Following MiFID II coming into force in July 20145, the focus is now on the significant amount of delegated legislation and technical standards that need to be put in place prior to the MiFID II provisions becoming effective in the EU in January 2017. Many of these technical standards are to be drafted by the European Securities and Markets Authority (ESMA).
ESMA published an initial Consultation Paper and a Discussion Paper in May 2014 setting out its initial views on a number of issues. It followed-up on these papers on 19 December 2014 by publishing its final technical advice to the EU Commission6 and a second Consultation Paper7 (which contains a number of draft regulatory technical standards (RTS) and implementing technical standards (ITS)).
A few areas of note from the Consultation Paper and technical advice are set out below:
Under MiFID II, ESMA is to provide technical advice on detailed product governance arrangements for investment firms manufacturing and distributing financial instruments and structured deposits. Having considered the responses from its earlier consultation, ESMA states that the technical advice now clarifies that, for the purpose of the product governance requirements, investment firms that create, develop, issue and/or design investment products should be considered as “manufacturers” for the purpose of the rules. ESMA states that the product governance rules should apply in a way that is appropriate and proportionate taking into account the nature of the investment product, the investment service and the target market.
In the technical advice, ESMA sets out separate product governance obligations for manufacturers and distributors. Manufacturer requirements include:
- the firm must maintain procedures and measures to ensure that the design of the product complies with the requirements as to the proper management of conflicts of interest;
- the firm’s compliance function must oversee the development and periodic review of product governance arrangements in order to detect any risk of failure by manufacturers to comply with their obligations;
- when manufacturing products, a firm must identify the potential target market for each product and be able to specify the type(s) of client for whose needs, characteristics and objectives the product is compatible;
- the target market must be identified at a sufficiently granular level to ensure the exclusion of investors for whose needs, characteristics and objectives the product is not compatible; and
- firms must consider the charging structure proposed for their products, including checking that costs and other charges are compatible with the needs, objectives and characteristics of the target market and do not undermine the return expectations of the product.
Requirements for distributors include:
- when deciding the range of investment products that will be offered, firms must have in place adequate product governance arrangements to ensure that products and services to be offered are compatible with the needs, characteristics and objectives of an identified target market and that the distribution strategy is consistent with such target market;
- when deciding the range of investment products and services to be offered and the target markets, firms must maintain procedures and measures to ensure compliance with all applicable MiFID II requirements, including those relating to disclosure, suitability, appropriateness, inducements and conflicts of interest;
- firms must review the investment products they distribute and the services they provide on a regular basis taking into account any event that could materially affect the potential risk to the identified target market and assessing whether the product or service remains consistent with the needs of such target market; and
- the management body must have effective control over the firm’s product governance process to determine the range of investment products to be distributed and the needs, characteristics and objectives of the identified target market.
Complex Products and Suitability/Appropriateness Assessments
ESMA is required to provide technical advice on certain aspects of requirements under MiFID II that firms make suitability or appropriateness assessments of their clients in respect of the provision of relevant financial services and activities, including provisions relating to complex and non-complex financial instruments. This is particularly relevant in relation to the application of the “execution-only” exemption under MiFID II where firms providing certain non-advised services or activities do not have to make any assessment as to suitability or appropriateness. This exemption is only available in respect of the instruments specified in Article 25(4) of the MiFID II Directive.
In addition to specifying specific instruments that benefit from the exemption, Article 25(4) contains a general category of “other non-complex financial instruments”. ESMA notes that Article 25(4) specifically excludes certain instruments from the list of products that can benefit from the execution-only exemption, including (i) shares embedding derivatives, (ii) structured UCITS and (iii) bonds or securitised debt embedding a derivative or incorporating a structure which makes it difficult for the client to understand the risk involved. ESMA states that such instruments should be excluded from provisions in delegated legislation specifying which instruments should come within the meaning of “other non-complex financial instruments” (currently contained in Article 38 of the existing MiFID implementing directive). ESMA’s position is consistent with the view of its predecessor (the Committee of European Securities Regulators (CESR)) that an instrument expressly excluded under Article 25(4) should not be brought back in under Article 38.
ESMA recommends adding two additional criteria to the current Article 38 criteria as to the requirements to be satisfied before an instrument can be non-complex:
- there is no clause, condition or trigger that could fundamentally alter the nature or risk of the investment or pay-out profile (e.g., a right to convert the instrument into a different investment); and
- there are no explicit or implicit exit charges that have the effect of making the investment illiquid.
In relation to the concept of a “structure which makes it difficult for the client to understand the risk involved”, ESMA notes that it is required to produce guidelines on this issue and that it is taking this work forward.
Transparency for Bonds, Structured Finance Instruments and Derivatives
In the Consultation Paper, ESMA undertakes detailed consideration of what constitutes a liquid market for the purpose of MiFID II Regulation. This is relevant in the context of the new pre-trade transparency requirements for bonds, structured finance instruments and bonds where competent authorities are permitted to grant waivers from such requirements in certain circumstances, including in relation to financial instruments for which there is not a liquid market. As required by MiFID II, ESMA focuses on average frequency and size of transactions, number and type of market participants, and average size of spreads. It proposes determining liquidity by dividing each asset group into more granular classes that share largely homogeneous liquidity characteristics and then sub-dividing such classes further by factors such as maturity, issue sub-type and issue size (for bonds) and derivative type, number of instruments, number of trades and total notional amount (for derivatives). Its conclusions for each sub-class are set out in detailed tables in the Consultation Paper.
Exchange Trading of Derivatives
In relation to determining whether a derivative is sufficiently liquid to be subject to the exchange trading requirement, ESMA considers similar factors as in relation to the transparency requirement and indicates in many cases that the thresholds will be the same or very similar as in relation to the test for the transparency rules, but this will not necessarily always be the case.
Considering that the Consultation Paper and technical advice run to well over a thousand pages in aggregate, the consultation period is short and concludes on 2 March 2015. A public hearing is set for 19 February 2015 in Paris. Following the end of the consultation, ESMA will seek to commence the process of finalising its draft RTS and ITS for submission to the EU Commission with it expected to submit the bulk of the RTS to the EU Commission by the end of 2015.