On 3 January 2017, the Markets in Financial Information Directive (MiFID II) comes into force. The legislation has number of objectives related to increasing investor protection, increasing product and market transparency – and improving corporate governance.
The introduction of the updated legislation has implications for wealth markets across Europe. Countries such as the UK and Holland have already made some progress by introducing initiatives such as a commission ban.
Over time the proposed changes will drive further regulatory homogenisation across Europe. The proposed additions to MiFID are extensive and not all included here. In this article we outline what we see as being some of the key points that will shape wealth management businesses in the run up to, and after its introduction in 2017.
The definition of independence. Under MiFID II, if firms wish to provide independent advice, they will have to ensure they do not limit the products they offer. MiFID II proposes that firms will have to consider a ‘sufficient range of products’ to meet the needs of clients within their chosen market which will have to be clearly defined.
This compares to the FCA definition requiring firms to undertake a ‘comprehensive and fair’ analysis of products. The FCA is currently seeking views on whether or not the need to consider a ‘sufficient range of products’ would require wealth managers and planners to redefine the breadth of products they consider before making a personal recommendation.
The FCA definition covers retail investment products. The MiFID II definition covers financial instruments including bonds, shares and derivatives currently not included within the FCA definition. The definition of independence under MiFID II remains a key point of debate from a UK perspective. The outcome could create additional costs for firms wishing to remain independent, or push more firms to become restricted.
Suitability. Since the inception of RDR in the UK, there has been significant emphasis on the need for advisers to understand and document a client’s ability to bear losses, and their risk tolerance. While the UK is further ahead than most of Europe, ESMA proposes that firms:
Disclosure. In MiFID II, the level of information to be provided to clients will be significantly more than is offered today and will require upgrades to systems and processes. For example, clients should be given access to quarterly reporting on portfolios with access to the detail that sits behind it when required.
More information should be made available to a client who has taken investment advice. This relates to which financial instruments have been used, the costs and charges and how these impact future returns on the investment portfolio, client agreements (which are more detailed than the current requirement) and information on client assets.
These new requirements have implications for client management processes, both front and back office.
Costs and charges. When it comes to costs, the EU is proposing to take disclosure a step further with the costs of service provided, and the costs of the product recommended to be included. This breakdown should include distribution and management fees, payments to and from third parties, including broker commissions and platform fees.
Once defined, these fees should be aggregated to illustrate to the customer the cumulative cost of their investments both in cash and percentage terms. This proposal will place greater emphasis on the need for platforms and back office providers to develop additional data management functionality to support this. It is also likely to result in advisers and their clients paying greater attention to where assets are invested and may help to drive further asset flows towards passive, or more competitively priced active funds.
However, defining and implementing the systems and processes required to achieve this desired outcome will be complex with the need for multiple suppliers of data sources to collaborate.
Appropriateness, complex products and execution only. EU legislation on ‘complex’ investment products requires product providers to carry out ‘appropriateness tests’ to determine whether or not the customer can make an informed decision about the product.
From January 2017, it is likely that all investment products apart from vanilla shares, bonds and non-structured UCITS funds will be considered complex. This will effectively narrow the scope of execution only business, and it could also result in advisers being forced to collect and share client information on non-advised business with providers. Investment in data management may be required.
Another implication is that it could force multi-asset vehicles classified as non-UCITS retail schemes (NURS) to change their structure. Asset managers have been hoping demand for these products would grow in the post pension freedoms environment, attracting the interest of advised and non-advised clients. However, it would now mean that the later group would have to take an ‘appropriateness test’ each time they want to purchase a NURS product.
Inducements. For firms that wish to remain independent, there will be an EU-wide commission ban on independent financial advisers and discretionary investment managers. These firms will be forced to adopt transparent fee structures similar to the approach taken by the FCA in the UK. However, to ensure a level playing field some countries are pushing ESMA to ban commission for all financial advisers.
Recording of telephone conversations. While a small but increasing number of advisers in the UK have started to record conversations with clients, it may become mandatory for all with implications for how these calls are filed and tagged within existing back office systems.
There are concerns about the cost implications of this process that will require digital storage, systems integration and compliance monitoring and analysis. ESMA is proposing these records should be kept for seven years.
Complaints handling. Under the Level II proposals, there will be a number of new requirements that go significantly beyond what is currently in place. This includes: i) a written complaints procedure for handling complaints, ii) the ability for clients to be able to make a complaint without charge, and iii) responding without unnecessary delay.
So what are the implications?
MiFID will have a significant impact on all aspects of the value chain and is likely to result in structural change across the European retail investment market, driving consolidation and innovation as firms seek to absorb the additional requirements while remaining price competitive.
Wealth managers, financial planners and discretionary investment managers will need to carefully consider the implications of remaining independent and potentially subscale. There will be additional research costs, as a broader range of financial instruments will have to be considered. If firms decide to focus on a specific set of needs, they will have to clearly state which market they are targeting. These additional requirements will either drive the need for greater scale through merger or acquisition, or more firms will opt to become restricted.
For asset managers, MiFID II introduces a new cost and charges disclosure requirement. Firms will have to disclose all costs and charges associated with an investment service and financial instrument, which are not caused by the occurrence of underlying market risk, at the point of sale and as appropriate, on an annual basis.
We have already seen greater transparency post-RDR resulting in advisers seeking investments that deliver better value for money for clients. One notable outcome has been a shift towards the use of passive investment funds with beneficiaries being fund groups such as Vanguard and Dimensional Fund Advisors that have both experienced significant growth in the last three years. Under MiFID II this trend is likely continue, resulting in further consolidation among active managers and discretionary fund managers.
Retail investment platforms and data providers have a key role to play in supporting asset managers, wealth managers and planners. New opportunities will arise from requirements relating to the need for access to additional financial instruments, pricing transparency and enhanced client reporting.
Back office and other third party software providers will have to develop additional functionality to help wealth managers with issues such as improved suitability, reporting, data aggregation and the ability to record and store digital voice files.
Analysis undertaken by the European Commission estimates that MiFID II is estimated to impose one-off compliance costs of between €512 million and €732 million and ongoing costs of between €312 million and €586 million per year. The one-off costs for asset managers and wealth managers are expected to be somewhere in the region of 60 basis points, reducing to an estimated 10 basis points for recurring compliance costs. Over time the proposed changes will drive greater competition and these costs may not necessarily feed through to consumers for this reason. If this is the case, firms will have to improve productivity.