PARTNER, REED SMITH
INVESTOR claims for mis-selling of derivatives inevitably follow market collapses. So do calls for regulatory reform. A primary objective of financial services regulation is to protect investors. This cannot mean ensuring that buyers and sellers of derivatives will never suffer a loss. The derivatives market is a zero sum game: market participants necessarily take opposing views. In the court of public opinion a major disconnect is nonetheless evident between investors and the line adopted by some banks when they say they contracted as a market-maker and a principal and that those who dealt with them could legitimately be expected to look after themselves. This has proved hugely unpopular, so what protection should sophisticated investors legitimately expect?
Policymakers contend that banks should always have an obligation to act in their client’s best interests, but that notion does not work between arms-length buyers and sellers in the derivatives markets. For retail investors the position may be different. They generally do not have the knowledge or experience either to appreciate the risks of derivatives or to participate directly in such markets. Their access to derivatives should ordinarily be through brokers or banks representing and advising them. For sophisticated investors, on the other hand, the position must depend upon how they participate in the derivatives markets.
The world’s wholesale and institutional derivative markets operate on the basis of contractual agreements. Protection of legitimate expectations must be viewed in this context. Sophisticated investors may agree to be treated as a market counterparty who deal at arm’s length with no protection. Or a sophisticated investor may agree to be treated as a client, and pay for execution services (quite a lot more if buying advisory or management services as well), where it may expect the bank to seek to get the best possible result.
The current European law introduced with MiFID to protect the interests of investors identifies several classes of investor: eligible counterparties; professional clients and retail clients. The law does not override the parties’ contractual agreements but does establish a presumption that eligible counterparties will invest as market counterparties at arms-length and look after themselves. Professional clients and retail clients will invest based on terms that brokers and banks are obliged to act in their best interests. This regime is subject to the further qualification that brokers and banks are entitled to assume that professional clients have sufficient knowledge and experience to appreciate the risks associated with the investments for which they are classified as professionals.
Within this regulatory regime the disconnect arises when it is perceived that investors are being treated by banks as market counterparties although it may be apparent that the ostensibly sophisticated investor does not properly appreciate that they are being dealt with at arm’s length. Financial promotion material and market banter may be mistaken for “advice” and the use of boiler plate standard terms and broadly drafted waivers or disclaimers may obscure the true nature of the relationship between bank and investor.
Policy makers should concentrate upon developing customer classification rules, disclosure and express consent requirements to eliminate misunderstandings between banks and investors about the basis upon which they are dealing with each other and the services provided. At the same time when it is clear that an investor dealt as a market counterparty, and did not seek or pay for advisory or management services, it should be the managers of the sophisticated investor who are held to account for bad derivative investment decisions – not the bank on the other side of the trade.