The UK's Wealth Management Association delineates the problems that private banks and asset managers will face when the European Union's Markets in Financial Instruments Directive (Mark II) comes into force. Expensive systems upgrades will be the order of the day.

In the last few days ESMA, the European Union's overarching markets regulator, faced questions from banks and trade bodies about the Markets in Financial Instruments Directive, Mark II, at a meeting in Paris. Among the questioners was Ian Cornwall of the UK's 14-man Wealth Management Association. Yesterday, he and his colleague John Barrass told Compliance Matters aboutthe WMA's concerns over this upcoming 720-pagedirective and its accompanying regulation, MiFIR.

The two regulatory experts were understandably worried about the costs that they expect the directive, when completed, to impose on their 250 member-firms, which consist of discretionary fund or portfolio management businesses, wealth management firms and the professional firms that serve them. At this stage, said Cornwall, “there's not enough detail for us to determine costs”. This did not, however, stop the two experts from pointing out the likely areas of additional expense. Cornwall added: “MiFID II is not as great as MiFID I in terms of headlines, but there is a massive series of projects that firms will have to manage.”

When good Europeans attempt too much

On the general subject of how wealth management firms should treat customers, the UK is facing some confusion because three overlapping regimes: “treating customers fairly” or TCF, with its six principles; the Retail Distribution Review which began to bite a couple of years ago; and MiFID with its impending upgrade. Cornwall asked an often-asked question and came up with his own answer: “Will there be an RDR II to clean up the mess? In my own view, we ought to change the RDR to match what's happening in Europe. We're all good Europeans now.”

The EU has come out with many directives (laws which have to be enshrined in the law of member-countries) and regulations (laws which take immediate effect without such transposition) under Michel Barnier, an EU commissioner who deals with financial supervision, but as he is to be replaced in November, Barrass regarded him as a 'lame duck' and expected no new policy until then. On a critical note, Barrass noted that the EU had plenty of legislation still outstanding, notably the fourth money-laundering directive; some data protection legislation; money-market funds legislation; and a regulation to do with benchmarks, i.e. indices (statistical measurements) such as LIBOR, 'calculated' (i.e. fabricated) from underlying data, that are used as reference prices for financial instruments or to measure the performance of investment funds. He took all this to mean that “too much is being attempted.”

On the other hand, the WMA's literature credits the European Parliament, which most people do not see as a proper parliament, with being the “first ever EP with real legislative power” and says that it has not only voted MiFID II and an accompanying regulation (MIFIR) into EU law, but also PRIIPS (packaged retail investment and insurance-based investment products) rules, MAD/MAR (the second market abuse directive and an accompanying regulation) and CSD/R (the central securities depository regulation), all of which are “key for our sector.”

In the almost impenetrable double-talk of the European Union, the MiFID legislation has now reached 'level 1' with the enactment of vague principles and rules that will, after 30 months or so, be binding on all relevant entities. 'Level 2', on which ESMA has been consulting interested parties, will consist of “non-essential technical details and implementing measures.” Once the responses – including the WMA's – are all in, new regulations will come. The deadline seems to lie in August. Cornwall commented: “we only got the first 'level 2' paperwork two months ago. There are bits of what we want to re-write even now. We've had to race through this lengthy stuff and it's very hard to get the firms engaged because they have the day job.”

The impact of MiFID II and MiFIR

On the subject of rules to protect investors from sharp practice, the new law will make things even tighter for firms than its predecessor MiFID I, which came into force in 2007. Unlike its predecessor, however, the change it engenders will not be 'iconoclastic', in Barrass' words.

“People shouldn't be frightened. It's not as dramatic as its predecessor, although it's quite tough in some areas. On the market side, more is new – it covers organised trading facilities [Europe's rough equivalent of the US swap execution facility], consolidated tape [a speedy electronic system that reports the latest price and volume data on sales of exchange-listed stocks] and the handling of dark pools [electronic alternative trading systems, very similar to stock exchanges but secretive, as allegedly abused by Barclays]. Even here, fundamental changes to create competition between trading venues were in MiFID I. Some of MiFID II/MiFIR is a response to market fragmentation and information distortions thrown up by MiFID I, including the industry's request for consolidated tape. This is for the larger firms but doesn't affect us a lot.”

“Our top five problems”

Barrass and Cornwall had a list of the top five problems that they had identified in the new legislation. In other words, they had identified the areas in which changes to administrative and IT systems were probably going to be the most expensive. These were, in no particular order:

• trading volumes;

• transaction-monitoring;

• telephone recordings;

• disclosures of costs; and

• loss thresholds of discretionary managers.

Let us deal with each in turn.

The execution of orders: what are 'trading volumes'?

