FINANCIAL SERVICES REGULATION BRIEFING MiFID II: WHERE DO ASSET MANAGERS GO FROM HERE? The one year delay to the implementation of MiFID II provided the industry with some welcome respite from the seemingly unrelenting waves of regulatory reform. European regulatory implementation timetables are always tight but the original MiFID II timetable was proving to be unrealistic for both the regulators and the regulated. But time is quickly passing and the recent publication of all three Level 2 delegated legislation served as a sharp reminder that the asset management industry, along with others, is reaching a critical time on the road to the new effective date of MiFID II. Given the breadth and complexity of the MiFID II reforms, and the consequential changes required to IT/systems and wide-scale document repapering, many managers are likely to be approaching the point when they need to accelerate their implementation projects to be ready on time. The results of initial scoping exercises and gap analyses will need to be converted quickly into detailed implementation action plans across all of the impacted parts of the business. But what are the key areas that asset managers need to be wary of in their MiFID II implementation work? Every manager will have its own view of which issues matter most for them, but with the picture starting to fill out with further Level 2 detail, in this briefing we discuss some of those areas which we think present the most significant overall challenges for the asset management industry. As most managers will by now have appreciated, the challenges will come in different forms. Some areas will require time consuming and expensive IT/systems build, some will have commercial impact on the manager or its clients or alter the structure of the markets in which they trade, some raise new legal or regulatory risks that need to be managed, some will require adjustments to corporate/internal governance arrangements, and some will require large scale re-documentation of contracts and internal policies and procedures. The latest legislative and implementation timeline is set out in Schedule 1. 1. Investment research: CSAs may survive after all It is now over a decade since the UK unbundled the provision of investment research to asset managers. At the time, the UK industry settled largely on a Commission Sharing Agreement (CSA) model the FSA could accept, just about, addressed the regulator's concerns over conflicts of interest. The interference of MiFID 23 MAY 2016 London Table of Contents 1. Investment research: CSAs may survive after all 1 2. Trading and market infrastructure 2 3. Transaction reporting 3 4. Best execution 5 5. Record keeping 5 6. Product Governance: a new regime? 6 7. Scope: how far does MiFID II reach in a group context? 8 Schedule 1 MiFID II Timeline 9 Schedule 2 Core elements of product governance requirements 10 Schedule 3 Application of MiFID II to AIFMs/UCITs ManCos 12 8. Contacts 16 RELATED LINKS Herbert Smith Freehills Financial services regulatory homepage FSR and corporate crime notes blog Financial services regulation insights Herbert Smith Freehills insights FINANCIAL SERVICES REGULATION BRIEFING HERBERTSMITHFREEHILLS 2 II in the UK's compromise around CSAs was unwelcome and predictably has generated considerable industry debate for a number of years. ESMA's proposals for Level 2 measures on investment research seemed to be heading to the conclusion that CSAs would not be consistent with the new rules and the industry would need to find a new solution. Practitioners attempted to bend and flex the words on the page to fit over the CSA model, perhaps in a modified form, but the proposals seemed fundamentally incompatible with the nature of a CSA as currently understood. The publication by the European Commission of the relevant delegated act (Level 2 Directive) in April 2016 may mark a significant fork in the road on the CSA debate. After lobbying from the UK, German and French governments, the Level 2 Directive appears to have re-opened the possibility of CSAs being used as part of the proposed "research payment account" model permitted by the new rules. However, the drafting is a classic European compromise text and, rather than tackling the issue head on, is a curious mix of concepts that are neither one thing nor the other. Importantly, the Level 2 Directive does contemplate the collection of the client research charge "alongside a transaction commission" rather than "separately" (provided the research charge is separately identifiable).1 As a result, one of the major conceptual roadblocks to CSAs being permitted post-MiFID II has been removed; it being a defining feature of a CSA that a single commission payment is made with the execution and research charge components being paid side-by-side in a pre-agreed split. On the other hand, parts of the research payment account requirements are inconsistent with how CSAs are typically operated. For example, a specific research charge has to be agreed with clients of managers as part of setting an upfront research budget which cannot be exceeded. However, it will arguably be possible to retain the core features of current CSAs and modify them to fit within these new requirements. In contrast, the Level 2 Directive retains the requirement that: "the research charge shall… not be linked to the volume or value of transactions executed on behalf of the clients".2 This is more challenging. It is a defining feature of current CSAs that the greater the level of transaction execution the greater the available pot of funds that accrues to purchase research; it is hard to square this with the "no link to volume or value" requirement. One of the concerns expressed by the industry over the research payment account relates to the possibility of having to treat cash in the research payment account as client money under the FCA rules. Some asset managers may not have the necessary permissions from the FCA (and related client money infrastructure and personnel) to be able to do this. Helpfully, the Level 2 Directive is clearer in stating that the asset manager may: "delegate the administration of the research payment account to a third party, provided that the arrangement facilitates the purchase of third party research and payments to research providers in the name of investment firm without any undue delay in accordance with the investment firm's instruction".3 The drafting could certainly be much clearer but this provision arguably permits the research payment account to be an account held by the asset manager at the broker rather than an account on the asset manager's books. This would have two main advantages. Firstly, it would be consistent with the way CSAs are currently operated. Secondly, the asset manager may be able to establish the arrangement such that it is not holding any client money under the FCA rules, although the asset manager will probably still be required to "control" the client money (which requires the asset manager to have the relevant FCA permissions on its authorisation to do that). 