Irish regulator updates guidance on decrement, back-testing

The Central Bank of Ireland (CBI) has released new supervisory guidance to investment firms to clarify aspects of the relevant Mifid 2 investor protection requirements and the expectations set out by the regulator in the SRP Letter on Mifid 2 structured retail products last year.

material or brochure and on the page on which the decrement index is described in further detail’.

The letter provides two sample warnings (one for the front page, and one for the page that describes the index in more detail).

period,' in light of the predominantly positive market conditions in recent years, firms must avoid using a large number of overlapping simulations which show little, if any, capital losses as that has the potential to mislead clients about the likelihood of suffering a capital loss.

These relate to how the warnings on use of a decrement index should appear, and the presentation of back-testing.

The use of decrement indices – ‘where a fixed dividend is periodically deducted from the underlying index and which can act as a 'downward drag' on performance where it is higher than the actual dividend paid, and in particular where the index falls below its initial level - was identified as an area of particular complexity by the regulator in 2022.

Going forward, financial firms using decrement indices in their products will be required to provide a prominent warning which must appear in a separate text box ‘on the front cover of the marketing

The letter also confirms that if a product uses a fixed dividend deduction in the form of a fixed point value rather than a percentage investors should be aware and understand that this 'drag on performance' will be accelerated if the index falls below its initial level, and that a sustained fall in markets will accelerate the decline in the value of the index.

‘This should be clearly reflected in the firm’s example scenario illustrations,’ stated the regulator.

The Irish regulator is also seeking to ensure that the presentation of historic data by structured products providers isn't misleading and noted that ‘using past performance representations covering periods of positive client outcomes, (…) may not accurately reflect the likelihood of future capital loss for investors.

According to the Central Bank, although firms can use the past performance of the underlying asset over an ‘appropriate

‘This often results in thousands of positive simulations over a short period that presents zero or minimal examples of capital loss,’ stated the regulator.

The Central Bank expects that the risk of capital loss must not in any way ‘be diminished, downplayed or masked by the firm’s presentation of past performance information’.

‘Firms are expected to ensure that all information presented is balanced, accompanied by prominent and clear warnings, and consistent with the risk profile of the product,’ it said.

The guidance update is part of the Irish regulator’s implementation of the findings from a series of targeted reviews on structured products led by Colm Kincaid (pictured), CBI’s director of consumer protection, aimed to keep product providers in line as the market shifts ‘towards increasingly complex structured products’.