Friday, 23 March 2018

Key Information Documents: a reason for retail investors to want to leave the EU/EEA?


With effect from Jan2018, a group of financial investments classified as “PRIIPs” are subject to new regulations with relevance to the European Economic Area, born under the European Union’s MIFID II (in the UK context).

One of the major impacts on retail investors is the appearance of the Key Information Document (“KID”) (UK FCA rehash).  Providers of PRIIPs are obliged to make freely and readily available a KID so that retail investors may read it prior to investment.

Some UK brokers appear to have gone that extra gold-plated millimetre by coercing retail investors into reading the KID prior to obeying their clients’ instructions.

And therein lies the problem. The content of the KID contains fundamentally misleading elements designed by the European Securities & Markets Authority.  A combination of the European Union’s issue-illiterate regulation combined with the brokers’ emotionally-driven avoidance of imaginary liabilities on imaginary obligations has the brokers unnecessarily inflicting a contingent liability on themselves.  The broker ends up wilfully misleading its customers in a pathetic attempt to be seen to be avoiding liability!

The contingent liability would crystallise when one retail investor complains that the actual performance of their investments diverged from the ESMA’s officially-sanctioned performance scenario defined in the KID, which the broker - and only the broker - coerced the retail investor to read.  The law requires the PRIIP manufacturer to produce the KID, requires the broker to make it available to the retail investor, but no part of the law in the UK requires the investor to read the KID.  Yet some brokers demand to know whether the investor has read the KID as a condition of obeying the customer’s instruction, divergent from the law’s requirements.

Prima facie, the situation meets the preliminary conditions for a mis-selling scandal.  Typically, at some stage of its lifecycle, a financial mis-selling scandal ends up being investigated by a state agency.  And this particular scandal would require one state agency to challenge the requirements defined by a different state agency.  That challenge would need to include an assessment of the contents of the KID.  Therefore, the challenge is something the state agencies would want to avoid, divert and pervert at almost any cost.

That a retail investor can spot something blatantly dysfunctional suggests the stench of some crass stupidity, blatant corruption, or perhaps both.  Thus, the can of worms opened...

In this blog:

What would a reasonable retail UK long-term investor want to read prior to investment?

How does a KID meet the retail long-term investor’s needs?

Warning: may contain nuts

The mandatory performance scenario

What the KID omits

Conclusion: the KID cannot meet the retail long-term investor’s needs because it is officially-sanctioned fake news

Why is this a risk to “coercive” brokers who demand their retail investors read it?
What is the cost of a KID?
Cost to the PRIIP
Cost of the KID to capital markets
Cost of the KID to retail investors
Cost to wider society
The ulterior protectionist motive behind the KID: America’s FATCA 2010?
What is FATCA 2010?
How does FATCA work?
How many American expatriates renounced their citizenship?
How did American advisors advise Americans?
How could the Europeans interpret FATCA?
Conclusion: collusive, lobbyist feudal protectionism
How should this issue influence a member nation’s membership of the EEA?


This blog post considers only listed closed-end investment trusts (the equivalent of American mutual funds) as the PRIIP.  There are potentially many other types of PRIIP, which this blog post disregards.

What would a reasonable retail UK long-term investor want to read prior to investment?

The onus is on the investor to determine their own decision rules, in accordance with their tolerance for risk and capacity for losses.

For a listed closed-ended investment trust (as a type of PRIIP), my view is that the minimum a retail UK long-term investor might want to read prior to investment into any PRIIP is enough to understand:

     How compatible the PRIIP is with the retail investor’s tolerance for risk and capacity for potential loss;
     The risks that the PRIIP takes to run its business, and how it manages those risks;
     The risks that other, rival PRIIPs take, and how they too manage their risks;
     Historic performance - returns on investment, in real terms - over a series of time periods (1 year, 3 years, 5 years and 10 years), compared to a peer group of comparable PRIIPs (past performance is no guarantee of the future, but the past tends to rhyme in the present);
     The financial statements of the PRIIP: does the management explain itself well?  Does it demonstrate a good, solid underlying grasp of the business?  How does it compare to its peers?  Does it over-simplify strategies?  Does it account for all relevant factors in the markets of its target investments, and if so, over what time periods?
     The price history of the PRIIP over a number of years, with further research to find out whether there was any particular reason for abnormal peaks and troughs, compared to its peers;
     The commercial environment of the PRIIP and its investments: Porter’s “five forces”, what comparative advantage does this PRIIP have over its peers, and are such comparative advantages likely to translate into a return on investment in real terms?
     The fit of the PRIIP’s risk within the investor’s total portfolio (diversify, concentrate, duplicate, omit, etc);
     Where the PRIIP appears to depend upon one particular named manager, the job history of that manager: luck or skill?