2. Trading and market infrastructure The bulk of the implementation effort associated with the MiFID II rules on trading and market infrastructure will fall on the sellside and providers of market infrastructure. However, even where the sell-side is more directly impacted by some of the changes, the buy-side will need to develop a commercial strategy to respond to the changes. The changes will probably not bring as big a shake-up to the structure of financial markets as MiFID I. However, MiFID II is still bringing a number of changes that, when taken together, will have a significant impact on the markets on which asset managers trade for their clients, for example: • the introduction of "equity-like" pre-trade transparency for fixed income markets and the consequent impact on liquidity; • the "double cap" mechanism on pre-trade transparency waivers for dark pools and the potential curtailment of "unlit" trading activity; and • mandatory exchange trading for the most standardised derivatives, further to the introduction of mandatory clearing under EMIR. Other areas of MiFID II will require more direct implementation effort for asset managers. We have identified the following as some areas where we think asset managers will need to focus their implementation efforts: (i) Post-trade transparency – Under MiFID I the buy-side could often agree with their sell-side counterparty that the sell-side would deal with any post-trade reporting requirements in respect of OTC transactions. Under the latest 1 Article 13(3) 2 Article 13(2)(b) 3 Article 13(7) FINANCIAL SERVICES REGULATION BRIEFING HERBERTSMITHFREEHILLS 3 draft of the relevant MiFID II regulatory technical standards (RTS) this is no longer the case and the selling MiFID firm in the transaction must file the report (unless the buyer is a systematic internaliser in relation to the instrument in question). Further, where a MiFID firm faces a third country firm, the MiFID firm always has the responsibility to report the OTC transaction. For some asset managers this may lead to a need for a significant investment in new systems to make the necessary reports. An alternative may be to look into the possibility of outsourcing the reporting to a third party (which could be sell-side counterparts). (ii) DMA agreements – We would anticipate the sell-side might look to make significant changes to their agreements governing direct market access (DMA) arrangements. The provider of DMA has always taken on legal and regulatory risk associated with their clients accessing markets in their name but MiFID II brings those risks into sharper focus. MiFID II requires a written agreement under which the investment firm providing DMA retains responsibility under the Directive. The wording of MiFID II is still unclear as to what the scope of retained "responsibility" needs to be: for example does it extend beyond responsibilities under MiFID II into other regulatory responsibilities such as under the new EU Market Abuse Regulation (MAR)? Does it extend to all contractual or tortious responsibility? The relevant MiFID II RTS also introduces a broad range of regulatory requirements on DMA providers in respect of diligencing, monitoring and controlling the trading of their clients. DMA providers are likely to look to the written agreement as a key mechanism to bind their clients into obligations which will enable them to comply with these new rules under the Directive. There are parallels with this situation and some of the challenging contract negotiations that took place around the Alternative Investment Fund Managers Directive (AIFMD). In both scenarios the regulations put the obligations on one party as a regulatory matter but left the contract with a third party as a means of ensuring compliance with those obligations and allocating consequential risks and liability. The resulting negotiations will be challenging for all involved if AIFMD is anything to go by. (iii) Indirect clearing – The move to mandatory clearing of certain OTC derivative classes under EMIR also triggered CCPs and clearing members to reconsider the account structures available to direct and indirect participants in clearing arrangements (and the related questions of the extent of asset segregation and asset protection). The EMIR requirement for CCPs to offer individually segregated accounts as well as omnibus accounts resulted in an industry dialogue that now sees a range of CCP account models on offer with a greater or lesser degree of asset protection. In particular, some CCPs offer "gross omnibus account" structures where the positions and collateral of a clearing member's clients are co-mingled but margined on a gross basis - such gross omnibus accounts being operationally more efficient than full individual account segregation yet retaining some of the benefits in terms of asset protection. Under MiFIR ESMA has to develop Level 2 measures to introduce equivalent client protections to those under EMIR in respect of exchange-traded derivatives (ETDs) and indirect clearing arrangements. Given the similarity of clearing OTC and ETD transactions, ESMA consulted at the end of 2015 on the MiFIR Level 2 measures and amendments to the EMIR Level 2 RTS on indirect clearing arrangements (to ensure both regimes were aligned appropriately). ESMA has proposed that under both EMIR and MiFIR (for OTC and ETD transactions respectively), CCPs should be required to offer a gross omnibus account in respect of indirect clearing arrangements. New rules will also be introduced to ensure that where there is a chain of intermediaries to the ultimate end user then corresponding levels of account protection need to be offered down the complete chain. These changes should be welcome to the buy-side as they are ultimately designed to ensure clients of clearing brokers are given greater protection against insolvency risk. Asset managers will need to carefully consider the legal treatment of the clearing account options being offered to them carefully and balance up the cost of the various options against the level of asset protection they want to achieve for their clients. When the new MiFIR and EMIR rules are finalised, CCPs and clearing brokers will have the flexibility to design their own account structures that comply with the rules and also respond to demand from their clients. Asset managers should therefore have an opportunity for their voice to be heard and to vote with their feet towards those providers who have the best offering at the right price. 