Compliance Matters interviewed Jonathan Wilson, the project director at the global compliance consultancy of Cordium, about the frenetic preparations that wealth management firms are having to make for the European Union's second Markets in Financial Instruments Directive.

This article takes the form of a question-and-answer session. Such is the scale of the compliance effort in this area that firms are going to be fine-tuning their MiFID II systems well into next year. Communication with clients will be an onerous task and firms will not only have to satisfy the directive's requirements but also do so in a way that does not cause alarm among their HNW clients. Many are deciding, probably wisely, to educate their clients about the process.

Q: MiFID II will affect wealth managers in many areas. Can you highlight just one topic that you think is causing an implementation challenge for wealth managers?

A: No! It’s a real challenge to pick just one topic because the dominant topics in MiFID II have remained key throughout – commissions and research, best execution, transaction reporting, telephone recording and product governance. Costs and charges disclosure arrangements are emerging as a key implementation challenge which we pick up on below. To identify just one theme would be complexity. Even as we approach MiFID II implementation in January firms are still seeking to interpret ESMA guidance, fit together cross-competing directive implementation requirements like PRIIPS (Packaged Retail and Insurance-based Investment Products) and MiFID II and working through the correct application the FCA intends for firms that manage funds as well as mandates. The complexity of MiFID II and the inconsistency of implementation means that firms will be fine-tuning MiFID II implementation well into next year.

Q: Client communication is an important aspect of MiFID II. What challenges will wealth mangers face with this?

A: MiFID II means clients will have to be informed if their portfolio depreciates 10% or more since the beginning of each reporting period, which can cause the following implementation issues.

• New technology may be required to value model portfolios throughout the reporting period.
• Who in the distribution chain will deliver the notification when the investment manager does not have a direct relationship with the client? MiFID II reporting and periodic statement responsibilities attach to the firm that has the direct relationship with the client.
• Who will tell the client about the purpose of the disclosure, if the firm does not have a direct client relationship, and how will it be explained in the context of the investment strategy and the client’s risk appetite?
• How should the industry engage with intermediaries such as IFAs, who may not fully understand this new requirement and understand the underlying issues, yet have the direct client relationship?

Firms also need to ensure they are reporting the 10% depreciation correctly. Explaining this new requirement to clients will be important to manage expectations and avoid creating unnecessary concern with some investors.

Q: What about product governance? How are firms tackling this?

A: The product governance provisions for MiFID II create a range of challenges for wealth managers. Firms must decide if they are “product manufacturers” or “product distributors” or both. How a firm defines itself will impact which obligations it needs to fulfill.

The aim of the new requirements is to ensure that products are sold to the target market they were designed for: manufacturers need to define who this target market is when they create the product and distributors must understand who the product is intended for before they sell it. If a product is sold to a customer who is outside the definition of the target market, the distributor must justify this decision, but this should be covered by the suitability assessment anyway.

If firms are manufacturers, then they must have a governance program in place that tracks how their products are designed, manufactured and sold. Manufacturers will require information from distributors that will facilitate their own internal product review arrangements. Firms will need to be sure they have the systems and processes in place to ensure products are sold to the intended market. This includes the provision of reporting by distributors to manufacturers about how and to whom the product is sold, compared with its target market.

The format, frequency and granularity of these notifications are still in the process of being worked out by the industry. It’s likely, however, that notification will be on a periodic basis, and possibly on an ad hoc basis if that is specifically requested by the manufacturer, though this may create logistical problems for the distributor if the format and frequency of the reporting is not standardised, or at least agreed between manufacturer and distributor.

Q: We’ve heard a lot of talk about LEIs (Legal Entity Identifiers) and transaction reporting. What’s the issue here?

A: The LEI is a 20-digit alphanumeric code which is specific to individual legal entities; it will be used by regulators to identify the parties in transactions, to help detect potential market abuse.

The rules state that LEIs must be provided on the required transactions for all entities involved in the transaction, including the buyer, seller, entity executing the transaction and any transmitting entities. Wealth Managers will therefore need to populate LEIs for their clients.

In theory, these LEIs should be obtained by the clients and passed on to the wealth manager. However, wealth managers are finding this challenging, especially when it comes to 'educating' clients about why this is necessary and obtaining the LEI information in good time to provide services to them. We know of firms that have taken it upon themselves to obtain LEIs on behalf of their clients – in some cases charging a fee for this – to ensure compliance.

However, this will also involve the firm having to renew the LEI annually, which itself comes at a cost and creates resourcing problems for wealth managers.

The incorporation of LEI details into transaction reports by 3rd January will be just one of the many technical things that firms have to do. Some wealth managers are choosing to outsource the process of MiFID II transaction reporting, though there will be limits on how far they can delegate responsibility for the information that is submitted.

Firms should ensure that they can continue to support MiFID II transaction reports after the starting date in case of any errors that ought to be corrected, or cancellations that ought to be made.

Q: MiFID II requires firms to disclose information about costs and charges for financial instruments and additional investment services. What trouble could this cause?

A: MiFID II will require wealth managers to be much clearer about the fees they are charging. That should be good news for clients, who will find it easier to compare costs and shop around but the very reporting designed to increase transparency may have a significant impact on wealth managers resources and therefore the costs clients need to pay. Additionally, there is a risk that inconsistent disclosure formats and standards will be implemented, creating more confusion for investors.

Firms might have trouble providing information about certain charges in advance. For example, some fees are affected by portfolio values, while time-based fees will also call for value-added tax to applied in some circumstances but not in others. Margins that are built into an instrument’s price ought to be disclosed as well. Firms will have to decide which fees can be provided in advance and whether these are actual or estimated values. They should also try to anticipate their clients' reactions to this information.

Firms must decide how they will provide these disclosures - perhaps through a portal, or in an email or letter. If a firm is offering more than one method of communication, the client must confirm his preferred method of receiving this information. Firms may also wish to amend their terms of business to reflect these new disclosure-related preferences.

The additional level of transparency for costs and charges will probably require firms to beef up their systems and data collection, while overhauling existing standards of disclosure. Wealth managers may ask data providers to collate and distribute information to clients - a number of solutions are emerging in this area.

Q: What guidance is coming in late? Are the delays interrupting firms' preparations badly? 

A: We have had final rules from Europe for a while, and now (on July 3rd) have the Financial Conduct Authority’s final rules (pending information for specialist firm types such as occupational pension scheme or OPS firms). The only additional guidance that we might expect is L3 from the European Securities and Markets Authority in the form of questions and answers that should provide guidance and make things clearer but not introduce anything new. The FCA published its second policy statement on this subject at approximately the time it said that it was going to. This is perhaps what many firms have been waiting for in order to get their implementation programmes moving.

* Jonathan Wilson can be reached on +44 20 7408 2448 or at jonathan.wilson@cordium.com