The FCA published a further Consultation Paper on MiFID II Implementation (CP 16/19) on 29 July 2016.
In CP 16/19 the FCA seeks views on certain proposed changes to the FCA Handbook; comments are invited by 28 October 2016.
It is welcome that the FCA is consulting on a staggered basis, with a view to finalising its rules by the transposition deadline of 3 July 2017, giving firms 6 months to prepare for the 3 January 2018 MiFID II implementation date.
Who should read CP 16/19?
The paper has a wide impact because the FCA seeks to implement positive elements of the MiFID II derived rules across all firms in its remit. The firms that should be reading and reacting to CP 16/19 are varied. Helpfully the FCA flags at the start of each chapter which firms should be interested in reading that section, including:
- MiFID firms (such as stockbrokers, investment advisers, corporate finance / venture capital firms, and investment managers);
- Firms with newly in scope activities (e.g. prospective organised trading facility operator, data reporting service providers);
- Firms benefiting from optional exemptions (set out in Article 3 of MiFID / MiFID II);
- Third country firms; and
- A wider range of organisations, including banks and other common platform firms, UCITS and AIFM investment firms, retail financial advisers, dormant account fund operators and CAD exempt firms.
What is the scope of CP 16/19?
A key theme of CP 16/19 is that the FCA considers that firms should not, by and large, have to make significant organisational or systems changes to implement requirements as many of the changes relate to “tweaks” to existing measures that are broadly in line with MiFID II requirements. However, firms do need to consider the changes to address where these may require an IT update, additional staff training or process refresh.
CP 16/19 covers a broad base of subjects and the importance of these to each firm will depend on the business model. We drill into some more detail on certain aspects of these below. The following FCA sourcebooks will be affected: glossary, CASS, DISP, FEES, IFPRU, IPRU (INV), MAR, SUP and various forms, as well as SYSC.
CP 16/19 should be read with CP 15/43 and CP 16/29 as well as a further CP the FCA plans to release towards the end of 2016.
CP 16/19 in brief
- Supervision – regulatory requirements to notify regulators of rule breaches and provide accurate and complete information are being updated to reflect the requirements in MiFIR. Firms need to extend monitoring and reporting for MiFID II as well as proposed transitional provisions to be included in the Supervision Manual (SUP) for notification of transaction reporting breaches under the current regime. As changes also include additional information requirements for a passport notification and changes to the procedures and forms, this is another area firms need to review;
- Management bodies and organisational requirements – the Senior Management Arrangements, Systems and Controls Sourcebook (SYSC) will reflect enhanced governance arrangements, through new management body measures, key organisational requirements and areas such as conflicts of interest. The FCA also explores how certain such requirements are to be extended to branches of non-EU firms and firms that benefit from exemptions set out in Article 3 of the MiFID II directive;
- Complaint handling – the Disputes Resolution: Complaints Sourcebook (DISP) will be extended to include the enhanced complaints handling rules from MiFID II and broaden the scope of such rules;
- Client assets – minor changes are required to the Client Assets Sourcebook (CASS) and the changes are applied across all designated investment business;
- Commodity derivatives – changes will be made to the Market Conduct Sourcebook (MAR) to set out guidance and directions on position limits, position management, and position reporting;
- Fees Manual – minor changes are required to accommodate the new organised trading facility (OTF) concept, changes for multilateral trading facilities (MTFs) and onboarding fees for Market Data Processors (MDPs);
- Prudential standards – limited changes are required to accommodate the OTF concept and removal of local firm exemptions, which will impact prudential requirements set out in IFPRU and INPR (INV);
- Whistleblowing – additional changes will be made to SYSC to introduce the MiFID II requirements, domestic requirements and measures from other EU legislation.
- Glossary changes
While we recommend digesting CP16/19 and all the proposed changes to the FCA Handbook in full (as MAR, SYSC, DISP, SUP and various forms such as the Branch passport notification form are affected), in this article we focus on the following key areas:
The developments in more detail
- Third country firms
Building on proposals in previous MiFID II implementation consultations, such as CP 15/43, the FCA plans to apply MiFID II type requirements across third country firm branches. There will be a flexibility of approach depending on the nature of the requirement e.g. conduct-based provisions will become rules, whereas prudential provisions will be guidance, allowing third country firms to demonstrate that they meet the spirit of the requirements from following broadly equivalent home state requirements.
The UK industry has a reasonable interest in the status of third country firms, given the UK’s Referendum result. The FCA’s position may be a blueprint offered to assist other Member States with implementation or to seek consistency that third country firms may find useful when operating across the EU. Firms may wish to consider how the provisions in this CP operate to help scope their future planning.
For additional detail of the position of third country firms and branches see below “Third countries”.