3. Transaction reporting Transaction reporting is not a new concept for asset managers. Its requirements will, however, significantly expand under MiFID II - many more transactions will need to be reported and in a much greater level of detail. Regulators continue to view transaction reporting as a fundamental tool in the fight against market abuse, a fact which the FCA has underlined through extensive enforcement action against firms for transaction reporting failings. The introduction of MAR in July 2016 is only likely to sharpen this focus. We anticipate that asset managers are likely to find transaction reporting to be one of the most timeconsuming and challenging areas of implementation. For many asset managers, the most fundamental issue will be determining how they will report. This will, in turn, depend on the extent to which they can rely on others to report on their behalf. While the starting assumption for many managers will be that they will continue to use their existing reporting framework, the changes introduced by MiFID II may shift the commercial and operational dynamics such that they may be forced to rethink this approach. We consider that managers should currently be thinking about the following key issues: FINANCIAL SERVICES REGULATION BRIEFING HERBERTSMITHFREEHILLS 4 • Scoping exercise. The first step in implementation should be to determine the scope of the firm’s instruments and activities that are reportable. This is unlikely to be a straightforward exercise given the significant expansion in scope and the introduction or revision of several key concepts (such as the meaning of “execution”). Despite requests from the industry, it seems unlikely that ESMA will produce an exhaustive list of reportable instruments. This analysis is likely to be complex and time-consuming, particularly for asset managers with multiple strategies, although they may be able to leverage any similar analysis conducted as part of MAR implementation. Although other elements can be progressed in parallel, it will be difficult for a manager to decide on its overall reporting framework until it has a firm grasp of the extent of its reportable transactions. • Reporting by the sell-side: assessing feasibility. Where managers transmit orders to EU-regulated brokers for execution, they will continue to be able to rely on the broker to transaction report. The position is, however, more onerous than under the current FCA rules and is subject to two key conditions: (i) that certain data is transmitted to the broker; and (ii) there is a written transmission agreement in place. At the outset, managers will need to assess the impact of these requirements to determine whether it will be feasible (or desirable) to continue to rely on its brokers. – Data transmitted to brokers. A number of questions have already been raised about whether, as a practical matter, managers will be able to transmit the required data to the broker. Managers will need to work with their brokers to assess this, including any potential impact on their systems and processes. – Transmission agreement. As with delegated reporting under EMIR, it seems likely that brokers will prepare their own template agreement (in some cases based on a standard template prepared by the main trade associations), which managers will then need to negotiate (other than in respect of certain mandatory terms which must be included). We expect that these negotiations will be made more challenging as both sides try to grapple with the meaning and effect of the new requirements. In general, we expect brokers will try to limit the number of prescriptive obligations in the agreement and minimise any liability, a position that managers will generally wish to resist. If a manager intends to rely on its brokers for reporting, it will be important to start the dialogue sooner rather than later. Both sides will need to agree a position which is commercially, operationally and legally acceptable and, failing this, the manager will need to implement an alternative solution. • Approach to reporting other transactions. There will be a number of reasons why a manager is still required to make its own transaction reports rather than relying on a third party. This includes, for example, where it is executing (rather than just transmitting) an order or if it is transmitting orders to non-EU brokers. In these circumstances, its options will broadly be to (i) submit reports itself; or (ii) use an approved reporting mechanism (ARM) or a trading venue. In either case, the firm is likely to need to undertake a detailed assessment of its existing reporting arrangements, internal reporting capabilities and IT infrastructure. Where a manager decides that it requires specialist third party support to build out its current IT systems, this is likely to be a significant procurement project and sufficient time should be allowed for development, integration and testing. Managers intending to use ARMs and/or trading venues will need to review the scope of these arrangements. Although we do not expect there to be a fundamental change to the basis on which they operate, we expect agreements will be updated to reflect the MiFID II requirements. Again, it will be important to allow sufficient time for negotiation of the agreement and transition to the new service. • Dealing with the overlap between MiFID II and other reporting requirements. Although MiFID II includes a provision stating that transactions reported under EMIR are not subject to transaction reporting (provided that the EMIR report contains certain information), it has become clear that this provision is unlikely to work in practice. It therefore seems increasingly likely that managers will be required to report the same transaction multiple times if it falls within the scope of several European regulations. Complying with multiple reporting regimes is likely to be complex and will present significant practical challenges for managers, particularly as regulators are increasingly focusing on the “quality” of reports and deterring “over-reporting” of transactions. Managers will need to think carefully about their approach to this issue before detailed implementation work and IT building starts. • Assessing the type of information to be reported. Finally, in addition to how they will report, managers should already have started assessing the information they will need to report. There will be a substantial increase in the number of data fields for each report, and some of these (such as those that identify individuals that originate the decision to trade and that execute it – such as portfolio managers, investment committees and traders) are likely to raise issues. Firms will need to consider whether existing systems capture the necessary data and, if not, the extent of changes required. The correct approach to the new fields is already generating debate within the industry. As is often the case, the regulations follow a “one size fits all” approach for reporting, and largely leave managers to work out for themselves how the data fields fit with their business model. Preparing sample reports based on the new requirements (particularly in relation to transactions that are not currently being reported) is likely to help highlight any key areas of concern at the outset. FINANCIAL SERVICES REGULATION BRIEFING HERBERTSMITHFREEHILLS 5 4. Best execution Best execution, like transaction reporting, is a familiar concept to asset managers subject to the MiFID I requirements. Whilst the MiFID II requirements largely build on the existing rules rather than introduce a conceptual change, they will still require a number of significant changes and it will be important not to underestimate the overall scale of work that will be required as part of implementation. In particular, the front office will need to be heavily involved in the detailed examination of how best execution is achieved across asset classes. In our view, managers should already be thinking about the following key issues: • Reviewing order execution policy. Firms are likely to need to rewrite their order execution policy along with the associated