Consumers investing in hedge funds, precipice bonds or split-capital investment trusts could in the future be required to sign a stronger ‘caveat emptor’ waiver, according to proposals set out by the Financial Services Authority.

In a 46-page discussion paper published this morning, entitled wider range of retail investment products: consumer protection in a rapidly changing world . the FSA suggests it needs to review the regulation of more complex products such as hedge funds, which could carry higher investment risk than many other products available to the retail investor.

The City watchdog also asks whether the regulatory regime should be changed to shift away from a product-based structure to one which looks more at the risks of the investment strategy adopted, as it may be too difficult to describe some hedge funds, for example, as higher risk.

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“The prohibition on marketing of unregulated collective investment schemes makes individual hedge funds…effectively invisible to retail investors. It may well be that some hedge funds could offer a lower level of risk than some wider range products that are already available to consumers. It could see irrational to prohibit access to products simply because they fall into a certain category…rather than on the basis of the risk characteristics of the product,” suggests the FSA.

More specifically, the regulatory body suggests it may need to implement a second regulatory regime with more disclosure requirement for retail investments such as structured capital-at-risk products — which it sees as part of the ‘wider range’ of investments allowing managers to invest in derivatives or apply leverage – as well as ensure “explicit acceptance of risk by investors”.

The FSA asks:“Would it be necessary or desirable for retail investors to sign an explicit acceptance of risk statement, which would place the onus for purchase of more risky products more firmly upon them? Would such an approach be feasible given the general levels of consumer understanding that exist in the retail market?”

Many factors or issues are raised about the problems of regulating these products and the existing retail investments, as the FSA points out a flurry of EU regulations will affect how certain product types have to marketed and sold, and there are still problems with assessing how much the consumer understands about investment.

Three risks are discussed in particular:

1. Retail consumers do not understand and regulated firms do not adequately manage, the significantly changed risk characteristics of UCITS III as compared to UCITS 1 funds;
2. Retail consumers may be confused by the different forms and distribution channels of wider range products, resulting in mis-buying or mis-selling, and
3. Different regulatory approaches applying to the marketability of different investments products means some retail consumers may not…have sufficient access to investment products that have comparable economic characteristics and therefore suffer detriment.

While the FSA is keen to ensure consumers are sufficiently protected against potential risks of mis-buying or mis-selling, the biggest problem it faces is EU regulatory bodies have to categorise investments according to those defined as ‘complex’ products and ‘non-complex’ products, as the terms of the Markets in Financial Instruments Directive – applicable from April 2007 – will require complex investments only be distributed with advice.

Additionally, the FSA is aware changes to UCITS regulations, under UCITS III, now mean many investments can carry derivatives and could potentially carry higher risk, whereas UCITS I specified what investments could be included in funds.

“Drawing a distinction between products based on volatility, illiquidity or complexity presents problems,” states chapter two of the report.

“The central difficulty arises in specifying with reasonable precision what is meant by ‘a high degree of volatility, illiquidity or complexity’. Many investments will display varying degrees of each of these characteristics. The risks inherent in investment products lie on a continuum, so any line drawn across it would have an arbitrary nature to it,” continues the FSA paper.

In order to try and assess how best to tackle future regulation and accessibility of these ‘wider range’ products, the FSA has proposed three options:

1. No change to the status quo;
2. Increase regulation, which could include treating more products like unregulated CIS, and
3. Create a new regime to deal with wider range products.

Feedback on the detailed discussion paper has to be submitted to the FSA by 28 October, 2005.