The German Federal Financial Supervisory Authority intends to prohibit the marketing, distribution and sale of credit-linked notes (Bonitätsanleihen) to retail investors for their own protection.

To this end, BaFin (as it is known) is proposing to prevail on the Government to pass a law that it hopes will be called the General Administrative Act and has published its own draft of it. Comments may be submitted in writing up until 2nd September.

BaFin plans to prohibit the retail distribution of certificates linked to creditworthiness risks of reference entities. Structured products linked to credit risks can be a useful investment alternative for institutional investors, but it does not believe that they belong in the hands of retail clients. BaFin knows that this will be unpopular with the certificates industry, but it is going ahead with it out of respect for the 'great significance' and 'central importance' of the certificates market, which it wants to protect from adverse comments. Credit-linked notes are highly complex - always a concern for regulators interested in 'investor protection.'

With credit-linked notes, the interest and repayment of the money invested depend on the credit risks of reference entities. Of particular relevance is whether a credit event relating to the underlying reference liability will occur – something that retail clients (even HNWs) are not generally able to assess. They cannot tell how great the probability of repayment of the investment amount is and whether the assumption of credit risk is adequately compensated for by the level of interest promised. BaFin has also detected the risk of a conflict of interest inherent in the product structure. Issuers are, on the one hand, producers of the credit-linked notes which are sold to retail clients and, on the other, they also maintain business relationships with the companies whose creditworthiness risks underlie their products and they may act as lenders themselves. The standard contractual terms for credit-linked notes give issuers considerable leeway in this context.

The regulator has also written: "The German product name is misleading and gives rise to investor protection concerns. Despite what the German name may suggest, credit-linked notes (Bonitätsanleihen) are not bonds (Anleihen) in the traditional sense. In fact, subjected to economic scrutiny, the role of the investor is not that of a (bond) lender: rather, the investor takes on a role similar to that of a protection seller who assumes the risk of a credit event. This confusion of roles gives retail clients the false impression that the product is an interest-bearing security."

In recent months, BaFin examined the extent to which credit-linked notes are being sold actively to retail clients and whether the risks involved are explained in sufficient detail to such clients. It found that issuers are producing credit-linked notes specifically for sale to retail clients. An assessment of advice documents showed that such clients generally do not receive an adequate explanation of how the products work.

With this ban, BaFin is making use of the "product intervention power" vested in it by the German Retail Investor Protection Act (Kleinanlegerschutzgesetz) in July 2015. Also of relevance is section 4b Securities Trading Act (the Wertpapierhandelsgesetz or WpHG).