repapering that this entails. MiFID II will introduce a number of new requirements which require substantial changes to the policy, including the need to explain “in sufficient detail and in an easy to understand way” how the firm executes client orders. Generally, the move is towards greater transparency with increased customisation for each asset class and more information on execution factors, the decision-making process and costs. Firms may also need to provide additional information on how they execute OTC trades. Revising the policy is likely to involve significant input from those involved in executing transactions and the time taken to translate this knowledge into the policy in an “easy to understand way” should not be underestimated. As a result of increased monitoring requirements (see below), firms should also be thinking about whether they can more explicitly link the policy to their execution monitoring procedures. • Process for public disclosures. Managers should be reviewing their systems and considering how they will capture execution data in order to comply with the obligation to summarise and make public, on an annual basis, information on the top five execution venues for each asset class for the previous year and information on the quality of the execution achieved. It would be prudent for managers to start capturing this data sooner rather than later. • Execution monitoring processes and addressing deficiencies. MiFID II will require firms to maintain detailed order execution monitoring processes. Although managers will generally already conduct such monitoring, they should identify any changes that will be required as a result of MiFID II. They will also need to consider if they require additional data in order to effectively conduct their monitoring and, if so, how that data will be obtained. We expect that execution monitoring will be an area of future focus for the FCA, and in particular the link between monitoring and the firm’s execution policy. Managers should therefore already be considering whether changes are required to improve the effectiveness of monitoring and whether there is a need for more robust governance arrangements to ensure that any deficiencies identified are properly addressed. 5. Record keeping Many parts of the MiFID II record keeping requirements are unlikely to be overly onerous to UK asset managers, who already have in place existing procedures and processes in compliance with current MiFID I and FCA record keeping requirements. However, the recording of relevant telephone conversations, electronic communications and face-to-face meetings will carry significant upfront and on-going resource demands for asset managers. Managers will need to take all reasonable steps to record certain telephone conversations, face-to-face meetings and electronic communications relating to actual or intended client and own account transactions. There are a number of issues in the detail of these requirements that continue to evolve and will require particular consideration as part of asset managers' implementation efforts. Internal calls It was initially envisaged that MiFID II would not include internal conversations and communications in the recording requirements. This position was aligned with the FCA's current telephone recording rules, which require some investment firms to record telephone conversations that result in or are intended to result in the conclusion of relevant transactions. This rule has been interpreted as being limited to external communications with clients. However, in its Final Report in December 2014, ESMA's guidance was revised to extend the MiFID II recording obligation to some internal telephone conversations, particularly those calls that relate to transactions that are concluded or are intended to result in a concluded transaction. This would apply, for example, to an investment manager instructing an internal execution desk to execute an order. Despite pushback from the industry, ESMA rationalised this expansion by stating that the recording of internal communications was necessary to meet the obligations under MiFID II and to safeguard against gaps in the continuity of the relevant conversations. In April 2016, the European Commission published a Level 2 Delegated Regulation supplementing MiFID II and included ESMA's additional language, explicitly subjecting relevant internal conversations and communications to the recording requirements. FINANCIAL SERVICES REGULATION BRIEFING HERBERTSMITHFREEHILLS 6 Monitoring Investment firms must monitor their records of transactions and orders subject to these record keeping requirements, including relevant telephone and electronic communications. ESMA initially took the view that this required investment firms to monitor their records, including taped communications, to assess compliance with their "wider regulatory requirements". In a reprieve for investment firms, the European Commission removed this expansionary language, limiting the requirement to periodically monitor compliance with their recording and record keeping obligations, and not their "wider regulatory requirements". Whilst investment firms are permitted to take a "proportionate and risk based approach" to monitoring these records, it is yet another on-going strain on compliance teams. Management oversight Asset managers must be able to demonstrate that their management bodies have effective oversight and control over their policies and procedures relating to the recording of telephone conversations and electronic communications. This will necessarily involve periodic reporting to management on the results of compliance teams' monitoring and an on-going assessment as to whether recording is being carried out in accordance with the firm's record keeping policies. Face-to-face communications The industry discussion on MiFID II record keeping requirements has, understandably, been very focused on the recording of telephone conversations. However, investment firms will also need to record "all relevant information" when receiving orders from clients during a face-to-face conversations. Such orders are treated as equivalent to orders received by telephone. Initially, it was suggested by ESMA that minutes of such meetings will be required and then signed by clients. This has subsequently been replaced with an option to choose the form of record, such as written notes or minutes, with no requirement for clients to sign the minutes, as long as the record is in a durable medium. Whilst many of the larger asset managers may already have internal procedures for recording telephone lines (with the result that the MiFID II rules are not such a big change in practice), we would anticipate that for many managers these sort of records of meetings will not reflect their current practices. 