Under the new directive, investment firms that execute clients' orders will have to make public (annually, for each class of financial instrument) the top five execution venues in terms of trading volumes where they executed clients' orders in the preceding year and information about the quality of execution obtained. Cornwall was full of doubt about this.

“Our problem here is going to be the sheer cost of producing the data. What is meant by the terms 'each class of financial instrument', 'trading volumes' and 'quality of execution obtained'? That last is a pretty tricky one. What is the time period to produce the data? There are potentially huge system costs with little benefit for retail clients.”

Transaction reporting

This is one of the areas of MiFIR that appears to be set in stone already. Cornwall said: “What's in the regulation is pretty much what's going to come in. There's not much wiggle-room.” Andy Thompson, the WMA's director of operations, then led Compliance Matters through three main issues.

1. The transmission of an order. An investment firm that transmits orders to another investment firm will still be able to rely on that firm to report the transactions but – and it is a big but – the transmitting firm will be obliged to provide much more information to the receiving firm than ever before and there must also be a written agreement between the two regarding the obligations that both parties have over this. Thompson added: “There's much more ownership. There has to be a contract between the two about who does what...or the manager can report it himself.”

2. 'Client identifiers'. This is problematic in a country such as the UK that still lacks some of the trappings of a police state. On the continent of Europe, governments of an authoritarian frame of mind – which was practically all of them – forced their citizens to carry papers during the war and never managed to kick the habit afterwards. The UK gave up national ID cards in 1954 and is still having trouble trying to force the next generation of them on Britons. Thompson remarked: “For natural persons the obvious substitute for a national ID number is likely to be a national insurance number, but some firms don't collect these. A passport number might do. For legal persons, there has to be a 'legal entity identifier' and the client must apply for an LEI before it can commence or continue trading. This has been in the press over the last year or two, but trusts aren't defined as 'legal persons' – they're 'legal relationships', according to STEP.” STEP is the Society of Trust and Estate Practitioners.

MiFID is not clear on the subject of trusts – in the words of a senior client advisor at Stanhope Capital, “the French don't 'get' trusts. They don't understand them.” A discussion paper that ESMA published on 22 May admitted that the organs of the EU must apply further consideration to the question of how to identify joint accounts, power of attorney and accounts held on behalf of minors. As Thompson put it: “They themselves [the Europeans] haven't come up with an idea of how to report these transactions. At the moment there are 23 fields I think in a transaction report. About 90+ will be in a transaction report when this comes in. Some existing fields will change. This is definitely in the 'top five' of system changes.”

3. Trader ID. This, said Thompson, is going to be problematic not just for firms in the WMA's audience, but “right across the piece.” There are two areas where people or entities have to be allotted IDs.

(i) For execution-only and advisory trades, there has to be identification for the “trader who pressed the button to initiate the execution.” One example of this is the person who presses the button to submit the order to the order management system.

(ii) For discretionary trades, the person responsible for making decisions has to be identified. If a committee makes the decision, there has to be a separate trader ID for each committee.

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A recent paper from the accountancy firm of Deloitte's states: “The discussion paper sets out 93 data attributes which firms may need to populate when submitting a transaction report, an increase from the current 25 attributes. Previous experience from MiFID I implementation demonstrated the difficulties firms can face in reporting accurately. There will be an increased dependency on static data for reporting (e.g. the identification of the trader or the algorithm). Firms should be thinking about the adequacy of their existing data systems now.”

Recording of telephone conversations or other electronic communications

MiFID II sets out a new regime here for communications regarding client orders.. On this topic Cornwall began: “It's not that new for us. We do it already. The main concern is cost. Rather than recording 6 months you're probably going to have to record 7 years. Indexing the data to make it possible to find this-or-that call from 7 years ago – that's where the money is. You might have to find out if Bill took that call at that particular desk in the building across the road years ago.”

This was an allusion to the MiFID policy that records of telephonic interactions with clients must be recorded for 5 years and not the current 6 months; the regulators can ask firms to retain them for 7 years if it so pleases. Many 'new' requirements – written recording policies, staff training, the monitoring of records – are already built into firms' existing arrangements.

There are to be notes of face-to-face meetings between wealth management firms and clients. ESMA is proposing that clients should be made to sign such notes, which the WMA thinks is probably going to be burdensome for firm and client alike.

Lastly, every client ought to receive relevant records if he asks for them. The WMA suspects that this might not be practical and that there are implications here for complaint-handling and interaction with the Financial Ombudsman Service.

Information to clients about costs and charges

MiFID calls for the disclosure of all costs and charges in connection with the investment service in question. Each firm will have to disclose its own charges; the costs and charges associated with the client's investment holdings; and any receipt of any third-party payments, i.e. inducements.

