The German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht – BaFin) has organized a public hearing on the prohibition of the marketing, distribution and sale of certificates linked to creditworthiness risks (“credit-linked notes” (Bonitätsanleihen)) to retail clients within the meaning of section 31a (3) of the German Securities Trading Act (Wertpapierhandelsgesetz – WpHG). The subject of the administrative act are credit linked notes which offer a means of investing in a borrower’s credit rating. The amount of interest and the capital repayment are dependent on the borrower’s credit rating. As long as the borrower does not experience a credit event, the investor will receive interest payments and, when the note matures, the nominal value. If a credit event does occur, however, the note is repaid early. In this case, interest payments cease, and the amount repaid may be significantly below the nominal value. Credit events are typically defined as cases of irregular performance on the part of so-called “reference entities” in their credit relationships. Consequently, following the acquisition of a credit-linked note, the client takes on a role of a protection seller that takes over the risk of irregular performance in the underlying credit relationship. In return, the client receives payments for assuming the risk of a credit event.
In the first half of 2016, BaFin conducted a survey on the issue and distribution of credit-linked notes. In the course of this investigation, it surveyed both issuers and investment services enterprises as the distributors of credit-linked notes. It found that issuers were producing credit-linked notes specifically for sale to retail clients. The issuers surveyed acknowledged this, and it could also be recognised from the characteristics of the issued credit-linked notes (e.g. denomination, accompanying information). While some of the surveyed distribution companies stated that they did not distribute credit-linked notes to retail clients or even said they refused to do so since the products were not suitable, a considerable number of distribution companies said they did distribute credit-linked notes to retail clients.
BaFin bases the intended prohibition of the marketing, distribution and sale of the credit-linked notes on section 4b (1) no. 1 in conjunction with section 2 no. 1a 1st alternative of the German Securities Trading Act (Wertpapierhandelsgesetz – WpHG). The BaFin holds that the distribution, marketing and sale of credit-linked notes as defined above to retail clients raises significant investor protection concerns because they are (i) highly complex products, (ii) have a misleading product name and description, (iii) are part of a market dominated by professional players and (iv) there is an inherent risk of conflict.
Market participants can comment on this proposed administrative act by BaFin until 2 September 2016.
The market share of credit-linked notes is €6,3 billion € or 10% of the German derivative markets. Main issuers of credit-linked notes are DekaBank, DZ Bank, HypoVereinbank and LBBW.