BACKGROUND

As mentioned in our February 2016 Client Briefing, the European Commission has extended the MiFID II application deadline by 1 year to 3 January 2018 (although the legislation to give effect to this has not yet been finalised). The extension does not affect the timeline for the adoption of the Level 2 implementing measures required by MiFID II. Under MiFID II, MiFID investment firms (Firms):

  • must safeguard client financial instruments and funds;
  • will be subject to detailed product governance rules where they manufacture and/or distribute financial instruments; and
  • must comply with strict rules on inducements (i.e. fees, commissions or any monetary or non-monetary benefits).

DRAFT DELEGATED DIRECTIVE

The Commission received Technical Advice from ESMA on 19 December 2014. Following that, on 7 April 2016, it published a draft Delegated Directive specifying rules across the three areas listed above. The draft Delegated Directive will now be considered by the EU Council and European Parliament. If neither objects, it will be published in the Official Journal.

SCOPE

In addition to Firms, the draft Delegated Directive will apply to both UCITS and AIFMD management companies when performing MiFID investment services that they are authorised to provide.

Credit institutions are in scope (when providing investment services and/ or performing investment activities), and references to “financial instrument” include “structured deposits”, in each case to the extent specified in Articles 1(3) and 1(4) of the MiFID II Directive.

SAFEGUARDS FOR CLIENT FINANCIAL INSTRUMENTS AND FUNDS

  • General safeguarding obligations

The draft contemplates obligations being imposed on Firms to: » keep records and accounts in a manner that enables the Firm to:

  • distinguish a client’s assets from other clients’ assets and from the Firm’s assets; and
  • ensure their accuracy;
  • regularly reconcile their records and accounts with those of third parties;
  • appoint a single officer with overall responsibility for safeguarding client instruments and funds;
  • ensure that client financial instruments deposited with third parties are separately identifiable;
  • ensure that client funds deposited in banks or qualifying money market funds (MMFs) are held in accounts that are separately identified from those that hold funds belonging to the Firm itself (explicit client consent must be obtained to depositing funds in qualifying MMFs);
  • introduce arrangements to minimise the risk of loss or diminution of client assets or related rights as a result of misuse, fraud, insufficient administration, inadequate record-keeping or negligence; and
  • where the Firm is obliged to enter into an arrangement that creates security or set-off rights over client financial instruments or funds, disclose that fact (and the related risks) to affected clients and record that information in client contracts and in the Firm’s accounts. 

 

  • Placing funds

Member States must:

  • allow Firms to deposit client financial instruments with third parties subject to certain conditions being met; and
  • oblige Firms, on receiving any client funds, to place those funds into accounts with a central bank, credit institution, non-EEA bank or qualifying MMF. If the entity with which those funds are deposited is part of the Firm’s group, no more than 20% of all such funds can be deposited by the Firm with that entity (subject to limited exceptions).

In placing funds, Firms must consider diversification and mitigation of risks.

  • Title transfer; securities financing

The draft also specifies measures dealing with:

  • the appropriate use of title transfer collateral arrangements when dealing with professional clients and eligible counterparties, and the explanation of risks to those clients (Firms cannot conclude title transfer collateral arrangements with retail clients); and
  • obtaining client consent to, and meeting other conditions in connection with, the use of a client’s financial instruments in securities financing transactions.

PRODUCT GOVERNANCE

The product governance requirements are relevant to Firms that manufacture and/or distribute financial instruments. Where a Firm does both, there is no obligation on it to duplicate the performance of obligations that apply equally to manufacturers and distributors.

  • Firms that manufacture financial instruments

For these Firms, obligations are imposed relating to:

  • managing conflicts of interest;
  • ensuring that staff have the requisite expertise;
  • controlling the management process;
  • assessing potential target markets at a sufficiently granular level;
  • assessing the risk of poor investor outcomes and when these could occur (i.e. market deterioration or the instrument not being commercially viable);
  • considering the charging structure of products, in particular by reference to the objectives and characteristics of the target market;
  • providing adequate information to distributors; and
  • regularly reviewing products and governance arrangements.

 

  • Firms that distribute financial instruments

For these Firms, the draft sets out obligations relating to:

  • ensuring that products and services, and the related distribution strategy, are compatible with the characteristics, objectives and needs of an identified target market;
  • obtaining sufficient information from manufacturers to enable them to understand the products they intend to distribute;
  • ensuring that the Firm’s management body has effective control over the product governance process; and
  • periodically reviewing and updating product governance arrangements.

INDUCEMENTS

  • Enhancing quality of service

As part of their obligations to:

  • take all appropriate steps to identify and to prevent or manage conflicts of interest; and
  • act honestly, fairly and professionally in the best interests of their clients,

Firms must ensure that inducements paid or received are designed to enhance the quality of the relevant service to the client.

The draft sets out the criteria that must be met for an inducement to be regarded as enhancing the quality of the service to the client:

  • it must be justified by the provision of an additional, or higher, level of service;
  • it must not directly benefit the Firm (or its shareholders or employees) without tangible benefit to the client; and
  • for ongoing inducements, there must be ongoing benefits to the client.

 

  • Records and disclosure

Firms must keep records of:

  • inducements received;
  • how inducements paid or received enhance the quality of service to the client; and
  • disclose certain information in relation to inducements to clients.

 

  • Investment advice on an independent basis/portfolio management:

Firms that provide investment advice on an independent basis, or portfolio management, must:

  • return or transfer related inducements to clients;
  • put a policy in place to manage those transfers; and
  • only accept “minor non-monetary benefits” that meet certain conditions and are unlikely to influence the Firm’s behaviour in a manner detrimental to clients.

 

  • Inducements relating to research:

The draft confirms that research provided by a third party to a Firm will not be treated as an inducement if it is received in return for:

  • direct payment from the Firm; or
  • payment from a separate research payment account controlled by the Firm (subject to certain conditions, including that it be funded by specific research charges to the client).