In an initiative aimed at strengthening Indian capital markets through greater transparency for investors, CRISIL has begun classifying capital market instruments based on their complexity. CRISIL 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. The initiative is on a voluntary and pro-bono basis. Complexity Levels of various financial instruments analysed by CRISIL are given at the end.
CRISIL Complexity Levels are being launched after extensive research. The conclusions have also been validated by a survey CRISIL carried out amongst retail and institutional investors to have their perspective on their ease of understanding various financial instruments. The feedback reveals that many investors do not fully understand the intricacies of all financial instruments in the market. This is especially true for the newer, more complex instruments, such as capital protection-oriented mutual fund schemes and equity-linked debentures.
As a result, there is an increasing likelihood of situations where some investors invest in complex financial instruments without fully understanding the risks 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 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 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 CRISIL Complexity Levels for financial instruments is CRISIL's latest initiative in its continuing efforts to educate market participants on complexity. By leading 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.