Implementation of the COBS 10 appropriateness test

Transcription

1 Financial Services Authority COBS factsheet Implementation of the COBS 10 appropriateness test In this factsheet: Introduction Client information Using information Using warnings Summary This factsheet is for you if: you provide non-advised investment services to retail clients involving financial instruments covered by MiFID (the EU Markets in Financial Instruments Directive) or any type of derivative. Introduction During 2008, we reviewed how a first sample of investment firms had responded to the introduction of the MiFID-derived appropriateness test in Chapter 10 of our revised Conduct of Business sourcebook (COBS), which came into effect in November The sample comprised of firms offering non-advised/ executiononly investment services, including some offering spread betting, non-advised trading of other contracts for differences (CFDs), warrants, or other complex instruments. Nearly all of the firms we have so far reviewed have made changes to respond to the appropriateness test, and we have found some good examples of specific approaches to implementation. We said that we would publish examples to illustrate possible approaches to COBS 10, which was largely new to the UK when it was introduced. The examples outlined below are designed to help firms consider their own processes under COBS 10 for determining whether clients have the necessary knowledge/experience in order to understand the risks involved with the product or service in question. There may be other ways of achieving the same outcomes and complying with our rules and you should consider the relevance of these examples to your business, as you may choose an alternative approach. Additional Q&A and case study material on the appropriateness test is available on our website: 1

2 Client information When providing a service that COBS 10 applies to, you must ask the client to provide information about their knowledge and experience relevant to the specific type of product or service in question, so that you can assess whether the product or service is appropriate for them. Information should be appropriate to the nature of the client, the nature and extent of the service being provided, and the type of product or transaction (including its complexity and the risks involved). Examples of good practice With only one exception, firms we reviewed had increased the amount and type of information they obtained from relevant clients (including applicant clients) about their knowledge/experience. Experience Firms have taken a fairly consistent approach to asking about a client s trading history and other experience, which seemed able to obtain the information needed to establish the extent of a client s experience. Questions were incorporated in on-line or paper-based application forms to open trading accounts, but could also be asked over the telephone where this channel was used, or even face-to-face. The number of questions varied, from one question to five or six. Specific examples of such questions include the following: How many times a year do you trade in shares, bonds, fixed interest and funds? None 5 or less How many times have you traded on margin in CFDs, Spread Bets, Futures or FX in the past 12 months? 5 or less

3 Which time period would describe how often you have traded each of the following products: Twice in the last month [at least] Twice in the last 6 months [at least] Twice in the last 12 months [at least] Twice ever [at least] Have not traded [at least] twice in this product CFDs Spread Bets Futures Other OTC derivatives Shares Options Warrants Other knowledge Firms approaches to gathering information about a client s knowledge (where this could not be inferred from experience) varied to a greater extent, though we found good examples of effective but proportionate and risk-based approaches to obtaining relevant and targeted information. General questions about a client s level of knowledge included the following examples: We have provided information on this website on how CFDs, Forex and Spread Betting works, the risks involved and trading examples. Have you read this information carefully and understood it? Do you hold any educational or professional qualifications relevant to the type of trading you wish to carry on with us, or that you have indicated has been undertaken by you? YES/NO If yes, please specify: However, firms had also found ways of incorporating targeted questions in application forms or telephone processes that served to highlight for clients key particular risks relevant to the products on offer. This could be particularly important for clients with no or limited experience. Good examples we saw of such questions include the following: Are you aware that potential losses can be significantly larger than your initial stake? Do you understand that some of these products are valued against the underlying security and that a small change to the price of the underlying security may result in a disproportionately large movement, either favourable or unfavourable? YES/NO Do you understand that there may be penalties for early redemption of your investment? YES/NO Do you understand that if you place a - buy bet where the quoted price settles below your buy price - sell bet where the quoted price settles above your sell price you will lose monies on the bet? 3

