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Interest rate swap doing your head?


Sophisticated Investor

The Regulator’s definition of ‘Sophisticated’ is driven by statute, which is based on the size of a company.  For what the Regulator calls ‘Sophisticated’ most of us would interpret as:
a) Has lots of money
b) Has lots of income and/or
c) Has lots of staff

The Regulator has redefined ’sophistication’ according to the flowchart that most of us are now familiar with:

Not including these cases in the review may have interesting consequences. These clients may now be forced to go to Court to obtain redress. (There may be a degree of rough justice in this, as they would be expected to be the most capable of mounting a robust legal action. Not always, though - depending on the depredations due to the swap). To the degree that any of these cases escape the ‘out of court settlement with mega non-disclosure terms’ syndrome, they may become the basis for a revised review. As the cases which reach the senior courts tend to be the most well argued, the Regulator is bound to take account of them. The Regulator’s other definition of ‘sophisticated’ is worth quoting in full:

“At the time of the sale, and irrespective of the size of the business, did the customer have the necessary expertise and knowledge to understand the service to be provided and the type of product or transaction, including its complexity, and the risks involved”.

Whether or not “the risks involved” included the then state of the future interest rate market, the source of the instant ‘profit’ to the bank generated by the sale, and the corresponding exposure to which the client was being contracted to underwrite, the regulator has not enlightened us. ‘Simpler’ products, such as swaps and plain collars (i.e., where no additional loading in the bank’s favour was added to the floor) are still, apparently, acceptable. This is a dangerous position for the Regulator to take. A table knife can be used as a murder weapon and then return to its normal duties for the foreseeable future.

As far as ‘sophistication’ is concerned, not many accountants or IFAs would be capable of giving advice in this area (even if allowed to by the FCA). Some accountants have prevented any client mis-sales by telling their clients: ‘if it’s from the bank, and you don’t fully understand it, don’t touch it’. Probably the ‘best advice’ with the benefit of hindsight – but of perhaps limited use to a client who has found an investment opportunity and sees their bank as the only practical way of financing it. No IFA spoken to thus far has any idea.

Nevertheless, the concept of sophistication is a valid one, and a test may be proposed based on:
a) Knowledge
b) Experience
c) Ability to conceptualise

These ideas will be expanded upon in future. However, it should be stated that we believe that the banks brainstormed the ideas behind derivative selling long and hard before the sales forces were set up (at significant cost!). And – as with pensions mis-selling – the ideas originally came from government initiatives!

We leave you with Dara O’Briain’s brainteaser, which will also be expanded upon at a later date. Go to the following link:

...And click on “5 – Fries” on the right, and then “Play Puzzle”. Have fun!
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