This list is just for starters.  It ignores the follow-on research required for every nook, cranny, twist and turn discovered.

At some stage, the retail investor is going to have deploy some degree of faith in the PRIIP.  Proper research is a never-ending job, yet the law of diminishing returns sets into research, just as it sets into everything else.  Irrespective of what research the retail investor does, the retail investor would ultimately have to adopt the same faith that a passenger has in an airline pilot: “Well, I guess he doesn’t wanna die either.”

How does a KID meet the retail long-term investor’s needs?

A KID is limited to only three pages of A4 paper, so there is no way it could ever achieve the depth of research set out in the list above.  Clearly, it’s not intended to be a substitute for research.  But what value could it add to any research?  If it adds no value, what is its point?

Warning: may contain nuts

By virtue of its brevity, a KID could only ever list some cherry-picked features that retail investors might vaguely recognise, e.g. this product contains derivatives, this product contains credit default swaps and so on.  It might state the intended audience/investor of the PRIIP, and how dominant a role it might play in a retail investor’s portfolio.  It needs to state the “risk factor” (a score between 1 to 7, from low-risk to high-risk respectively) and state the time period over which the risk profile is expected to be valid.

In all cases, the maximum that the KID seems capable of doing is to provide data for a basic screener, i.e. a filter to the retail investor to select PRIIPs.

But:
     there are a wide range of commercial screeners in the marketplace, certainly in the English-speaking world, e.g. Morningstar.com, DigitalLook, ProRealTime, and so on.  There is no market failure to justify state intervention; and
     A simple list of cherry-picked features isn’t something that any investor - retail or professional - could understand without some context, either qualitative or quantitative.  A PRIIP might contain a derivative in the horror-shocking way that a car contains a device that deliberately causes explosions (aka the “engine”), but the KID provides so little context that the purpose of the KID is presumably about triggering emotional reactions based on scaremongering headlines.

The KID also lists factual information about the PRIIP’s registered office, its complaints procedures, its fees (how credible are these fee disclosures?) and the normal boilerplate stuff.  All of this data appears in other mandatory documents; none of this data justifies the EU to re-invent the wheel.

In substance, these features of a KID are to a PRIIP the equivalent of the warning on a packet of peanuts, “WARNING: MAY CONTAIN NUTS.”  Or, if one can imagine such a stupidity, a label on the side of a car, “Warning: contains explosive components”.

It gets worse.  One element of the KID’s design makes the content of the KID fundamentally misleading.  So much so, that it contradicts a mantra of financial regulators chanted for decades.  The element is the performance scenario.

The mandatory performance scenario

One of the key mantras of financial regulators to retail investors is “Past performance is never a guide to future performance.”

To a retail investor, this is blindingly true.  A small retail investor is very unlikely to be able to manipulate the share price at any time.  A retail investor who doesn’t get this deserves no protection from their own stupidity.

And yet, a mandatory section of the KID is to forecast returns on investment over several time periods (holding periods) and several scenarios.  The forecast looks like it is a complex, formulaic interpolation based on some statistical (or other pseudo-scientific) model.  In other words… forecasting a fantasy of future performances… on past performance.

Absolutely astonishing!  One section of the KID commercially requires the PRIIP to disclaim future performance as a consequence of past performance, and another section of the same KID legally requires the PRIIP to disclose a fantasy of the future based on past performance!!

What the KID omits

Omitted from the KID is the bulk of financial reporting that standard-setters (e.g. the International Accounting Standard Board) have long-since defined as relevant to the reader of a PRIIP’s financial performance.  The KID inexplicably omits balance sheet*, cash flow statement*, equity statement, post-balance sheet events, enumerated related party transactions (with context), and so on.

