Complexity Levels
In an initiative aimed at strengthening Indian capital markets through greater transparency for investors, CRISIL Ratings had introduced complexity levels to classify financial instruments viz. capital market instruments, money market instruments (commercial papers, certificate of deposits) and fixed deposits based on their complexity. These complexity levels reflect the ease of understanding and analysing the risk elements in these instruments. Instruments are classified into three categories: simple, complex, and highly complex.
CRISIL Ratings does not use complexity levels to classify the complexity of bank loan facilities. This is because the bank loan facilities are part of a suite of the products that are designed and offered by the lender. Hence, in the case of bank loan facilities, the lender is aware of the complexity of the instruments.
Complexity levels were launched after extensive research. The study revealed that many investors do not fully understand the intricacies of all financial instruments in the market. This is especially true of the newer, more complex instruments such as equity-linked debentures.
Some investors invest in complex financial instruments without fully understanding the features involved. For instance, consider a partially compulsorily convertible debenture issued by a company. The conversion price is normally fixed at the time of issue, with options for reset based on certain parameters. An investor may not understand the calculation of conversion price, and the effect of share price, on the returns, and may incur significant losses as a result. Such instances can in turn shake market confidence in newer instruments. Complexity levels help the investor determine the degree of sophistication and due diligence required to understand the risk factors involved in such instruments.
Complexity is distinct from risk: saying that an instrument is simple is not to say that it is less risky, but the risk will be easier to understand in a simple instrument than in a complex one. For instance, equity investments can be very risky, while government securities are much less risky, but the risks in both cases are easily identified; both instrument types are therefore classified as simple. Partially compulsorily convertible debentures, on the other hand, are complex instruments with risks that are not so easy to identify.
CRISIL Ratings’ Complexity Levels help issuers and intermediaries get a clearer understanding of the appropriate target customers for an instrument. Already, the world over, market regulators are trying to address issues such as mis-selling and the appropriateness of instruments for various classes of investors. CRISIL Ratings’ Complexity Levels help address such issues. They will also help regulators-over time-in determining the maximum complexity levels that are appropriate for a particular class of investors, such as pension funds or insurance companies.
The introduction of Complexity Levels for financial instruments was CRISIL's initiative in its continuing efforts to educate market participants on complexity. By empowering more investors to invest in instruments that are appropriate for them, this will help in the orderly long-term growth and development of India's financial markets.