6. Product Governance: a new regime? MiFID II will, for the first time, introduce substantive rules on product governance requiring MiFID firms to have effective arrangements and processes to prevent "bad" customer outcomes arising from the manufacture and distribution of financial instruments (of all types, including funds). For distributors, the Level 2 Directive controversially extends the regime to investment services as well. More detailed ESMA Level 3 guidance is expected. Product governance regulation is not new for the UK. The FCA (FSA) has for many years published guidance setting out its expectations of regulated firms in relation to the design and sale of financial products, centred on compliance with high-level systems and controls requirements and FCA Principles, in particular treating customers fairly (TCF). One TCF Outcome is that products and services marketed and sold in the retail market are designed to meet the needs of identified consumer groups and are targeted accordingly. The FSA published guidance on "The Responsibilities of Providers and Distributors for the Fair Treatment of Customers" (RPPD) in 2007 and more specific guidance in the context of "structured products" (e.g. SCARPS and structured deposits) in 2012 and 2015. Various international bodies (the European Supervisory Authorities, IOSCO and ESMA) have also published guidance in this area. The new MiFID II rules reflect, to a significant extent, the existing UK regime. However, MiFID II takes things to a new level. Its requirements (especially under the Level 2 Directive) are more prescriptive and expect more of all parties in the product life cycle. The changes could have a significant impact on manufacturers and distributors and the day-to-day interaction between them. Scope Products: the regime applies to all categories of MiFID financial instruments, regardless of complexity, including shares (listed and unlisted), debt instruments, funds and derivatives. Services: controversially, the Level 2 Directive expressly extends the requirements on distributors to include "services" they offer clients. This is not defined, but seems aimed at treating MiFID-governed investment services (such as portfolio management, investment advice, order transmission and execution services and custody of assets) in the same way as "products" under the regime. "Manufacturers" is widely cast as MiFID investment firms which create, develop, issue and/or design a financial instrument; including firms advising corporate issuers on the launch of new instruments. There could be several manufacturers of the same product. On the funds side, AIFMs or UCITS management companies are not directly subject to the rules, yet they are likely to be indirectly impacted where they are involved in the manufacture of products alongside, or distribute products through, firms which FINANCIAL SERVICES REGULATION BRIEFING HERBERTSMITHFREEHILLS 7 are subject to MiFID II. ESMA believes the European Commission should consider extending the new rules to AIFMs and UCITS management companies. "Distributors" are MiFID investment firms that offer or sell financial instruments (and under the Level 2 Directive, services) to clients. For multi-layered distribution models, the firm with the direct client relationship has ultimate responsibility to meet the product governance requirements; however, any intermediary firm in the distribution chain still has specific responsibilities. Not a "one size fits all" regime – proportionality The legislation expressly recognises that the requirements apply on a proportionate basis, depending on variables such as the nature, complexity and risks of the product and the "target market" of end-investors. Yet finding a consistent and workable calibration of the requirements across a diverse range of products, services, distribution models and markets will be challenging. Overview of core elements The core elements of the requirements (Level 1 and Level 2) are summarised in in Schedule 2. Key practical challenges Two areas are particularly challenging for both sides of the industry: (i) how a product's "target market" is described; and (ii) what data will need to flow from distributors back to manufacturers to help manufacturers monitor whether their product has reached its target market. Target market framework The concept of "target market" is central. Europe's idea boils down to putting labels on the product "tin", like the food industry. But financial products and how they are sold are more complex than food. So finding a standard set of descriptors which meet all (or at least most) situations and are meaningful (to manufacturers, distributors and end-investors), is a big challenge. ESMA is due to develop an EU standard framework. Various industry bodies are looking at possible descriptors. Several areas of difficulty are emerging. For example: • What are sensible elements to define a "target market"? A client's regulatory client categorisation (e.g. retail versus professional) will not be sufficient on its own. But many other possible criteria – such as the investor's financial needs and objectives, risk tolerance, ability to bear losses or financial expertise – are largely subjective and circumstance specific. Other possible criteria, such as whether the product should only be sold on an advised basis, need to cater for a wide variety of different distributing models. • To what extent does "target market" need to be defined for non-complex financial instruments - such as listed shares, listed debt and non-complex UCITS funds – which would be considered potentially appropriate for any investor? The Level 2 Directive recognises, for example, that some financial instruments will be appropriate for "mass market". But what does "mass market" (which is not a regulatory concept) mean and is that (or something similar) the only label required for these instruments? Arguably, yes – and given the number of these instruments which a discretionary manager or adviser must have access to in order to service clients, the simpler the labelling, the better. But such a bland "target market" might be almost meaningless, so it would not be surprising if ESMA considers that more is necessary. • The descriptors must work for both manufacturers and distributors. A major difficulty here is the variety of distribution models and intermediation to cater for - discretionary-managed, various levels of advised, execution-only, platforms etc., and the variety of situations in which financial products can be bought which could affect whether the "target market" defined by the manufacturer is a reliable guide. A higher risk, complex fund or structured product might not be considered suitable for an investor buying direct through a platform on a non-advised basis but could well be entirely appropriate as a strategy as part of a discretionary / advised portfolio, for example. • Products manufactured by firms which are outside the EEA and not subject to MiFID II present extra difficulties for distributors. The Level 2 Directive obliges them to have effective arrangements to ensure that they obtain "sufficient information" about such instruments and determine the target market even if not defined by the manufacturer. There may be less commercial incentive to offer such non-EEA products, given the added burden and regulatory risk of misreading the "target market"; which might limit product choice. Data from distributors to manufacturers The basic idea is that the "target market" labelling should enable distributors to report back to manufacturers regularly on how products have actually been distributed, so that manufacturers can monitor potential