By comparison, the PRIIP itself is likely obliged either by law or by listing rules to produce an annual financial report, subject to external audit.  The financial audit has its limitations - most notably some of the more issue-illiterate financial reporting standards that financial reports are obliged to follow - but its over-riding objective is to confirm that the PRIIP’s annual report (if prepared under EU law) presents a “true and fair view” of the PRIIP’s financial performance.  Annual reports typically start at 40 pages and, in HSBC Bank plc’s case for 2017, 274 pages.  That’s how much detail is required to present a “true and fair view”.  Substantially more than three pages of A4 paper!

By clear implication, this means that the KID is so riddled with omissions that the KID can only ever be an “untrue and unfair” disclosure from the PRIIP.

As an aside - outside the scope of this blog post - a cynic might reasonably argue that the huge volume of annual financial reports is intended to obfuscate the truth with excessive, boilerplate, plausibly deniable, but officially “fair” presentation.  Fair enough, there is merit in this argument.  It extends the case of this blog post against KIDs.  In so doing, its makes KIDs even weirder.  A question for academics: how could three pages of ostensibly officially-sanctioned fake news add any value to 250 pages of differently-officially-sanctioned fake news?  (This blog post won’t answer this question.)

* nowadays known as “Statement of Financial Position” and “Statement of Cash Flow” respectively.  Apparently, the change in name makes it all-so-much easier for us ordinary plebs to understand.  Hmm.  Perhaps cynicism in financial reporting might be a future blog post!

Conclusion: the KID cannot meet the retail long-term investor’s needs because it is officially-sanctioned fake news

On balance, it seems that the KID is more of a diversion than a useful tool to the retail long-term investor.  It serves no useful screening function, because other tools do a better job of screening.  It contains too little comparable data to put any assertion into context.  Between KIDs, the content is only partially comparable, because every PRIIP is different combination of risks, risk-mitigations and objectives.

In other words, it is officially-sanctioned fake news: a mandatory set of half-truths and quarter-truths designed solely to tick the box of financially-illiterate bureaucrats, whose results contradict the EU’s own requirement for companies (including PRIIPs) to present a true and fair view.

The PRIIP seems to be as much victims of the KID as the retail investor is.

Why is this a risk to “coercive” brokers who demand their retail investors read it?

In spite of being officially-sanctioned fake news, some execution-only brokers have seen fit to require retail investors to confirm they’ve read the officially-sanctioned fake news as a condition for obeying the retail investor’s instruction.

In the UK, the law is crystal clear: there is an obligation on PRIIP manufacturers to provide a KID, but there is no obligation on retail investors to read it.  Instead, it is a commercial decision by the broker to coerce their retail investor customers to read the KID.  To disguise the fact that the choice is that of the broker, the broker then typically implies that the law obliges the retail investor to read it (using the childish emotional stupidity that “If the EU says it needs to be produced, then it needs to be read”).

Why have some UK execution-only brokers chosen to make up the law as they go along?

Almost certainly, the emotional process of the broker’s “risk management department” is to “dump” the compliance risk onto the customer, a standard groupthink (group-emote?) reaction that passes off as “risk management” nowadays.  If the customer can be legitimately blamed, and ticks a box to accept blame, then that’ll do for us: the blame is off our desk, because we’ve ticked all the boxes that says so.  Compliance by buck-passing and tautology.

The broker’s risk management team - and its insurer - clearly have no idea what tort they have thus committed.  By coercing the retail investor to read the KID in deviance to law that has no such obligation on retail investors, the brokers have put themselves effectively in a causal chain of contractual liability regarding the KID, no matter how unfair or untrue the KID is.  Why should anybody read the KID if no part of it is enforceable?  Why require the customer to read the KID unless to make the KID enforceable?  The PRIIP manufacturer holds the KID out as an invitation-to-treat, so that means no risk to the PRIIP itself, but the broker has converted the invitation-to-treat into a condition precedent of an order.  So what happens to the broker if, say, the performance scenario in the KID doesn’t happen as fantasised?  To what extent is coercing the retail investor to read officially-sanctioned fake news meeting the obligation to put the customer’s interest first?

