MiFID II challenges
Dominic Müller and Luke Nelson take a look at the main implications from the FCA’s third MiFID II consultation paper
The Markets in Financial Instruments Directive II (MiFID II) takes effect on 3 January 2018. As part of the process leading to its arrival, the FCA released a third consultation paper (CP), published in the autumn, focusing on the conduct of business rules and product governance. The core aim of this is to bring fairness and transparency for investors.
Investor prorection
Preparing for investor protection provisions has been a gradual process for UK firms, including absorbing clarifications at the EU level and the FCA’s plans for transposition. The FCA’s third consultation provided welcome clarity, but underscored longstanding challenges.
Overall, the FCA has put a distinctive stamp on MiFID II by extending it in certain areas or fleshing out possibilities left open by the statutory text. The proposals provide much-needed clarity on the transposition (despite certain elements, such as research charges) that change how business is done.
Many remaining questions may only be clarified when firms start conforming, or when the regulator reviews their progress. The FCA’s indication that it does not plan to extend the ban on inducements to restricted advice given to professional clients drew a sigh of relief – as they would have expanded the compliance burdens by applying the inducements rules to the firm’s entire client base. Firms are sensitive to the impact of these rules on business models and operational requirements, so shielding an important segment of the market should be a comfort. But firms are still concerned that insufficient clarity has been provided to demonstrate that inducements (when allowed) enhance the service quality to clients. As professional clients have deeper expertise, and as the identification of advice as restricted clearly puts clients on notice that firms are pushing their own products, the FCA did not feel that the extension of the inducements compliance requirements for such activities was warranted.
Firms have struggled with this issue under MiFID I’s business conduct rules. The apparent contradiction is resolved in that the Commission provides a few examples in the Level 2 text as to what qualifies as service enhancement, but that still leaves firms with a number of interpretative questions for activities that are not covered by the Level 2 examples. The European Commission’s Level 2 text focuses on whether inducements increase the client’s access to a range of financial instruments and provides examples of what may enhance service. While helpful, it is unlikely
these will be the only factors the FCA will look at in making such determinations.
Since the regulator has yet to provide guidance, firms will need their own quality enhancement tests without regulatory clarification. It is unlikely firms will refrain from any business solely on this account but it remains an area of uncertainty.
Firms also face heightened regulatory consequences for ensuring they are tracking and monitoring revenue sources accurately. While this should have always been done, and while the application of these rules to the paying firm provides a safeguard, firms need to now ensure they can identify which commissions must be rejected, which can be received but rebated and which can be accepted. For many this will be a significant operational challenge, but one that is critical to avoid violating the core purpose of the inducement rules, which is to ensure that the integrity of investment advice and management is not swayed by benefits received by the asset manager from those selling financial products to it.
Valuing research
MiFID II offers a separate regime for research because it can benefit clients, provided the costs are accounted for. The FCA’s clarification that research budgets can be set across investment strategies means concerns around establishing budgets per client have been alleviated. Although the research budget can cover multiple clients,
the Level 2 text requires research payment accounts (RPAs) to be aligned to individual clients. Even though the sell-side will have to unbundle research from execution costs, the research will be produced for a general audience as opposed to individual clients. As a result, firms must make complex cost-allocation decisions when the benefits of research to clients may be hard to assess and may change. It will be challenging to estimate charges as part of client disclosure since the value of the research to a client will only be known after it’s been purchased, making it hard to stay within the budget expectations. The MiFID II documentation and quality enhancement requirements will force firms to identify cost-benefit linkages between research and clients – a learning process as it departs from how research has been consumed.
The Level 2 text indicates research charges can be collected alongside transaction charges (provided the research charge is not dependent on the volume of transactions and execution costs). So some of the features of current commission sharing agreements (CSAs) will possibly survive, even though aligning with RPA requirements will mean notable changes. It will be unlikely firms continue to refer to them as CSAs. For example, it is unclear whether multi-client CSAs will be possible if research costs need to be accounted for on a client-by-client basis.
Rethinking practices
The FCA’s proposals clarify that many of the traditional CSA practices will need to change. Research charges must be immediately diverted to a ring-fenced RPA, which would prevent brokers from retaining research charges directly. Since the sell-side often administered CSAs, this will impose management responsibilities onto the buy-side firms and force asset managers to alter how charges are routed and handled.
The related research disclosure rules could be a double-edged sword. The requirements impose an operational burden and regulatory exposure for accurate disclosure, but will also provide a mechanism to track, quantify and allocate research costs. Firms using RPAs will need to regularly assess research quality, document how client portfolios are benefited and provide audit trails of payments to research providers. In reality, firms would need to collect and analyse this information to ensure that the RPA requirements were being met, but additional disclosure obligations mean the FCA will have a means by which to assess compliance. These disclosures also provide a common frame of reference between the regulator and firms to arrive at clearer and more specific expectations on governance of these accounts.
One area where the FCA’s consultation arguably injected more confusion than clarification was the scope of investment advice subject to inducement rules. The FCA wants the definition of advice for the MiFID adviser charging rules to include broader activity than a personal recommendation. At the same time, the Treasury is consulting on limiting regulated investment advice to when a personal recommendation is given. The FCA has indicated it will wait to see what the Treasury decides. As the Treasury is likely to focus the definition on personal recommendations, it is unlikely the FCA will follow through on its proposal. Firms should monitor shifts in the scope of advice and how it is applied differently for inducements than other areas, as getting it wrong could inadvertently mean violating MiFID II requirements.
The FCA’s decision to apply the MiFID independence standard across both professional and retail client advice will provide welcome consistency and clarity. Given the independence standards under MiFID II and the Retail Distribution Review (RDR) are so similar, any widespread changes to the scope of advice offerings will be unlikely. Currently, independence can be demonstrated to a relevant market – as opposed to the whole market – and MiFID II reinforces this pre-existing approach by focusing on unbiased advice as opposed to comprehensiveness. The consultation also suggests independence can be based on markets limited to broadly defined products, such as pensions, which would be a welcome option for some firms.
Compliance challenge
Another challenge is the enhanced product governance requirements. In particular is identifying target markets to ensure compliance with product governance requirements and ensuring information flows between manufacturers and distributors, to monitor if the target market is being reached. This is especially true from the perspective of product manufacturers receiving information from multiple distributors, who may fail to present the information consistently. Once such discrepancies are ironed out, manufacturers should receive management information
around who their end investors are.
Related to this, manufacturers sometimes face logistical challenges in conveying information to a network of distributors. Concerns distributors had about getting information from UCITS and AIF management companies (since they are not directly regulated by MiFID II) have been lessened by the FCA’s indication that it intends to apply MiFID II product manufacturing requirements to non-MiFID firms as guidance.
The FCA is likely to be proportionate to product governance, have lower expectations around more vanilla products and will prioritise the supervision of structured instruments. Once confirmed, it will allow firms to concentrate on products that are arguably the least transparent and most potentially harmful if sold to inappropriate investor classes.
The FCA’s transposition of MiFID II will result in a complicated rule book. For many firms, the complicated landscape applies for a global business. There is still a lot to assess before aligning operational processes to MiFID II obligations, but the FCA’s consultation at least provides a clearer sense of how those obligations will be transposed in the UK.