issues with distribution outside the "target market". This is likely to involve significant practical and commercial challenges. For example: • Agreeing which data fields are necessary (i.e. meaningful to the manufacturer) and practicably deliverable (by distributors). If a product's "target market" includes several descriptors (such as client category, client needs and objectives, client FINANCIAL SERVICES REGULATION BRIEFING HERBERTSMITHFREEHILLS 8 exercise, type of distribution channel), it could be unworkable to expect information across all criteria and of limited value to the manufacturer's product governance anyway. The Level 2 Directive suggests that relevant information could include data about the amount of sales outside the manufacturer's target market, summary information of client types, a summary of complaints received or sample client feedback to questions suggested by the manufacturer. Manufacturers need to explore what else they need and can use: distributors need to work out what they can deliver and how (e.g. via third party data services providers). • Not all data will be useful for manufacturers. In heavily intermediated distribution models (e.g. platforms), manufacturers may not have sufficient understanding of the full context in which their product is sold. If, for example, a special asset class fund is labelled as not being compatible for investors with low ability to bear capital losses, and a discretionary manager selects the fund as suitable as part of a balanced portfolio, data which recorded this as an "outside target market" sale would not by itself be particularly useful for the manufacturer, although it would enable it to make further enquiries to detect any patterns suggesting unintended investor outcomes. Investigating such areas could be burdensome without enhancing investor protection. • Data fields and protocols will need to be standardised across manufacturers and products. Both the above areas have potentially significant systems, IT, data, legal agreements and cost implications for the asset management industry. Fund managers, other product manufacturers and distributor firms should continue to engage with each other and with regulators, to help shape a sensible framework. 7. Scope: how far does MiFID II reach in a group context? Having just completed AIFMD implementation programmes, asset management groups would be forgiven for thinking that their AIFMs will be spared the reform to come under MiFID II. Unfortunately that will not be the case. MiFID II will affect AIFMs as well as, potentially, non-EEA based (third country) entities within asset management groups. Any MiFID II implementation project will therefore need to consider not only MiFID investment firms but the universe of affected group entities. To illustrate and bring the point to life, the table in Schedule 3 cherry picks a few areas of impact of MiFID II on group entities other than those investment firms that will be subject to MiFID II directly. Above and beyond this table, looking into the future, there have been indications from ESMA that provisions of AIFMD will be harmonised with those of MiFID II. The AIFMD is scheduled for review by the European Commission by 22 July 2017. The technical scope of application of MiFID II will also raise practical challenges for larger asset managers with a more diverse range of business lines (and therefore regulatory categorisations) within their corporate group. Having developed IT systems, or internal systems and controls, to ensure compliance with MiFID II, managers will have to think about whether to use such arrangements for businesses and transactions that are technically out of scope because, in practice, it will be more difficult to run multiple arrangements for different parts of the group. Managers will need to balance the benefits of the operational simplicity of running common IT and systems and controls across their group against the negatives of complying with the MiFID II requirements where not technically required. FINANCIAL SERVICES REGULATION BRIEFING HERBERTSMITHFREEHILLS 9 SCHEDULE 1 MiFID II Timeline UK EU July Feb Apr/May May Q3 3 Jan Apr Commission legislative package to delay application by one year Final Level 2 delegated acts published in OJ? Most RTS/ITS* expected to be adopted by Commission Level 2 delegated acts published MiFID II entered into force Q2 3 Jul FCA expects to have completed transposition Go live date FCA CP2 (Jul) and CP3 (Sep) on implementation Political agreement reached on delay package 2018 3 Jan Original go live date HMT to complete implementing legislation Q4 * Except RTS 2 (non-equity transparency), RTS 20 (ancillary activity) and RTS 21 (position limits) which are expected to take longer 2016 2017 Transposition of MiFID II Directive in all Member States 2014 FINANCIAL SERVICES REGULATION BRIEFING HERBERTSMITHFREEHILLS 10 SCHEDULE 2 Core elements of product governance requirements Product Life Cycle Manufacturer Product design • Maintain, operate and review a product approval process for each financial instrument (including significant adaptations) - which must: − Specify the identified target market of end clients “at sufficiently granular level”. The type of client for whose “needs, characteristics and objectives” financial instrument is compatible/not compatible − Ensure all relevant risks are assessed (for target market) − Ensure distribution strategy is consistent with target market − Complies with conflicts and remuneration requirements • Ensure product is designed to meet needs of identified target market. Including charging structure and risk/reward profile • Have a written agreement outlining mutual responsibilities, when collaborating with non-MiFID/third-country firms • Ensure staff involved in manufacturing financial instruments have necessary expertise and the management body has effective control over the approval process Product Life Cycle Manufacturer Distributor Disclosure & Information Make available to distributor all appropriate information on the product and the product approval process (including identified target market) Have adequate arrangements to: • Understand characteristics and target market of product • Obtain information from manufacturer (on product, product approval process, target market etc.) • If manufacturer is non-MiFID/third-country firm, take reasonable steps to obtain adequate and reliable information about product Distribution Take reasonable steps to ensure product is distributed to identified target market • Assess compatibility of product with needs and characteristics and objectives of clients. Also applies to firm’s “services” under the Level 2 Directive • Ensure distribution strategy is consistent with target market • Only offer product when in interests of client FINANCIAL SERVICES REGULATION BRIEFING HERBERTSMITHFREEHILLS 11 Product Life Cycle Manufacturer Distributor Post-sale Regularly review the products (and for distributor only, services) it offers/markets: • Taking into account any event that could materially affect potential risks to identified target market • Manufacturer only: identify “crucial events” which would affect potential risk/return expectations (e.g. solvency of issuers/guarantors) Distributor