- MiFID opt-out narrowed for certain Article 3 Firms
Like MiFID I, MiFID II includes an exemption under Article 3, which enables Member States to exempt certain firms from authorisation as a MIFID investment firms (“Article 3 Firms”). However, Article 3 of MiFID II now provides that Article 3 Firms must be subject to ‘at least analogous’ requirements in relation to certain aspects of (i) authorisation and supervision; (ii) conduct of business; and (iii) organisational requirements, but not the whole range of requirements that MiFID investment firms are subject to.
The FCA states (see para 1.21 on page 11) that in its view “domestic requirements applied to Article 3 Firms must achieve the same effects as MiFID II, and be substantially similar, to each of the individual requirements listed in Article 3(2)(a) to (c) and their corresponding implementing measures”.
Therefore, throughout CP16/19 the FCA provides information on the requirements it will be imposing on Article 3 Firms. This may make little practical difference in the UK as the FCA’s predecessor, the Financial Services Authority, imposed similar requirements to Article 3 Firms as were applied to MiFID investment firms. In MiFID II, the range of firms potentially within scope of Article 3 is expanded to encompass certain firms using commodities, emission allowances and derivatives for hedging as well as firms that only receive or transit orders to financial institutions and provide investment advice and which do not hold client monies or assets and do not do business outside the UK.
- Conflicts of interest
While MiFID II does not fundamentally change the existing conflicts of interest provisions in SYSC 10, it does strengthen certain key requirements with the ambition of enhancing the effective handling of conflicts of interest within firms. The key point is that firms must now not only manage conflicts but also implement measures to prevent conflicts of interest from occurring.
MiFID II revises the current requirements as it:
- requires firms to take all appropriate steps to identify, prevent and manage conflicts of interest from arising – new elements are “prevent and manage” and “appropriate” (rather than the current wording “take all reasonable steps to identify conflicts of interest”);
- states explicitly that firms need to identify, prevent and manage conflicts caused by inducements and remuneration or incentive structures – with this the FCA spells out an implicit inference from MiFID I;
- strengthens obligations on senior management to interrogate related management information (such as the conflicts of interest record) and requires periodic assessment and review of conflicts policies on at least an annual basis;
- enhances significantly the content and quality of the disclosure made to clients when firms cannot manage or prevent conflicts of interest arising; and
- extends requirements to structured deposits.
With respect to disclosure to clients, firms will now be required to include the specific description of the conflicts of interest that arise, the steps undertaken to mitigate those risks and the risk to the client. Firms need to update their organisational and administrative arrangements, including the approach to and content of conflicts disclosures (which is now explicitly very much a measure of last resort and constitutes evidence that a firm’s conflicts policy is deficient) – see proposed additional content in SYSC 10.1.8 R.
The FCA proposes to extend the amended SYSC 10 obligations to all firms, including third-country branches, reflecting its view of the importance of having appropriate and robust organisational and administrative requirements in place to manage conflicts of interest. Firms will wish to work through the SYSC Navigation Guide in appendix 2 of the CP (see page 73) to drill into more detail to identify whether changes apply as rules or guidance to a specific business model. There are small changes to the provisions of SYSC 5.1, particularly 5.1.1 to 5.1.11, which outline requirements for segregation of duties, an important facet of a compliant approach to conflicts management and prevention.
Practically, there is a marked ramping up and spelling out of obligations from MiFID I to MiFID II. As an example, the provisions of SYSC 10.1.4 R involves a small drafting change that materially shifts the threshold of when conflicts arise. This has been changed
- from: “types of conflicts … whose existence entail a material risk of damage to the interests of a client”
- to: “types of conflicts … whose existence may damage the interests of a client”.
Certainly, these aspects of MiFID II were, in part, introduced to address compliance shortfalls. Given the continued emphasis on senior manager accountability, a quick win is to review materials and processes in light of the spirit of the enhanced regime. This could involve a gap analysis of current processes, procedures and documentation against the small, but important, drafting changes in SYSC 10, to identify any areas to refresh. Additional measures, such as training and monitoring need to updated to support any revisions.
The FCA does not expect firms to implement material systems and controls changes. If there is a significant gulf between the practical reality and the FCA’s relatively blithe statement, it would be advisable to respond to questions 11 and 12 (see page 28) to raise awareness of that (taking appropriate steps to preserve confidentiality or even avoid self-incrimination). Examples of small changes with wider IT, procedural, training and compliance monitoring impacts may include how the firm deals with receipts of inducements, record keeping obligations, and the approach to disclosure and frequency of policy reviews – for example a firm must identify how client agreements, policies and other documents need to be amended for the enhanced nature of disclosure.
