Derivatives and structured products’ complexity, current practices, industry habits and, regulatory attempts.
What makes a structured product complex? There is no standard definition of perceived or real complexity in the financial derivatives industry.
Some products may be labeled “complex” or “exotic” based on subjective criteria such as their lack of popularity. Inversely, one may oversee the complexity of frequently traded products simply because market participants got used to trading them: the force of habit. The gap between financial complexity and investor sophistication makes it essential to define product complexity. [...]
This post is a summary of our blog article co-written by Rene Hess, LexiFi's Consultant based in Singapore, and Meriem Kanzari, LexiFi's Marketing Specialist.
1. Motivation to define complexity
While the vast majority of structured products are considered by ESMA and other regulators as complex, measuring this complexity is key to determine if clients have sufficient financial knowledge and experience to understand the key features, benefits, and risks involved in a given investment.
"It is surprisingly hard to find a practical definition of complexity."
Despite its importance, it is surprisingly hard to find a practical definition of complexity. [...]
2. Regulators’ attempts to define and regulate complexity
There have been some attempts to define derivatives and structured products’ complexity notably in Europe, North America and, Russia. [...]
"Observing how the US democratization principles get tricky when it comes to retail investors, while Russia divides qualified and non-qualified investors."
3. Non-regulatory attempts to define complexity
While there are ways to express risk in both absolute and relative terms, this is more difficult when measuring complexity. There is no standard measure to express complexity as an absolute.
In this article, we introduce the checklist-based approach, then provide a more analytical example based on product behavior given market evolution. [...]
"The checklist approach is popular thanks to its simplicity."
4. Conclusion
Defining an approach for complexity depends on multiple factors: objectives, context, target use, audience sophistication, technical capabilities, and regulatory requirements. Market participants seem to tend towards a mixed approach.
The checklist-based approach seems to be a good start to give a hint about product-level complexity. [...]
One thing is sure: to us, one should not mix up complexity and risk!
By Rene Hess and Meriem Kanzari