, for instance, which requires that customer orders are executed at the best possible terms, now defines precisely how this has to be assured. 15 The basic prospectus according to 6 WpPG creates the framework for issuance of a number of similarly structured securities whose respective conditions of sale can only be fixed shortly before they are issued. According to 6 (1) WpPG, a basic prospectus may only be prepared for non-dividend securities including any warrants which are to be issued in connection with an offer for sale programme, and for non-dividend securities issued continuously or repeatedly by deposit-taking credit institutions which satisfy the other conditions of 6 (1) No. 2 a) and b) WpPG. Besides debt instruments and warrants 6 (1) WpPG applies particularly to certificates and other derivative securities. No securities may be offered for sale on the strength of the basic prospectus. The prospectus must first be completed with the publication of the final conditions of offer in accordance with 6 (3) sentence 1 WpPG. See BaFin (2006). 16 A termsheet contains a short summary of the characteristics and conditions of a security, e.g. issuer, life, listings and security identification number. The termsheets used for sales purposes to inform investors about risks in accordance with law also include information on the financial structure and risks of the securities. March 19,

14 EU Monitor 43 The role of self-regulation Self-regulation is essentially an alternative to achieving a regulatory objective through government intervention. Self-regulation uses a wide range of instruments which includes guidelines, standards or sectoral agreements between market actors, stakeholders, nongovernment organisations or associations. The advantages of self-regulation largely lie in two areas. Firstly, the non-government actors generally have a more detailed professional and technical expertise in the area subject of regulation than government bodies owing to their close involvement in the business. Hence, potential guidelines can be drafted quickly and monitoring and compliance with these standards can be ensured effectively. This can ensure a high degree of voluntary compliance by the market actors. Secondly, regulatory goals can generally be achieved more efficiently, effectively and quicker than would be possible by government intervention. Usually, legislative intervention by the state requires a lead time of at least two to four years. In addition to the effective monitoring of the common standards by the market actors themselves or by a joint supervisory body, it has to be assured that the broad mass of market actors participate in the self-regulation. One inducement to assure broad acceptance of standards can be the issuance of a quality seal that is conditional upon compliance with the standards. Principles of the Derivatives Code 1. The issuer s credit standing is made public at all times. The information on an issuer contained in sales prospectuses and in ratings is published in a readily understandable form on the Internet. 2. The underlying is presented transparently. 3. Product clarity is the guiding principle for the way in which derivative securities are presented. 4. Derivative securities are offered for sale at prices which are in reasonable relation to the product structure and market situation. 5. Each signatory assures that trading is possible in principle for its own derivative securities. 6. The signatories undertake to comply with the Code. This applies similarly to the obligations to inform and advise customers. These obligations are designed to ensure that in the end result, as under present law, customers can reach a decision on buying a particular financial instrument such as a certificate on a suitably informed basis. In practice, this is mainly done by distributing general information material on the nature and risks of particular types of financial instrument as well as product-specific documents such as termsheets. Further, if investment counselling is provided, there is the now extended obligation to only recommend investments which are suitable for the customer or, if there is no suitability criterion, to draw the customers attention to investments which are not appropriate for them. Particularly relevant for the certificates market is probably another rule under which so-called inducements, which can also include sales commissions, will only be permitted in future on certain conditions. All in all, the MiFID is therefore another important and, compared with previous rules, even tighter instrument for protecting investors within the regulatory framework of the German certificates market. 5.3 Rules regulating trading on a stock exchange If certificates are traded on a stock exchange, there are additional statutory rules and stock exchange regulations which are designed to protect investors. The regulations for the relevant stock exchange segments where certificates and warrants are traded 17 stipulate, among other things, that bid and ask prices must be continuously quoted. The possibility of selling at any time, which is extremely important for the investor, is thus supervised by the stock exchanges. These regulations also set ceilings for spreads, i.e. the difference between bid and ask prices. The general prohibitions provided for in the Securities Trading Act (WpHG), for instance regarding insider trading and market abuse, also apply to the trading of certificates on a stock exchange. In practice, most of these rules also apply when certificates are traded off the exchange since the issuers cannot afford to offer their securities for sale through these platforms on terms which are worse than those available on the stock exchange. 5.4 Derivatives Code as additional voluntary selfregulation Despite the great many regulatory rules for the certificates market there are areas where additional self-regulation by the market actors appears meaningful. The members of the German Derivatives Forum have formulated common minimum standards for the publication of risk-return profiles, for pricing and for the trading of certificates in order to strengthen investor confidence in the certificates market. These standards were announced on December 19, 2006 with the so-called Derivatives Code which entered into effect on January 1, The purpose of the guidelines is to strengthen investor confidence in certificates and establish quality standards for the German certificates market. The Code formulates principles covering the areas of issuer risk, transparency of the underlying, product clarity, pricing and trading. The Derivatives Code is a voluntary commitment by the members of the Derivatives Forum. 17 See 82 ff of the Stuttgart Stock Exchange Rules Conditions for Participation in the Quality Segment for Structured Products (Frankfurt Stock Exchange), No. 3 ff. 14 March 19, 2007

