MiFID II came into force on 3 January, imposing very extensive changes to the regulatory regime for investment firms and other participants in investment markets. The idea behind it? To protect investors and ensure that financial markets operate fairly and transparently. But what has changed and what impact will those changes have? Financial Services and banking lawyer Tony Watts explains what you need to know.
The most striking thing about MiFID II is the sheer size of the legislative package that is involved. It consists of the MiFID II Directive, the MIFIR Regulation and a heavy package of level 2 and 3 measures (delegated and implementing acts, regulatory technical standards, implementing technical standards, guidelines and recommendations) as well as additional rules and guidance introduced by national regulators. This work will be ongoing – further material and measures can be expected from the FCA.
Many larger firms will be well prepared for MiFID II. Small and medium-sized firms have fewer resources to deal with the heavy demands made by the new rules. They may still be carrying out their implementation plan (and some may have overlooked the significance of MiFID II for them altogether). All firms are likely to face a period when they must digest and embed the changes.
The FCA understands the challenges. It has stated that it will not take enforcement action against firms for not meeting all requirements straightaway if they have taken sufficient steps to meet the new obligations by the start date. It’s not clear how long this window will remain open and what the degree of tolerance is. It is certainly very advisable for firms to complete their preparations as a matter of urgency.
This note deals with some of the areas which have in my experience raised significant issues for small to medium-sized firms of various kinds – including investment managers and advisers, brokerage firms, fintech firms (such as direct investment platforms), retail CFD and derivatives firms and banks. It is selective and is not a checklist; all firms should carry out their own impact analysis. MiFID II ranges much wider than the areas dealt with below. By way of example only, it includes complex requirements on transparency and trade reporting and position limits for commodities trading.
Permissions and scope
The range of financial instruments to which MiFID II applies remains broadly the same, with the addition of some commodity derivatives (so firms operating in these areas should confirm their position). Some conduct-of-business rules will also apply to structured deposits, though these are not technically included as financial instruments.
The scope of exemptions, however (i.e. where a regulatory authorisation or permission is not needed), has been reduced so firms with exemption from authorisation for some or all activities should have considered their position. In particular, the scope of exemption for firms who deal only on their own account (and not for clients) is now narrower.
A major change is that MiFID II introduces a new form of trading venue – an Organised Trading Facility (“OTF”) which facilitates trading in bonds and derivatives. This activity is widely defined. Operating an OTF requires a specific FCA permission. Because the definition of an OTF is wide, some firms offering secondary markets (such as direct investment or crowdfunding platforms) may fall the wrong side of this definition and should consider their position.
If they have not already done so, firms should review whether their regulatory status covers their present activities.
In any event, some FCA rules applying MiFID are extended to firms which would otherwise be outside them – such as MiFID Article 3 firms (a category which will include many high-street IFAs) or collective portfolio management firms (exempt under MiFID Article 2) so these firms should also consider the rules as extended to them.
While some MiFID II requirements appear superficially similar to the old rules, as extended they are in effect more onerous. Areas where particular issues arise are:
- Product governance – Distributors and manufacturers of financial products must have robust policies and procedures in relation to introducing and monitoring financial instruments which they manufacture or distribute.
- Conflicts of interest – MiFID II requirements are in effect much stricter than the previous rules. They have a far greater emphasis on prevention of conflicts which have a risk of detriment to clients. Disclosure of such conflicts should be regarded as a last resort, rather than a solution to the problem. Both the FCA and ESMA have expressed concern about policies (and summaries of them provided to clients) which are high level and formulaic, simply restating the rules and adding commitment to comply with them. Conflicts policies and summaries of them for clients must be more specific detailing actual conflicts that arise in relation to the firm.
- Record keeping – The circumstances where telephone conversations relating to client instructions must be recorded is significantly extended (and these records must be kept for at least 5 years – longer if the FCA requires). General record-keeping requirements are much more extensive. Many firms need to review their policies in this area.
Investor protection requirements
The changes are extensive. They include:
- Information and documentation – What must be provided to both retail and professional clients in relation to a firm and its services is more detailed. Most firms operating in the investment area need to review their client documentation. Changes include the obligation to provide far more detailed information on costs and charges – for example, requiring costs for bundled services to be presented on an aggregate basis (e.g. where a discretionary fund manager provides services in conjunction with a platform which provides custody or holds client money).
- Independent Advice – Adviser firms must identify whether the advice they provide both to retail and professional clients is independent (i.e. based on a sufficiently wide view of the market) or not, and client documentation must state this. This applies to those advising both retail and professional clients, and to all financial instruments. Firms must provide suitability reports to retail clients in respect of advice given to them.
- Inducements – The rules on receipt and payment of fees, commissions and non-monetary benefits are much wider than before. In particular, firms providing independent advice or discretionary management services must not accept fees or commissions from product providers or other third parties with the exception of some (narrowly defined) minor, non-monetary benefits. Conflicts-of-interest policies should reflect how the firm deals with inducements.
- Investment Research – MiFID II requirements go much further than pre-existing FCA rules on use-of-dealing commission in relation to portfolio management and advice. Where research is provided in relation to these investment services, it must be clearly paid for by the firm from its own resources or by the client through a Research Payment Account (and on a basis clearly agreed by, and budgeted with, the client).
- Suitability and appropriateness – Suitability standards remain the same but the circumstances in which firms need to assess appropriateness for non-advised transactions has changed, including in relation to instruments whose structure makes it difficult for them to understand.
- Client reporting – Again, there are significant changes applying to both professional and retail. Portfolio managers must provide statements three-monthly (unless they can be accessed online) and must specifically report a depreciation of 10% or more in value of the portfolio. Firms must provide regular periodic reporting on costs and charges. Where firms operate in conjunction with a platform provider (which provides custody and client money services) it may be necessary to discuss with the platform provider who provides what information.
- Best execution – Again, the requirements as to achieving the best result for clients in relation to their investment transactions are much more granular and there has been regulatory concern that firms’ policies in this were insufficient even under the old rules. More information is necessary as to the actual venues where orders are executed for clients (or if they are passed to other firms for execution, how such firms are selected and monitored firms executing orders will be obliged to summarise and make public on an annual basis the top five execution venues used in terms of trading volumes and information on the quality of execution obtained for each class of financial instruments).
- Underwriting and placing – In the corporate finance area, there are new substantive conduct-of-business obligations in relation to placing. Unfortunately, there has been no attempt at national or EU level to clarify the scope of the activity of placing without a firm commitment basis so the scope of this activity remains obscure in relation to corporate finance and venture capital business.
Brexit will not affect the obligations of firms to comply with EU obligations in the short or medium term. It may be, in fact, that they will always cast their shadow, particularly if the UK achieves a special status relating to financial services as it has announced that it wishes to do. The European Securities and Markets Authority is already considering its first use of product intervention across the EEA in relation to retail contracts for differences and CFDs. Firms should complete their MiFID II preparations as a matter of urgency. And if they have not yet considered the impact of MiFID II on their business, they should urgently do so.