When, in years to come, the academics and economists look back on the current recession, there will undoubtedly be common factors that will draw the interest - the rise of sub-prime markets, the fall of Lehman Brothers, the bankruptcies of entire cities in the United States. For those operating in the financial services arena, however, we think that it is the rise of the regulator, on the back of public and governmental outrage at the behaviour of the financial institutions blamed for the crisis, which will resonate most strongly. Given a remit of "never again", regulators across the world have sat up, gripped their freshly-bestowed powers firmly, and waded into battle.
These newly aggressive regulators have already left many casualties in their wake, and, later this year, when the UK's Financial Conduct Authority ("FCA") will for the first time utilise its product intervention powers, contingent convertible instruments ("CoCos") will be added to the roster of the fallen.
What are CoCos?
CoCos are hybrid capital securities which feature both debt and equity elements. Issued as a bond paying a coupon, they convert into an equity security when a certain trigger event occurs. This trigger point is normally linked to the issuer's regulatory capital ratio. CoCos were originally designed for purchase by institutional investors, principally asset managers and banks and their popularity has increased dramatically in recent years given the high yields offered.
The FCA has reported that the value of CoCos issued between 2009 and 2013 is estimated to have reached GBP 40 billion (USD 70 billion), 20.7% of which was issued by UK banks. Indeed, Bank of America Merrill Lynch predicts that the market value for European Additional Tier 1 capital CoCos could exceed EUR 150 billion by 2020.
With expected rapid short-term growth in issuance, the FCA has decided to implement measures to mitigate the potential harm caused to investors by CoCos' complex and unusual characteristics, and in October 2014, it will restrict the distribution of CoCos to retail investors.
While financial institutions continue to increase their issuance of CoCos to fulfill prudential capital requirements, the FCA fears that their proliferation, and the returns offered, could see the investor market expand to incorporate ordinary retail investors. This is particularly likely at a time such as this of low interest rates when inexperienced and unsophisticated investors are...