15 Retail certificates: A German success story In future, all the members of the Derivatives Forum can issue product descriptions and prospectuses with a quality seal testifying to their compliance with the Code. The right to use the quality seal can be withdrawn if an issuer fails to comply with the Code. The Derivatives Forum plans to publish details about compliance with the Code in an annual report. All in all, the Derivatives Code makes for a further improvement in investor protection through greater transparency in the certificates market by providing target group-specific information. The Derivatives Code should be elaborated further on a continuing basis in line with market, product and regulatory developments. The first opportunity will arise already in spring 2007 with the need to adjust the Code to the German MiFID Implementing Act. Further, the Derivatives Forum should work proactively in the near term to encourage other issuers to become signatories to the principles of the Code and further broaden acceptance of the Code, which currently extends to about 60% of the market (measured in terms of the volume of certificates issued by members of the Derivatives Forum currently in circulation). In addition, it should be considered whether monitoring compliance with the Code in an annual report is sufficient, or whether further instruments are needed. 6. Summary and outlook The German market for retail certificates has become a firmly established market for investment products in its own right within just a few years. We expect the volume outstanding to grow further by around 30% to approximately EUR 142 billion in In the mid-term, we consider a trend growth of 15-20% p.a. feasible. The strong growth in the last years is mainly due to three factors: firstly, issuers were quick to respond to retail investors needs during the bear market at the beginning of the decade and offered innovative investment products with an attractive risk-return profile. Secondly, with the recovery of the capital markets since the beginning of 2003 issuers have developed other innovative products and considerably broadened the investment spectrum with new underlyings. Retail investors can now realise investment strategies to which only institutional investors had access just a few years ago. Thirdly, Germany offers a benign regulatory framework for the certificates market, consisting of four main components: rules on prospectus requirements when issuing certificates, rules regulating trading on the stock exchange, rules on distribution (which will be regulated in more detail by the MiFID), and additional voluntary selfregulation through the Derivatives Code. All in all, this combination of four regulatory pillars benefits not only issuers and investors but Germany s financial market as a whole: meanwhile, investment certificates, as an innovative product made in Germany, are selling successfully in other European countries and in Asia. Besides the strong innovation shown by product providers, this four-pillar regulatory framework establishes an important precondition for this success story to continue in the mid term. Hence, the German government s announcement back in September 2006 that it does not intend to tighten the level of regulation in the certificates market any further is to be welcomed. Raimar Dieckmann ( , March 19,

16 EU Monitor 43 Annex: Types of certificate, an overview Type Description Description Market expectation Risk/reward Index products With index certificates the Some examples: investor buys the index directly. Index Certificate They enable the investor to Delta-1-Certificate participate in the price performance of a defined basket of shares on a 1-to-1 basis. Guarantee products With guarantee products at least the capital invested or another predefined amount is paid out at maturity. This reduces the potential return; the focus is on safety for the investor. Discount products Bonus products Sprint products Strategy products Some examples: A.I.D.A. Nikolaus Bond Vario PowerPlay Swing-Lock-in Opportunity Bond With a discount certificate the Some examples: investor can buy the underlying CLOU-Discount at a discount to the current Protect-Discount market price. In return for the Two-Asset-Discount discount, the investor accepts a Discount Plus cap on the maximum potential Deep Discount return. Rolling Discount With bonus certificates a certain amount is credited to the investor if the underlying never falls below a predefined price level during the term to maturity. The investor participates in any price gains on a 1-to-1 basis. With sprint products the investor makes money in principle on rising prices. Up to a predefined price level the investor doubles his participation in potential price gains. These products consist of several underlyings. The underlyings used can have different weightings. With strategy and theme products particular indices, shares or strategies are used in an underlying. Some examples: Protect-Bonus Bonus Plus Bonus Pro Some examples: Sprint Certificates Double-Chance Some examples: Europe, Strategy DAX Top 10 CROCI The market expectation is Identical to a direct optimistic. The investor investment. expects share prices to rise. The market expectation is uncertain. The investor does not want to put the capital invested at risk. The expectation is a slightly falling, rising or stagnating market. The investor also expects declining volatility. With bonus products the market expectation is a sideways to upward trend. With sprinter products the market expectation is always geared to rising prices. With these products the market expectation depends on how the certificates are structured. The return is limited to a predefined maximum amount. The risk lies between an equity and bond risk. The potential return is comparable to the equity risk. The potential return is equal to or even higher than that of the underlying. Nonetheless, bonus products have a much lower risk than a direct investment. The potential return is comparable to that of the underlying. Source: Harengel/Scheuble (2005) 11 Copyright Deutsche Bank AG, DB Research, D Frankfurt am Main, Germany. All rights reserved. When quoting please cite Deutsche Bank Research. The above information does not constitute the provision of investment, legal or tax advice. Any views expressed reflect the current views of the author, which do not necessarily correspond to the opinions of Deutsche Bank AG or its affiliates. Opinions expressed may change without notice. Opinions expressed may differ from views set out in other documents, including research, published by Deutsche Bank. The above information is provided for informational purposes only and without any obligation, whether contractual or otherwise. No warranty or representation is made as to the correctness, completeness and accuracy of the information given or the assessments made. In Germany this information is approved and/or communicated by Deutsche Bank AG Frankfurt, authorised by Bundesanstalt für Finanzdienstleistungsaufsicht. In the United Kingdom this information is approved and/or communicated by Deutsche Bank AG London, a member of the London Stock Exchange regulated by the Financial Services Authority for the conduct of investment business in the UK. This information is distributed in Hong Kong by Deutsche Bank AG, Hong Kong Branch, in Korea by Deutsche Securities Korea Co. and in Singapore by Deutsche Bank AG, Singapore Branch. In Japan this information is approved and/or distributed by Deutsche Securities Limited, Tokyo Branch. In Australia, retail clients should obtain a copy of a Product Disclosure Statement (PDS) relating to any financial product referred to in this report and consider the PDS before making any decision about whether to acquire the product. Print: Druck- und Verlagshaus Zarbock GmbH & Co. KG ISSN Print: / ISSN Internet and

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