only: periodic reporting to manufacturer on experience with product, for example: • Amount of sales outside manufacturer's target market • Summary of types of client • Complaints summary • Client feedback on sample question supplied by manufacturer FINANCIAL SERVICES REGULATION BRIEFING HERBERTSMITHFREEHILLS 12 SCHEDULE 3 Application of MiFID II to AIFMs/UCITs ManCos MiFID II requirement Applies directly to AIFMs / UCITS ManCos? Applies indirectly to or otherwise affects AIFMs / UCITS ManCos? Conduct of business rules covering, inter alia: • Acting honestly, fairly and professionally in the best interests of clients • Fair, clear and not misleading marketing communications and other information • Information disclosure to clients (regarding financial instruments, investment strategies, execution venues, costs, charges, the nature of the investment advice, risk warnings) • Suitability and appropriateness Depends: • Yes, if the AIFM/ManCo is a collective portfolio management investment firm (CPMI) i.e. it performs the "MiFID bolt-on" activities for nonAIF/UCITS clients. These provisions will apply to the performance of the relevant activities • No, if the AIFM/ManCo is a collective portfolio management firm (CPM) i.e. those AIFMs that do not provide "MiFID bolt-on" services to nonAIF clients No Organisational requirements covering, inter alia: • The adequacy of policies and procedures in relation to compliance with MiFID II by the firm, employees and tied agents • Organisational administrative arrangements related to the prevention of conflicts of interest • Systems, resources and procedures ensuring continuity and regularity of service provision • Outsourcing of critical operational functions • Record keeping Depends: • Yes, if the AIFM/ManCo is a CPMI firm i.e. it performs the "MiFID bolt-on" activities for nonAIF/UCITS clients. These provisions will apply to the performance of the relevant activities • No, if the AIFM/ManCo is a CPM firm i.e. those AIFMs that do not provide "MiFID bolt-on" services to non-AIF clients No Algorithmic trading, HFT and Direct Electronic/Market Access (DEA or DMA) • Systems and controls around trading, including limits and thresholds • Disclosure to regulators No Not even for CPMI firms. One might have been forgiven for thinking that FCA would goldplate these provisions such that they also applied to AIFMs. It is, of course, strange for these rules to apply to MiFID investment firms, but not AIFMs (they would of course apply to any MiFID investment firm delegate of an AIFM) but the FCA's December 2015 consultation paper on the implementation of MiFID II (CP15/43), which deals Yes, in respect of DEA usage: • CP15/43 provides that before provision of DEA by a firm, due diligence of the prospective client (which could include AIFMs or other entities) must be undertaken to assess their suitability for using the service. • Further, MiFID II also requires a “binding written agreement” with the client (e.g. AIFMs and other entities) where an investment firm provides direct electronic access to a trading venue. This contract is required to set out the essential right and obligations of the parties and will undoubtedly include FINANCIAL SERVICES REGULATION BRIEFING HERBERTSMITHFREEHILLS 13 MiFID II requirement Applies directly to AIFMs / UCITS ManCos? Applies indirectly to or otherwise affects AIFMs / UCITS ManCos? with the transposition of the algorithmic trading and DEA provisions and provides draft FCA handbook provisions, clearly limits its application to MiFID investment firms and third country firms with establishments in the UK (i.e. branches) heavy representations and covenants from the using counterparty, given that under MiFID II the DEA providing investment firm remains responsible for the use by clients of the DEA being in accordance with MiFID II and the trading venue's rules Potentially, in respect of algorithmic trading: • Delegates of an AIFM that are MiFID investment firms will be subject to rules of algorithmic trading and HFT that the AIFM is not subject to. So any delegated mandates for such a strategy will effectively need to be hemmed into the MiFID II structures (which require, for example, "appropriate trading thresholds and limits") Dealing commission and payment for research • Restrictions on the use of dealing commission affecting the ability to purchase research • Use of research payment accounts Very likely4 N/a. Impact is likely to be direct – see column to the left Product manufacture Rules applicable to "manufacturers" (i.e. those involved in the creation, development, issuance or design of financial instruments): • Ensuring the design of the financial instruments does not adversely affect clients or lead to problems with market integrity • Assessing conflicts of interest • Identification of target market (and clients for whom will not be appropriate) • Undertaking scenario analyses to assess risks • Considering charging structures and ensuring: (i) compatibility with the needs, objectives and characteristics of the target market; (ii) no undermining of return expectations; and (iii) Depends: • Yes, if the AIFM/ManCo is a CPMI firm i.e. it performs the "MiFID bolt-on" activities for nonAIF/UCITS clients. These provisions will apply to the performance of the relevant activities • No, if the AIFM/ManCo is a CPM firm i.e. those AIFMs that do not provide "MiFID bolt-on" services to non-AIF clients Yes In many asset management groups there may be deemed to be more than one manufacturer of a given product: the AIFM but also a MiFID investment firm. Even third country group entities might be deemed to be a manufacturer. We would expect it unlikely that an AIFM would claim it has no role in the product development of its AIFs, although much of the initial product development process may be housed within the MiFID investment firm of asset management groups The obligations under MiFID II apply directly only to the MiFID investment firm in the chain. We would expect internal procedures, policies and intra-group contracts to ensure that the MiFID investment firm will be able to meet the obligations that affect it directly for funds that it may not manage directly or in respect of which it might not have a direct nexus with the distributor. Indeed MiFID II requires where investment firms "collaborate…to create, develop, issue and/or design a product" 4 The FCA, brimming with policy intention, goldplated the AIFMD in requiring that AIFM's comply with COBS 11.6 on dealing commission restrictions. There is no reason to think it would approach the COBS implementation of the MiFID II rules any differently. Indeed the FCA already hinted that it may move in that direction in its February 2015 Feedback Statement on its dealing commission discussion paper: "Our preference remains to implement any further changes to our domestic inducements and use of dealing commission rules in line with the final reforms under MiFID II. Depending on the form and content of the final legislation, we may also need to consider our approach to areas such as the treatment of UCITS and AIFM investment management activities". FINANCIAL SERVICES REGULATION BRIEFING HERBERTSMITHFREEHILLS 14 MiFID II requirement Applies directly to AIFMs / UCITS