Appropriateness Test ExplainedBy CCTrader - November 12, 2019 |
When raising BUY orders for complex instruments on CCTrader you will be required to undergo an Appropriateness test.
What is a complex instrument?
Complex instruments are those instruments as categorised under MIFID II rules (Investment services legislation) as having complex features which make it more difficult for a retail client to understand.
For instance: ETF’s or ETN’s that are classified as Leveraged or Inverse fall under the complex category. Also In case of bonds, all bonds classified as CONVERTIBLE, PUTABLE, CALLABLE, CALL/SINK, PERP/CALL, SINKABLE, SUBORDINATED, SUBORDINATED BONDS, SR SUBORDINATED, BONDS ELIGIBLE FOR BAIL IN TOOL PURPOSES, ELIGIBLE FOR BAIL IN or UNLISTED
The scope of the test is to enable us understand the level of investment knowledge and experience the client has prior to placing trades in such complex instruments.
Questions on profession, education and previous transactions will be asked together with a brief knowledge assessment of the actual instrument type selected.
This Appropriateness Testing is mandatory during pre trade under the MiFID II legislation whenever a retail clients intends to place orders in complex instruments.
The test result provides us with insight as to whether a client possesses the necessary knowledge and experience to trade in complex instruments. The test is done once and results are kept in the audit trail. The test can be repeated after 24 months.
Once the test is complete, clients will be able to raise the order even if the test is failed, provided consent to the related important warnings is given by the clients. Additionally, once the test is done the first time, the clients will be given the related warning to indicate that a buy order is being raised on a complex instrument and whether this is appropriate or not in line with the stored test result. Warnings apply whether clients pass or fail the test.
Where is the Appropriateness test done?
The Appropriateness test is applied on the new CCTrader platform.com (clients trying to raise an order for a complex instrument on older CCTrader flash platform will be blocked and asked to take the test on the new platform in app or browser via https://live.cctrader.com
How is the Appropriateness test done?
The test has 2 sections.
Section A: This is a generic section that assesses the client’s background, education and financial instruments’ understanding. This section is the first part of the test and is the same for all instrument types.
Section B: The second section is related to the specific features of the particular instrument type selected.
Are there exceptions?
Professional clients are assumed to have the adequate knowledge and experience, therefore, clients classified as “professional” clients will only get a warning and will not need to perform a test.
Information on specific instruments falling under the Complex Category
Floating Rate Bonds
Floating (or Variable) Rate Bonds, also known as Floating Rate Notes (FRNs) are those fixed income instruments whose income derived from interest income is not fixed and is generally derived from a money market reference rate, such as LIBOR or the Federal Funds Rate. Generally, a spread is quoted on this money market reference rate, which spread is commensurate with the going risk premium of the underlying risk premium. The stronger the creditworthiness, the lower the spread (and the lower the prevailing coupon) whilst the weaker the creditworthiness, the greater the spread (and the higher the prevailing coupon). It is highly common for a coupon of a Floating Rate Note to fluctuate during the lifetime of the bond, and is re-set at the prevailing pre-determined dates, reference rates and spreads as set out in the Offering Documentation / Prospectus of the underlying bond in question.
Callable bond is a bond that can be redeemend by the issuer prior to its scheduled maturity dates. The prospectus of these types of bonds should clearly highlight the levels (price) and timing (date) as to when the issuer of a bond has a right to redeem (call) the bond earlier than its maturity date. The issuer must clarify where a bond is callable and the exact terms of the call option. If interest rates have declined since the company first issued the bond, the bond issuer will most likely want to refinance the bond at a lower rate of interest (coupon rate). This means that for a callable bond, the bond issuer can return the bond principal and halt interest payments from the call date till the bond’s scheduled maturity date.
A putable bond is a bond that allows the bondholder to force the issuer to repurchase the security at specified dates before the scheduled maturity date and specific prices. Bondholders have the option of putting bonds back to the issuer either once or on a number of different dates. Bond indentures will stipulate when and how the bond can be sold. The advantage of putable bonds is that if interest rates rise after the investment date, and hence the price of the bond would have fallen, the investor can reocver some or all of that loss by forcing the issuer to redeem the bond at par value.