Imagine ten years in the future.  The performance of the PRIIP would turn out differently from that of the performance scenario set out in the KID that the broker forced the investor read at the time of first investment.  The investor would raise a formal complaint.  The broker would do the knee-jerk reaction “You read it; not our fault” to whitewash their complaints procedure.  The investor would escalate the complaint, asking the broker to spell out the law that required him to have read the KID prior to investment.  While the broker would stick its own corporate head up its own corporate anus, the investor would escalate the matter to both the Ombudsman (a matter of conduct) and the Financial Conduct Authority (a matter of policy choice, in particular breach of UK FCA’s COBS 2.1, the “client’s best interests rule”).  The broker would probably find itself referring the matter to its own insurers - most likely its Directors and Officers Liability insurer - who are likely to spot that the broker would have indeed screwed up by making the law up as it went along.  That would be enough for the insurer to admit liability, or to settle out of court.  The investor might get some sort of payout, and the brokers’ premia would go up.  And then the floodgates would open.  All retail investors would have been misled by this mis-selling scandal.  The Financial Conduct Authority, having denied the existence of any problem at all up to this point (representing the interest of the state rather than that of the retail investor), would run out of excuses for inactivity, and at this point, lobbyists would go into overdrive to keep the issue buried and well away from the courts.  From this point onwards, the anatomy of UK payment protection insurance scandal offers the template for the unwinding of the scandal.

What is the cost of a KID?

Cost to the PRIIP

The KID consumes resources to produce, which the PRIIP needs to fund, which increases the PRIIP’s costs and thus reduces returns to the investor.

The incremental cost is probably very small, because the KID is functionally another small report that spits out of the existing overhead that each PRIIP already has to employ to perform other existing reporting requirement.

The issue is the KID is not the use of resources of the PRIIP (and therefore its investors), but to the disinformation that the KID spreads about the PRIIP.

Cost of the KID to capital markets

If most retail investors can rationally finacially-literate enough to see the nonsense that a KID is, then the KID shall become a standing joke to the financial world, an epitaph to irrational policy choices of the EU and its agency ESMA.

If most retail investors are irrational, then they will have insufficient financial literacy to see through the disinformation that a KID is.  This makes the KID a dangerous document, because it presents a false and unfair view of a PRIIP.

The net result is that KID offers a very significant risk of undermining the integrity of the capital markets by encouraging the dissemination of disinformation, i.e. officially-sanctioned fake news.

Cost of the KID to retail investors

Because MIFID II requires that PRIIP manufacturers provide a KID as a condition precedent to permit retail investors to invest in PRIIPs, the immediate-term impact of KIDs is to shut non-compliant PRIIPs out of the retail market.

This reduces competition by PRIIP manufacturers to win investment by investors - including retail investors - and thus protects compliant PRIIP manufacturers.

Not by sheer co-incidence, compliant PRIIP manufacturers reside typically within the European Economic Area and non-compliant PRIIP manufacturers reside typically everywhere else.  Notably America.  It’s protectionism.

This protectionism is the most likely ulterior motive of this aspect of MIFID.  We’ll resume this argument later in this blog.

Cost to wider society

The KID represents the “triumph of pseudo-science over common sense”.  It is a small, but notable, contribution by the state (in this case, the proto-state) to invert reality.  It runs in parallel with pseudo-science destroying scientific literacy in the field of climatology.

Having contaminated the retail investor market with officially-sanctioned fake news, plenty of vested interests will use the officialness of KIDs as a force shield to hide or to evade bad decisions that disserve their customers.  The impact of this shall be to erode further public trust in the financial services sector.  It is highly unlikely that KIDs-for-PRIIPs is going to cause a civil war (!!!), but it is another straw on the same camel’s back.

The presence of pseudo-science in the European law book demonstrates an unholy alliance between an anti-empiricist cult of Marxism and self-serving corporatist lobbyists.  The EU provides many meeting places for these groups.

The ulterior protectionist motive behind the KID: America’s FATCA 2010?