ManCos? Applies indirectly to or otherwise affects AIFMs / UCITS ManCos? transparency • Provision of information to distributors (including on appropriate distribution channels) they need to "outline their mutual responsibilities in a written agreement". As a result, AIFMs will be implicated and need to play their part in ensuring the MiFID firm can meet its obligations Careful attention will need to be paid to how this process is mapped across group entities Product distribution Rules applicable to distributors (investment firms that offer or recommend products and services to clients) of financial instruments: • Use information obtained from manufacturers and own information on clients to identify (a) target market and (b) distribution strategy. To be kept under regular review. Identify groups of clients for whom the product or service is not compatible • Ensure products (and services) that are offered or recommended are compatible with needs, characteristics and objectivities of identified target market • Ensure distribution strategy consistent with identified target market • Ensure client interests not compromised as a result of commercial or funding pressures • Compliance with MiFID II disclosure, suitability, appropriateness, inducements and conflicts rules Depends: • Yes, if the AIFM/ManCo is a CPMI firm (a collective portfolio management investment firm i.e. it performs the "MiFID bolt-on" activities for non-AIF/UCITS clients), these provisions will apply to the performance of the relevant activities • No, if the AIFM/ManCo is a CPM firm (a collective portfolio management firm i.e. those AIFMs that do not provide services to non-AIF clients) Yes, if it is assumed than an AIFM is a manufacturer. To ensure that the distributors can meet their obligations under MiFID II distributors are required to have in place "effective arrangements" to ensure that they obtain sufficient information about financial instruments manufactured by manufacturers that are not directly subject to MiFID II. This would include AIFMs as well as third country/non-EU group entities They will also be required to use "all reasonable steps" to ensure they obtain from manufacturers "adequate and reliable information" to ensure products will be distributed in accordance with the needs, characteristics and objectives of the identified market. There is a relaxation where information is publicly available (provided it is clear, reliable and produced to meet regulatory requirements) This means that we are likely to see the imposition of contractually binding terms that provide for the provision of key information and assessments by AIFMs, who might otherwise have not had product governance obligations under MiFID II Costs disclosure • Detailed cost information must be made available to retail clients, professional clients and eligible counterparties (with certain exemptions) • Where investment advice provided or UCITS or PRIIPS KID/KIIDS provided, "full" point of sale disclosure (ex ante) that provides two numbers (a) aggregated costs related to the manufacture and management of financial instruments and (b) aggregated costs related to the investment service. In other cases, no aggregation is required, although all costs and charges relating to the investment still Depends: • Yes, if the AIFM/ManCo is a CPMI firm (a collective portfolio management investment firm i.e. it performs the "MiFID bolt-on" activities for non-AIF/UCITS clients), these provisions will apply to the performance of the relevant activities • No, if the AIFM/ManCo is a CPM firm (a collective portfolio management firm i.e. those AIFMs that do not provide services to non-AIF clients) Yes Distributors of funds need to disclose to their clients the detailed ex ante and ex post cost disclosures in relation to financial instruments. This includes granular information that is aggregated. To the extent the manufacturer of a financial instrument (such as a unit in an AIF) does not already calculate these amounts, they will likely be required to by the distributor. Otherwise the distributor will not be able to meet its obligations with regard to recommending the AIF. So, AIFMs can expect to have to produce more detailed cost information than they might be used to (including ex ante estimates on difficult items such as broker execution costs). AIFMs are likely to be planning their costs calculation system FINANCIAL SERVICES REGULATION BRIEFING HERBERTSMITHFREEHILLS 15 MiFID II requirement Applies directly to AIFMs / UCITS ManCos? Applies indirectly to or otherwise affects AIFMs / UCITS ManCos? have to be notified to the client • Where the firm has an on-going client relationship with the client, post-sale information about costs and charges needs to provided on an annual basis • Third party payments received in connection with the investment service to the client also to be disclosed (they are effectively treated as rebates that need to be identified to the client) • Ex ante disclosure required even where difficult to predict/know (e.g. for transaction costs) build for PRIIPs over the coming months. They must note that the MiFID II cost disclosure provisions are not harmonised with PRIIPs. Any PRIIPS system build should consider also additional disclosures that might be required under MiFID II Client agreements and client information • Enhanced disclosure Depends: • Yes, if the AIFM/ManCo is a CPMI firm (a collective portfolio management investment firm i.e. it performs the "MiFID bolt-on" activities for non-AIF/UCITS clients), these provisions will apply to the performance of the relevant activities • No, if the AIFM/ManCo is a CPM firm (a collective portfolio management firm i.e. those AIFMs that do not provide services to non-AIF clients) To the extent the AIFM is a client of a MiFID investment firm, it will be a beneficiary of these provisions FINANCIAL SERVICES REGULATION BRIEFING 8. Contacts Clive Cunningham, Partner T +44 20 7466 2278 M +44 7989 558 095 firstname.lastname@example.org Nick Bradbury, Partner T +44 20 7466 2087 M +44 7971 249 680 email@example.com Tim West, Partner T +44 20 7466 2309 M +44 7809 200 693 firstname.lastname@example.org Nigel Farr, Partner T +44 20 7466 2360 M +44 7785 254 972 email@example.com Nish Dissanayake, Senior Associate T +44 20 7466 2365 M +44 7595 967 331 firstname.lastname@example.org Mark Staley, Senior Associate T +44 20 7466 7621 M +44 7809 200 323 email@example.com Daniel Rados, Associate T +44 20 7466 2239 M +44 7730 092 206 firstname.lastname@example.org Pat Horton, Professional Support Lawyer T +44 20 7466 2789 M +44 7809 200 880 email@example.com If you would like to receive more copies of this briefing, or would like to receive Herbert Smith Freehills briefings from other practice areas, or would like to be taken off the distribution lists for such briefings, please email firstname.lastname@example.org. © Herbert Smith Freehills LLP 2016 The contents of this publication, current at the date of publication set out above, are for reference purposes only. They do not constitute legal advice and should not be relied upon as such. Specific legal advice about your specific circumstances should always be sought separately before taking any action based on the information provided herein.