4 One firm had also devised questions to check whether the client had knowledge of relevant market terminology and concepts, through questions such as the following: Do you understand the terms: gearing/strike price/puts/calls? YES/NO Do you understand the terms: total/partial capital protection? YES/NO Firms made a wide range of information about the firm s products and services available to clients (this practice pre-dated the COBS changes). In the case of spread bets or other CFDs, seminars are usually offered by firms, and many firms provide demo or practice systems for new clients to try first. Such tools are available to increase inexperienced applicants knowledge of these products and their risks. One firm specifically asked on its application form whether the applicant would like to sign up for its educational tool. Another firm asked on the application form whether the client had used the information and educational tools the firm made available. Information provided about risks was generally acceptable, although there is scope to improve on the more established industry explanations of risk for spreadbetting and other CFD trading we saw being used by many firms. This wording pre-dates MIFID/COBS and appears based on out-of-date FSA Handbook material. Firms should note that COBS allows them more flexibility about how they describe risks for their target audience. Firms asked applicants to confirm that they understand the risks associated with the trading they are considering. But one firm also asked the applicant to say why they think they have the knowledge to understand the risks, which mitigates potential risks around self-certification by the applicant. (See also section below on using warnings.) Example of poor practice Although firms asked about clients experience, one or two asked nothing about an inexperienced applicant s knowledge, apart from asking them to self-certify that they understood the risks of the type of transaction envisaged. Using information to determine appropriateness As we would expect, all firms visited actively review and assess the information provided by clients/applicants. In nearly all firms this was a manual review (though some are considering the scope for automation), often involving more than one area of the firm. Processes enabled any missing information or other queries to be identified and clients to be contacted as necessary. Two firms had adopted an approach under which they allocated set scores/points to each answer to each question asked as the main means to assess appropriateness in a consistent way. The total score gained by each client informed the firm s conclusion and the decision made on the appropriateness of the product/ service to the client. Other firms that did not score answers still reviewed each answer under a standard procedure they had drawn up in order to determine appropriateness in a consistent manner. In a number of firms, where different types of trading account are available, the client s risk profile also helps to determine the type of account they are offered (for example, an account with some form of stop-loss feature). This risk profile now reflects information obtained on the client s knowledge/ experience under COBS 10. 4

5 Using warnings Under COBS 10, the requirement is that if you consider, on the basis of information you have obtained, that the product or service is not appropriate to the client, you must warn the client. You must also warn the client that you are unable to determine appropriateness if the client will not provide the necessary or sufficient information to enable you to reach a view. A majority of firms we visited had introduced new formal procedures to warn clients/applicants in such circumstances, having regard to the answers the client gave to the questions asked by the firm. In some cases a warning is triggered online if questions are answered in a particular way. In other cases a warning would be provided by letter or after the client s information has been collected and considered by the firm. In some cases, we also saw the warning included in the hard copy application form after the relevant questions. A warning was also given on the telephone if the appropriateness test was conducted this way. The wording of the post-question warnings is fairly consistent across the firms sampled in terms of its key points, though the length varies and some pop-up online warnings are shorter. Typical formulations we have seen cover such points as the following: On the basis of the information supplied on your application form in relation to your knowledge and experience, we consider that [x/y/z] are not appropriate products for you. If you still wish to proceed with trading on this account with us, you should consider carefully the fact that you may be exposing yourself to risks that you may not have the knowledge or experience to assess properly or control. Therefore, if you do wish to proceed with trading on this account with us, you should ensure that you familiarise yourself with the products and fully understand the nature and risks involved. You should seek independent advice if necessary. With all firms in our sample, the provision of a warning did not necessarily mean that a client is simply rejected by the firm or rejected for the product in question. Firms had identified various possible ways to proceed, including indicating ways in which the client might obtain further relevant information, or indicating (without the firm providing investment advice) further options the client might wish to consider. The type of product in question and the risks posed for the client can have a bearing on a firm s response in such circumstances, with firms being more cautious for what they regard as higher risk/more complex products. All firms offering spread betting or other non-advised CFD trading continued to ask their clients to certify that they understand the risks associated with spread betting/cfds and that they regard spread betting/cfds as suitable for them. All such clients/applicants were referred to the firm s standard product risk warnings and some firms specifically asked applicants to confirm that they have actually read the risk warnings. One firm checked with each applicant through an initial telephone call that they appreciate the risks of spreadbetting, before an account is activated. The declarations can also be used to highlight key risks once more. One good example of this was where a firm s application form required the applicant to agree that they understand and accept the risks associated with spread betting, CFD trading and/or spot forex trading (as relevant); for example that my losses may exceed any deposit or margin and may be unlimited. Another example was a firm s online warning, which required clients to accept the fact that with complex instruments your initial capital may be at risk, the price may be highly volatile and liquidity may be limited should you wish to sell at a later date. 5

6 No firm we saw relies on these self-certifications alone. However, firms that place any degree of reliance on self-certification by the applicant that they understand the risks, should ensure that explanations of relevant risks are readily accessible and signposted, and clearly and fairly presented in a user-friendly format. For example, in addition to the point made earlier about the scope to improve the established language used by some firms to explain risks, these explanations should not be buried in a dense (and small font-size) Terms of Business document. Summary We were pleased to see that most firms sampled had integrated the appropriateness test into their client profiling and account opening process. However, we were disappointed that one or two firms seemed to regard COBS 10 as more of a tick-box exercise, with no benefits to the firm or its clients and had not really sought to integrate the test into their normal account opening procedures. All firms were keen to stress that, even without a regulatory requirement, they did not wish to take on clients who did not understand what they were doing. However, from what we have seen so far, we believe that COBS 10 (along with other COBS requirements on risk disclosure) can strengthen customer awareness of risks through a better highlighting and reinforced disclosure of relevant risks. This can be achieved through the questions firms ask of clients, the warnings they provide, and the encouragement they give clients to access the information they make available. 6