The Foreign Account Tax Compliance Act (FATCA) 2010 of the United States of America is my speculative suggestion for the starting point of the EU’s PRIIPs regulation.

What is FATCA 2010?

FATCA is an incredibly invasive law, and onerous for all American citizens with interests outside of America.

Crudely, American taxation is based on citizenship, rather than geography.  Whereas a Brit can migrate to, say, Australia, and (eventually) fall out of the UK income tax net, an American citizen is always subject to American tax wherever in the world he is.  So, if he lives and works in Australia, he has to return both Australian and American tax returns and will typically pay a combination of both countries’ income taxes, subject to the provisions of any tax treaties that might exist between America and Australia.

However, America’s problem is that has never had a competent method of discovering taxable income outside its borders.

FATCA is a huge step towards America’s ability to collect tax from its expatriate citizens.  But, typically, America’s federal Deep State adopts a similar mentality as does the European Union in such policy choices, i.e. “a sledgehammer to miss a nut”.  Consequences that were (and are) blindingly obvious to anybody with a brain were (and still are) somehow “unforeseen” by the policy makers paid to foresee them.

How does FATCA work?

Via FATCA, the American Congress placed an administrative burden on all banks worldwide whose customers included an American citizen.  Such banks are obliged to report to the US authorities the names, addresses, identities, bank account details and the highest balance during the calendar year for each American citizen for every calendar year.  FATCA demanded that banks which did that not comply would either have to impose (and account for) a withholding tax on their American customers, or have to close the accounts of American customers.  And, of course, these foreign banks quickly discovered that they were doing the job of the American Internal Revenue Service for free!

Some foreign banks decided that serving Americans wasn’t worth the hassle and closed accounts of American expatriates.

Imagine being an American expatriate in a northern European state where a bank account is fundamental both to one’s legal identity in that state, and to the ability to trade in a largely-cashless economy.  How would you feel about receiving a letter from your bank that basically says, “Dear Customer.  You are American.  Your government - that you ultimately voted for - sucks.  We’re closing your account in 30 days.”

American expatriates thus had a very clear and stark choice.  Either find a local bank willing to be unpaid whores to the Deep State of America.  Or renounce one’s American citizenship to escape the American tax net.

That the American expatriate also had to complete yet more tax forms, effectively duplicating the obligation on the foreign banks, added to the coercive burden of FATCA.

Bear in mind that the story so far relates only to bank accounts.  In fact, FATCA covered all assets of American expatriates, including their investments.

How many American expatriates renounced their citizenship?

According to the US Treasury department, as reported by Bloomberg 01Nov2017,  the numbers of American citizens renouncing their citizenship has increased significantly since 2010.

The distribution of the numbers from 2010 onwards fits the usual pattern of human behaviour, where faith trumps understanding of the written word.  FATCA was well signposted, hence why renouncements increased a little in 2009.  Except for 2012 - which looks like a timing difference (smooth out 2012 with 2013 and a continuous trend from 2011 to 2014 looks possible) - the rate of renouncement grew until 2016, the number being 5,411.  Bloomberg speculated that if the last quarter of 2017 followed the trend of prior years, then the number for 2017 would be 6,813.  The numbers actually fell in 2017Q4 to 5,133 according to the New York Post 09Feb2018.

Much media comment attributes the number of renouncements to FATCA.

The official data is from the Federal Register.

How did American advisors advise Americans?

To take only one example, Thun Financial, advisors to American expatriates, published a brochure entitled, “Why Americans Should Never Own Shares in a non-US Mutual Fund.”

It sets out very elegantly the reasons behind the title.  What should be the basic freedom to dispense of your net income as you see fit became twisted under FATCA.  FATCA created a punitive, contingent, unreasonable, Kaftaesque nightmare for law-abiding American expatriates.  It became another good reason for wealthy American expatriates to consider renouncing their citizenship, if doing so were cheaper than simply complying with this obscene law.

As Thun concludes, “A thorough analysis of the tax, cost, reporting and security issues of foreign investments invariably leads to the conclusion that when it comes to wise and efficient investing, savvy American investors keep their wealth invested globally, but through U.S. financial institutions to manage the myriad tax and regulatory issues.”

