Overview

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.

Product Description and Scale

The CRISIL Complexity Level of an instrument is a reflection of the ease of understanding and analysing the risk elements in that instrument. Financial instruments are classified into three levels of complexity: Simple, Complex, and Highly Complex.

Criteria

The parameters that CRISIL considers for determining the complexity levels of financial instruments are:

•	Ease of calculation of payout and returns The ease of calculation of payouts and returns affects the complexity of a financial instrument. For instance, in a corporate bond, the interest rate and debt repayment schedule are known beforehand, making payout calculation simple for an investor. On the other hand, determining the payouts for an equity-linked debenture requires considerable understanding and computational effort.
•	Clarity on timing of cash flows Certainty in cash flow timing helps investors plans their investments well. Any uncertainty will affect returns, and will need to be managed. For instance, prepayments on asset- or mortgage-backed securities expose investors to reinvestment risk, adding to the complexity of the investment process.
•	Number of counterparties involved in the transaction The number of counterparties involved in the instrument also adds to the complexity. For instance, consider a guaranteed corporate bond. The investor will have to take into consideration the risk associated with both the issuer and the guarantor, and also factor in the guarantee mechanism. In a plain vanilla bond, on the other hand, the investor is only concerned with the issuer's credit risk. This makes the plain vanilla bond far easier to analyse.
•	Familiarity of market participants with the instrument An instrument type that has been in the market for some time is easier for market participants to understand than one that has just been introduced. For instance, equity shares have been a routine investment for decades, and the market's understanding of shares is therefore good. On the other hand, when equity derivatives were introduced, there were very few participants who understood these instruments at all well. Over time, as the market gains familiarity with an instrument type, the implied complexity reduces. Hence, the Complexity Level of an instrument may change over time, as the market becomes increasingly familiar with it.

CRISIL Complexity Levels will assist

•	Investors, both retail and institutional, in determining the degree of sophistication and due diligence required to understand the risk factors involved in an instrument before making an investment decision.
•	Issuers and Financial Intermediaries, in deciding the target segment for each instrument, and directing selling efforts accordingly. Thus, the problem of mis-selling can be addressed to a large extent.
•	Regulators, in addressing issues such as mis-selling, and also in stipulating the maximum complexity levels for investment by a particular class of investors, for example, pension funds and insurance companies.

CRISIL Complexity Levels are a service provided by CRISIL free of charge to all users. CRISIL Complexity Levels may be used without changing their meaning or context, but with due credit to CRISIL.

Disclaimer: CRISIL Complexity Levels are based on information obtained by CRISIL from sources it considers reliable. CRISIL Complexity Levels reflect the ease of understanding and analysing the risk elements in capital market instruments. The initiative is on a voluntary and pro-bono basis. CRISIL does not guarantee the completeness or accuracy of the information on which the categorisation is based. A CRISIL Complexity Level is not a recommendation to buy, sell or hold the instrument; it does not comment on the market price or suitability for a particular investor. CRISIL is not responsible for any errors and especially states that it has no financial liability whatsoever to the subscribers / users / transmitters / distributors of this product