- Governance – management body and organisational requirements
In order to enhance the effective oversight of firms, under Article 9 of MiFID II, the firm’s management body is required to assume clear responsibilities across the business cycle of the firm, including setting strategic objectives, the adequacy of policies relating to the provision of services to clients and responsibility for the risk strategy and internal governance of the firm.
Current requirements, found in SYSC 4.3A, will be extended. Accordingly, the FCA will subject common platform firms to new and enhanced requirements to promote sound internal governance arrangements as well as a sound risk culture. The measures will be appropriately extended to third country firms. Small drafting changes in SYSC extend the effect of the measures. For example, existing organisational measures in SYSC 4.3A.3 (which is about the repute and expertise of the management body) are extended from “CRR firms” to the wider range of firms within the definition of “common platform firms”.
While the FCA does not think these changes will have significant impact on UK firms, firms should look out for European Securities and Markets Authority and European Banking Authority joint guidelines on the assessment of suitability of members of the management body and key function holders under CRD IV and MiFID II.
A point of note is that MiFID II is a package of measures (see What is MiFID II?
below). In the proposed amendments to SYSC, the FCA has set out provisions of certain directly applicable implementing regulations such as the expected MiFID Org Regulation, the delegated act that supplements MiFID II organisational requirements and operating conditions (see the draft released on 25 April 2016). Firms must be mindful to apply these requirements as well as any applicable parts of SYSC.
- Complaint handling
The FCA proposes to copy the MiFID II requirements into a new chapter in the Dispute Resolution: Complaints sourcebook (DISP).
Possibly the most important point of note is set out in the proposed DISP 1.1A.5 G and further clarified in 1.1A.6 R. In the context of “MiFID Complaints”, complaints must now be captured and handled in line with rules where the complaint comes from any client type (so retail, professional clients and eligible counterparties (in relation to eligible counterparty business)) rather than just “eligible complainants”. For third country firms, this is modified to apply only to complaints from retail and elective professional clients.
Other points of interest that should be factored into document storage and record keeping systems, training and processes include:
- The jurisdiction of the Financial Ombudsman Service has been extended to cover sales of and advice of structured deposits in line with provisions laid out in DISP 2.3.1A R;
- The requirement to extend complaint record keeping to complaints from professional clients;
- The various other rules addressing areas such as complaint resolution process and time limits.
Complaints handling is another area for which the FCA does not expect firms to implement material systems and controls changes, so firms should flag if this is not the case (see question 19 (see page 41)). Nevertheless, small drafting changes in DISP 1 and the introduction of the new section DISP 1.1A may result in wider IT, procedural, training and compliance monitoring impacts – for example, complaints handling systems need to introduce a “MiFID Complaint” category and should reflect this in reporting obligations (see DISP 1.1A.33), staff may need additional training to categorise complaints, policies and other documents need to be amended.
- Remuneration for sales staff
MiFID II remuneration requirements intend to ensure that sales staff are not incentivised to act in ways which are detrimental to the best interest of the client.
The FCA proposes a new section to SYSC 19 (Remuneration Codes) that will only apply to:
- Common platform firms (e.g. to cover MiFID investment firms but not collective portfolio management firms);
- Article 3 firms; and
- Branches of third country firms.
The existing SYSC 19 Remuneration Codes (19A – E) focus on the senior management of firms who are ‘material risk takers’, with certain principles applied on a firm-wide basis. These will continue to be relevant to MiFID firms. Using an additional section, SYSC 19F, facilitates the introduction of the high level MiFID II–based rules designed to help prevent failures in the sales process. It also reduces the risk of creating measures that conflict with broader sets of remuneration provisions under development in Europe.
These provisions are reinforced in new proposals in SYSC 3A.1A which introduce measures similar to the provisions in the MiFID Org Directive to common platform firms, for example, the management body must define, approve and oversee a range of areas including:
- skills, knowledge and expertise required by staff (see our commentary on knowledge & competency requirements);
- resourcing requirements; and
- a remuneration policy supporting the delivery responsible business conduct, fair treatment of clients and designed to avoid conflicts of interest in relationships with clients.
Firms should also see provisions in SYSC 5.1, which address the application of skills, knowledge and expertise requirements to firms and also what such requirements mean within the context of a systems and controls mechanisms.
Those interested in the remuneration provisions may also be drawn to the whistleblowing-related changes covered in chapter 9 of CP 16/19 that will result in the FCA making changes to SYSC 18 (18.6), which we do not cover in this summary, as firms should already have relevant process in place.