This concluding remark from Thun is the most likely explanation for why Congress had permitted FATCA worked the way it does, i.e. the objectives included American protectionism for the American financial services industry.

How could the Europeans interpret FATCA?

From the European perspective, FATCA amounted to the most disgusting form of jurisdiction creep, fundamental disrespect of other countries’ laws and customs, breaches of data privacy, and breaches of a European concept of rights.

The right that FATCA gave itself to order a foreign bank to close accounts with an American expatriate, in particular, was highly offensive, especially in those countries where a bank account is a fundamental component of the expatriate’s identity in that European country, even more so if the American expatriate was a dual-national of that European country.

Worse, FATCA had effectively locked American retail investors out of European capital markets.

FATCA had deployed a very effective non-tariff barrier to trade, by locking American taxpayers into the American financial services industry.  The Americans had given the Europeans a taste of the Europeans’ own non-tariff medicine!  How very dare they!!

Conclusion: collusive, lobbyist feudal protectionism

At the time, the EU had no such equivalent regulation.  Instead, it imposed an incremental regulation that mandated the production of a KID as a precondition for making a PRIIP available for sale to an EU member state’s citizen. This requirement met the typical non-tariff barrier to trade within the European Economic Area, easy to window-dress as “consumer protection”.  It successfully bars American producers of PRIIPs without naming any nationality, so complies with the non-discrimination values of the EEA Agreement (wiki) and Treaty of the Functioning of the European Union (TOFU) (wiki).

Although the KIDs-for-PRIIPs law successfully bars American non-compliant manufacturer of PRIIPs, it is really important for the retail investor to note that the law successfully bars all non-compliant manufacturers of PRIIPs, including PRIIPs from manufacturers whose base of operations are in the European Union.

The net result is the thin edge of the wedge for the retail investor.  Neither American nor European retail investor has effective direct access into the other jurisdiction’s capital markets.  Thus, the retail investor cannot escape the stupidity of each respective state, or the feudal treachery of each respective Deep State, or the greedy filthy hands of each state’s financial services industry.  For the European retail investor, it closes part of the investment universe, locking Europeans into the European financial services industry, to an equivalent extent as that engineered by America to lock Americans into its financial services industry.

It is protectionism, pure and simple, designed to protect producers very much at the consumers’ expense.  And provides retail investors with officially-sanctioned fake news in the process.

How should this issue influence a member nation’s membership of the EEA?

The overriding strategy for any member nation government of the EU is solidarity, being the on-going game of “prisoners’ dilemma” or an oligopoly: governments have an interest in toeing the line and co-operating, but governments also have a greater interest in ratting on the deal and hoping that everybody else is a sucker who gormlessly toes the line.

Members of the EEA thus live with a policy trade-off.  Their economic agents suffer the economic cost of complying with ESMA’s KIDs-for-PRIIPs regulations, but benefit from having their competitors (both foreign and domestic) being locked out of the retail investor market.

But were the member state able to revoke the KIDs-for-PRIIPs law, then the member state would enable comparative advantage to work normally.  This would more-likely-than-not reduce the opportunity cost to any investor in that state (whether retail or institutional).  This would be true even if foreign PRIIPs manufactures were to have rigged the trade in the foreign state’s favour.

KIDs-for-PRIIPs is not a show-stopper.  Obviously!  But it demonstrates perfectly how dysfunctional the modern Western state has become, and how feudal it still sees its masses of ordinary plebs that sheepishly obey the law.  Accordingly, it is yet another straw on the same camel’s back.

Hypothesis: the more and more that the world becomes protectionist, the greater the opportunity cost shall be for any member of the EEA if it chooses still to obey EEA law.  KIDs-for-PRIIPs, alongside other examples in other fields of EEA regulation, demonstrates this hypothesis.

For Brexit, getting out of the TOFU remains the number one priority in the short-term, but continued membership of the EEA remains the only practical means of delivering Brexit in the medium-term.   Yet, longer-term membership of the EEA looks increasingly expensive in an increasingly-protectionist world where local democracy is deliberately overridden by a mere technocrat’s opinion.