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Some observations on MiFID II

Anthony Kirby, EY, London, 22 January 2016

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The European Union’s heavy MiFID II raft of regulations – which are to be delayed for a year – bring a number of challenges for wealth managers. Dr Anthony Kirby, the head of regulatory reform at the accountancy firm of EY, examines some of them.

The European Union’s Markets In Financial Instruments Directive, in its second iteration – known by the clunky acronym of MiFID II – is designed (so its framers say) to protect investors from sharp practice more comprehensively than now and to promote competition and efficiency in markets. Whether these goals are achievable is another issue. As with all such regulation, the obvious risk is that the pain is not worth the gain, forcing the financial services industry to take a regrograde step without helping the end-consumer. Another challenge is to ensure that the European Union's legislative adventures are, as far as possible, congruent with the things that national politicians can achieve.

Recently it was reported that EU politicians are thinking of delaying the rollout of MiFID II by a year so that it would kick in at the start of 2018 instead of 2017 in an effort to give the financial sector more time to adapt to a more-or-less impossibly tight schedule. Even then, people at the European Securities and Markets authority think that this might not be enough either.

Regulatory Technical Standards

Also recently, the European Securities and Markets Authority has published its latest batch of 28 final rules (called Regulatory/Implementing Technical Standards – RTSes) which cover the operation of markets and reporting requirements under MiFID II.

The RTSes feature technical elements, showing how MiFID II will fulfil its promise to make markets more 'transparent,' protect investors from sharp practice more comprehensively, and improve the safety and resilience of the EU's financial markets.

They also describe how the measures are going to apply to market participants, market infrastructures and national supervisors. ESMA’s recommended rules will require approval by varous organs of the EU later this year before coming into force, which might happen as early as 3rd January 2017.

New areas of complexity

We know that MiFID II has a wider reach than MiFID I, affecting a broader range of instruments, venues and activities, and will change the balance between the buy-side, sell-side and established/new entrant client service intermediaries. As far as private banks and wealth managers are concerned, there will be important revisions to (i) products (classification, governance, manufacture and distribution), to (ii) arrangements that pertain to suitability and 'appropriateness,' to (iii) disclosures (to investors and/or to the authorities) about costs and charges, to (iv) ways to show that 'best execution' (when a broker gets the best price for a trade in the shortest time) is taking place, and to (v) record-keeping. There could also be new areas of complexity to manage as the quality of protection for investors (including HNWs who want to invest in the US or offshore) against various threats may vary from country to country. Let us look at the five aforementioned areas in more detail.

(i) New client classes and rules for products. The classes of client enumerated in MiFID I are going to be transferred into MiFID II, with the exception of public-sector bodies, local public authorities, municipalities and private individual investors. These four entities may be allowed to decide not to receive some protection afforded by the conduct-of-business rules (and thus be treated as 'professionals' on request) but otherwise they are going to be classed as retail. MiFID II will also introduce a more comprehensive 'product governance' process to ensure that the products on offer are suited to the characteristics, objectives and needs of private clients.

Product manufacturers will have to provide extensive information (about the characteristics of products, the end-consumers for whom each product is intended and costs) to distributors to allow them to assess 'target market suitability' continually.

(ii) 'Suitability' and 'appropriateness' arrangements. Varous regulators in the EU were thinking about these two subjects when MiFID I took effect but since 2007 they have thought about them even more. Not all wealth managers have been tracking their clients’ risk appetites and there has therefore always been a real risk that those clients will continue to invest in products that do not meet their objectives they have set for investing. The fines for poor systems and controls or for miss-selling have focused the minds of risk mangers on reputational risk and the costs that firms accrue when things go wrong.

MiFID II stipulates that financial firms must give 'suitability reports' to their private clients at the onset of their relationships with them and distributing firms should undertake periodic 'suitability' reviews, taking the products on offer on the market into account. Firms also have to perform 'appropriateness tests' for selling complex products on a 'non-advised basis' (i.e. products that nobody can sell through the 'execution only' route). It is expected that the final EU 'delegated acts' (highly undemocratic secondary legislation framed and passed by people who have never been elected) will say more about how firms ought to demonstrate the 'suitability' of their products to customers.

(iii) Disclosures of costs and charges. MiFID II will probably prescribe new rules for these. It is worth noting that MiFID I's 'suitability assessments' (which private banks give to customers) must take the costs and charges of comparable products into account – a piece of 'heavy lifting' for private banks and wealth managers. At the time of writing (and pending further stipulations from the forthcoming secondary legislation), it is thought that firms will be obliged to aggregate their own costs plus all costs from all other sources when they work out the total cost figures for investment and ancillary services to clients, with costs shown as both cash amounts and percentages. They are likely to look at different things before and after trading. After trading, they will pay attention to ranges and numbers, including price bands and consideration for 'best efforts' for less liquid instruments. By contrast, disclosures made before trading might pay attention to the factors that might influence prices in a meaningful manner. Payments that 'third parties' make to an investment firm should also be shown on a statement.

(iv) Best execution. The newly-issued RTS 27 and RTS 28 float the idea of more onerous disclosures to strengthen the 'best execution' regime set up by MiFID I. To ensure that firms execute orders in the most favourable conditions for their clients, ESMA holds to the view (in Final Report §9.1(9)) that the relevant firms should log “execution quality information” about factors such as price, speed and the likelihood of execution for each instrument for each trading day if the data is to be of value for users. This will have a significant bearing on the costs of the data-processing systems that will have to receive, analyse and 'benchmark' such a volume of information.

The harder definition legal best execution under MiFID II Art 27(1)’ firms must “take all sufficient steps…”’ will need to take account of other strands under MiFID II Art 27, for example, the requirement under Art 27(6) that all investment firms publish data on the top five venues where they executed client orders, and information on the quality of execution obtained. Firms will need to attune their best execution policies to ensure that their evidencing can be supported by the appropriate transaction cost analysis (TCA) tools for each asset class. They might also need to take a view on whether to name executing brokers or ultimate trading venues in their policy.

(v) Record-keeping/client reporting. The record-keeping requirements under MiFID II are onerous. Firms ought to record all telephone conversations and electronic communications when they receive and transmit orders (even incomplete ones), when they execute orders on behalf of clients, or when they deal on their own account. They should also record all internal conversations and communications about orders from clients, taking in face-to-face conversations which they should record and store as minutes. National regulators might require records to be kept for seven years in a durable medium.

The rules for reporting information to clients are equally prescriptive. Firms must make execution reports no later than the first business day after execution, with the content of the reports similar to those that go out to private clients who want to be classed as retail. They should issue portfolio management reports quarterly on a durable medium, and portfolio managers will be obliged to report to clients when the total values of their portfolios depreciate by 10% or multiples of 10%.

A cornucopia of information

The amount of information that business, operations and compliance professionals will have to assimilate, process and report is stupendous. Steven Maijoor, the chairman of ESMA, said recently: “The magnitude of this change should not be underestimated.” No matter whether private banks and wealth managers are servicing mass-affluent, affluent, high-net-worth or ultra HNW clients, they will have to try to salvage as much privacy for clients as they can out of the process while still trying to please the taxmen and regulators. Some firms will have to upgrade their systems and process their data (including unstructured data) more efficiently.

Business leaders in private banking and wealth management also ought to understand how to react to MiFID II with respect to strategic choices involving such things as financial planning analysis, robo-advice or stress-testing as a service. Firms, moreover, have to remain competitive without incurring costs by rushing to comply with mere proposals from the EU that that organisation might change later, resulting in 'throw-away' work.

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