Bail-ins and bail-outs arise out of necessity rather than choice. Investors and deposit-holders in a troubled financial institution would surely prefer to keep it solvent, rather than the alternative which would be for them to lose the full value of their investments or deposits if the bank goes under. Typically bail-ins was resorted to in cases where a government bail-out is unlikely due to either (a) the financial institution’s collapse is not likely to pose a systemic risk because it does not fall into the “Too Big To Fail” category; or (b) the government does not possess the financial resources necessary for a bail-out because it is itself heavily indebted. The new bail-in tool in the EU bank resolution toolkit is an important step forward to safeguard financial stability in Europe, notably in relation to mitigating moral hazard and other problems inherent in a strong reliance on bailouts.
One of the resolution tools is the bail-in tool whereby Resolution Authorities are, amongst others, empowered to write down or convert into common equity certain liabilities of a failing bank (including tier 2 capital instruments such as the Notes). The bail-in tool ensures that not only shareholders but also creditors of the failing institution suffer appropriate losses and bear an appropriate part of the costs arising from the failure of the institution.
A perpetual bond, which can be a debt instrument with a fixed or variable rate of interest is a bond with no fixed maturity. It is therefore common to treat perpetual bonds as equity and not as debt and it is for this reason that these types of bonds are classified as deeply subordinated debt. Issuers of perpetual bonds pay coupon payments forever and do not have to redeem the principal, and hence the perpetual bond cash flows can be treated as a perpetuity. Issuers of perpetual bonds have primarily been financial institutions however the primary bond market has, over recent years, witnessed the resurgence of corporate bond issuers issuing perpetual (hybrid) bonds. perpetual bonds function much like dividend-paying stocks or certain preferred securities. Just as the owner of the stock receives a dividend payment as long as the stock is held, the perpetual bond owner receives an interest payment as long as the bond is held. A variety of risks are associated with perpetual bonds. Perhaps the most notable is that a perpetual period is a long time to carry on credit risk. As time passes, bond issuers, including both governments and corporations, can get into financial trouble and even fail. Perpetual bonds may also be subject to call risk, which means that the issuer can recall them.
Prospects MTF Bonds
Prospects is a market regulated as a multi-lateral trading facility and operated by the Malta Stock Exchange (MSE). Prospects is aimed at Small to Medium-sized Enterprises, facilitating their access to the capital markets. Therefore, a prospects bond is a bond issued by a SME in Malta, with the size of the bond ranging between €1million and €5million. The Prospects platform caters for listing equities and/or corporate bonds. When listing corporate bonds 100% of the bonds are issued onto the market through the IPO.
Prospects is a multilateral trading facility (MTF) operated by the MSE and serves as a trading platform for debt and equity securities issued by companies. It is targeted mainly at start-up companies and Small and Medium Enterprises (SMEs). SMEs cannot have more than 250 employees and must have either an annual turnover of less that €50 million or total assets of less than €43 million. Securities issued by SMEs tend to be illiquid. The illiquidity factor increases the risk for investors and when funds are needed, there might not be a market to sell to liquidate position.
Leveraged and Inverse Products
Leveraged and inverse ETFs pursue daily leveraged investment objectives which means they are riskier than alternatives which do not use leverage. They seek daily goals and should not be expected to track the underlying index over periods longer than one day. They are not suitable for all investors and should be utilized only by investors who understand leverage risk and who actively manage their investments.
Short and Leveraged Exchange-Traded Products are only intended for investors who understand the risks involved in investing in a product with short and/or leveraged exposure and who intend to invest on a short-term basis. Any investment in short and/or leveraged products should be monitored on a regular basis (as frequently as daily) to ensure consistency with your investment strategy.
You should understand that investments in short and/or leveraged exchange-traded products held for a period of longer than one day may not provide returns equivalent to the return from the relevant unleveraged investment multiplied by the relevant leverage factor. Potential losses in short and/or leveraged exchange-traded products may be magnified in comparison to investments that do not incorporate these strategies