Disclosures should be 'before the event' ('ex ante') and 'after the event' ('ex post'). Each should be an “illustration showing the cumulative effect of costs on return when providing investor services.” Cornwall commented: “The ESMA advice provides no illustration of what the illustration should contain, so we don't know about this. It's difficult from the wording to identify exactly what has to be reported and in what format.

“This is going to be a huge cost to firms. The system costs are likely to equal telephone numbers. And, as I say, it has to be disclosed annually to the client.”

This is actually what point 59 of the ESMA 'consultation paper' (ESMA/2014/549) of 22 May states.

“ESMA considers that an investment firm should be obliged to provide its clients both ex-ante and ex-post with an illustration showing the cumulative effect of costs on return when providing investment services, such as portfolio management and investment advice. The illustration should help the client to understand the overall costs and should increase the client’s understanding of the cumulative effect of costs and charges on the investment. The illustration can be a graph, a table or a narrative and should be provided at the point of sale. When providing the illustration the investment firm should ensure that the illustration meets the following high level requirements:

i the illustration shows the effect of the overall costs and charges on the return of the investment;

ii the illustration shows any anticipated spikes or fluctuations in the costs, such as high costs in the first year of the investment (upfront fees), lower costs in the subsequent years (on-going fees) and higher costs at the end of the investment (exit fees); and

iii the illustration is accompanied by an explanation of what the illustration shows.”

Far from being confusing as the WMA supposes, this appears to be quite well-expressed. It may, however, have been mangled since 22 May in a European parliamentary re-write.

Cornwall concluded: “One point is that a lot of the investor-protection is not just retail-focused like us. Some of the investor-protection provisions have been widened to take in professional clients. Also, PRIIPS is a document you have to hand to clients. That'll happen in 18 months' time.”

Reporting to clients, including loss thresholds

Cornwall disclosed: “Most clients already whinge about the volume of papers they get. They can't opt out of reports. At the moment, if the client wants it annually he has to write to ask for it annually. If he doesn't, it's six-monthly. Now it's going to quarterly.”

This is an allusion to the new rule that reporting must be quarterly as regards valuations and safe custody statements. The focus will have to be on performance and not costs. There is to be no client opt-out this time. The regime, furthermore, is to use loss thresholds for discretionary accounts that are agreed with the client – 10% or 20% or 30% etc. – in multiples of 10%. The way Cornwall put this made it sound as though the client was to have even more control here: “you have to have them in accordance with what the client elects.”

Article 42 of the MiFID Implementing Directive currently requires additional reporting where “investment firms provide portfolio management transactions for retail clients or operate retail client accounts that include an uncovered open position in a contingent liability transaction”. The application of these requirements has raised some uncertainties over the scope and the effects of this obligation.

In note 20 of its letter, ESMA says that it thinks that this requirement should be modified in order to “clarify that the agreement of loss thresholds triggering the reporting obligation is an obligation and not an option for firms. Specific predetermined thresholds could also be identified (e.g. 10 % (and multiples of 10%) of the initial investment or the value of the investment at the beginning of each year.”

Cornwall believed that this proposal lacked detail, especially as regards cash movements, individual holdings as opposed to whole portfolios, transfers between spouses and transfers to individual savings accounts or ISAs.

Target markets

The ESMA 'consultation paper' mentions the phrase 'target market' 40 times. Firms will have to ensure that each product they manufacture and/or offer and the distribution strategy they adopt for each are consistent with the identified target market, both from the outset and from time to time thereafter.

One example among many states: “Member states should ensure that the investment firms which manufacture financial instruments ensure that those products are manufactured to meet the needs of an identified target market of end clients within the relevant category of clients, take reasonable steps to ensure that the financial instruments are distributed to the identified target market and periodically review the identification of the target market of and the performance of the products they offer.”

The WMA's problem with this crucial phrase, despite its repetition, is that it is ill-defined: “We're at a loss as to what that term means.”

A lack of clarity

Plenty of other things in the MiFID II/MiFIR legislative process are ill-defined as well. The WMA's experts told Compliance Matters that terms such as 'costs', 'switch', 'suitability' needed further elaboration, as did things such as the amount of reliance a firm might place for compliance on other parties such as internal auditors. The UK's Financial Conduct Authority is not planning to publish any determination about how it will handle MiFID's relationship with RDR until the autumn of next year.

A dismal year

Whatever the ESMA papers say at the moment, the eventual outcome of this legislative exercise is going to be a series of expensive systems upgrades. Ian Cornwall predicted: “There will have to be a lot of prep on the part of firms, mainly starting in the last six months of 2015. They'll have to do some prep then. John Barrass added: “The best we can do is to say the sort of things you'll have to think about. 2016 is going to be a pretty dismal year for firms.”