- Changes to client assets sourcebook
MiFID II imposes incremental changes to CASS as these are broadly aligned. Some areas where changes will be made include:
- provisions to require firms to consider non-retail TTCA appropriateness, in effect codifying risk management techniques to take account of client liabilities;
- update to CASS 6 in respect of the granting of ‘general custody liens’ to further narrow the limited exceptions to the prohibition and require disclosure of associated risks, again in effect codifying current practice (and see also CASS 7.11.59 for the corresponding rule relating to client money);
- extension to the requirements on delegation of safekeeping duties to a third party to also apply to sub-custodians appointed by an investment firm;
- the definition of a qualified money market fund and seeking explicit client consent to segregating funds in a QMMF (prompting minor client agreement changes);
- allowing for a very narrow exemption to restrictions on client money group bank deposits;
- proposals for preventing unauthorised use of client assets – the FCA is hopeful that this merely reflects current practice but firms ought to review and update client agreements if not; and
- requiring collateral and monitor continuing appropriateness when arranging securities lending.
The FCA believes most other areas of MiFID II client asset provisions are already captured in CASS and will make only minor drafting changes rather than copy out for these areas. The FCA will also maintain areas of its CASS provisions that were notified to the Commission under MiFID (the article 4 procedure). This includes, for example, a requirement that clients using a prime broker service have daily reports on the value and location of client assets, third party custody agreements terminating a TTCA, unclaimed assets and the prime brokerage agreement disclosure annex.
The FCA maintains the facility whereby professional clients of non-MiFID firms may opt out of CASS 7 (client money rules). CASS will continue to apply to third country branches.
To implement these changes, the FCA intends to maintain a single CASS sourcebook via an ‘intelligent copy out’ approach and make the changes apply for all designated investment business. The FCA’s implementation proposals should not mean significant changes to CASS.
- Fees Manual
The manual will be amended to include provisions for the new regulated activity of operating an OTF. We are not covering this in detail. Firms may want to be aware of the revised fee for a variation of permissions for a multilateral trading facility (an MTF) – which has increased from £250 in some cases to a blanket £12,500.
Fees will be charged for firms wishing to connect to the FCA’s Market Data Processor. Building on previous consultation (CP 15/34) the FCA, the FCA clarifies that it proposes rates of £20,000 for applying to establish conformance in order to submit transaction reporting data and £10,000 for each application to establish conformance for all other data types. After MiFID II implementation, this will affect relatively few firms. CP 16/19 provides useful examples and information on impacts as well as a table of other relevant charges (see page 51).
The FCA has published a third MiFID II Consultation Paper (CP16/29), following on from CP15/43 and CP16/19, which includes changes to the Conduct of Business and Perimeter Guidance Manuals as well as material on product governance. This will be followed by the likely publication in late 2016 of a fourth consultation and then in 2017 of a single policy statement covering all aspects of the FCA’s implementation of MiFID II.
HM Treasury is also expected to follow its March 2015 consultation paper with a policy statement and further consultation from the PRA (see also PRA CP 9/16) will follow in due course.
A note for Brexit
Given the UK’s Brexit vote in June 2016, the FCA is keen to remind firms that they “must continue to abide by their obligations under UK law, including those derived from EU law and continue with the implementation plans for legislation that is still to come into effect”. The application date for MiFID II is now 3 January 2018, with final rules due to be laid by 3 July 2017. The FCA states that it will keep MiFID II related proposals under review “to assess whether any amendments will be required due to changes in the UK regulatory framework, including as a result of any negotiations following the UK’s vote to leave the EU”. Nevertheless, many firms may wish to continue to access EU markets. This will be facilitated by sound firm level compliance and equivalent provisions remaining embedded in UK law and regulation.
What is MiFID?
By way of reminder, the MiFID II package updates and expands the current regulatory regime for investment services. The package includes the recast Markets in Financial Instruments Directive (Directive 2014/65/EU) and the Markets in Financial Instruments Regulation, also known as MiFIR, (Regulation (EU) No 600/2014) as well as a range of implementing measures and delegated acts (which will be either Regulations or Directives), which are still under development. Even though the Regulations will be directly applicable and the Directives will require implementation at Member State level, the efficacy of the legislation needs to be facilitated by changes to the UK regulatory regime, including the FCA Handbook.
Recital 109 of the MiFID II Directive states: “ … The provision of services by third country firms within the EU is subject to national regimes and requirements. Firms authorised in accordance with them do not enjoy the freedom to provide services and the right of establishment in Member States other than where they are established.” A Member State may consider that the appropriate level of protection for its retail clients or elective professional clients can be achieved by the establishment of a branch by the third country firm.
In that case, the branch has to be established in line with the provisions in Article 39 of the MiFID II Directive. For per se professional clients and eligible counterparties, the regime is set out in MiFIR. MiFID II preserves the right for Member States to set their own national regimes governing the provision of investment services and activities by third country firms (subject to an equivalence regime relevant to firms servicing per se professionals and eligible counterparties and which is due to be phased in – see article 46(1) MiFIR).