Mifid II – the second phase of the European Union’s Markets in Financial Instruments Directive – is just a few weeks away.
It is one of the widest-ranging pieces of investment legislation for many years, touching on nearly all aspects of trading, whether as individuals, corporate entities, charities, trusts or discretionary managers.
The directive fits within all the other various pieces of legislation, springing out of the mire created by the 2008 financial crisis, and is causing some compliance departments quite a few headaches.
A survey commissioned by Intelliflo and published in December 2017 found that Mifid was a big issue for advisers.
When asked what the biggest challenges for their businesses were over the next 12 months, respondents to the survey listed:
- Complying with Mifid II.
- Being ready for GDPR by May 2018.
- Cyber security.
- Recruiting staff.
- Robo advice.
- Preparing for Brexit.
Rob Walton, chief operating officer at Intelliflo comments: “Although Mifid II comes into effect at the start of the year, our survey reveals the concerns advisers have about being fully compliant with it.”
Yet the legislation is supposedly bringing in positive change for investors. As the Financial Conduct Authority (FCA), the body responsible for implementing Mifid II in the UK, has claimed, it will “strengthen investor protection”.
“In the words of the FCA,” says Richard Romer-Lee, managing director of Square Mile Investment Consulting and Research, “Mifid II aims to strengthen investor protection, reduce the risk of disorderly markets, reduce systemic risks and increase the efficiency of financial markets, and reduce unnecessary costs.”
While the industry broadly welcomes anything that makes investing better, there are many more obligations and duties upon advisers, fund managers, discretionary fund managers, platforms, product providers, research analysts and the end investors themselves, which need to be grasped before 3 January 2018.
Suitability
One of the main points for advisers is in the way suitability reports must be carried out.
Although essentially Mifid II does not fundamentally change the requirements already on UK advisers, namely to ensure the fund they recommend will be suitable for each individual, it does “impose a new obligation on investment advisers to provide suitability reports to retail clients before any transaction is concluded”.
This is the view of Susann Altkemper, counsel for City law firm CMS, who comments: “In practice, this might be difficult to achieve, and unless advisers can rely on a narrowly drafted exception, they will need to adjust their processes or consider changes to business models altogether.”
She points out that suitability reports are also required where the advice does not lead to a transaction, or where the advice is not to buy or sell a financial instrument, and whether there had been better alternatives.
The implication is that where there is no trade or transaction, advisers may have not kept detailed documentation on such advice beforehand.
This all changes under Mifid II – advisers will have to make sure they keep extensive and detailed file notes.
Moreover, advisers cannot just state to the regulator that they met the definitions of suitability, they “have to state how suitability is met”, Jennine Watts, regulatory solutions manager at SEI Wealth Platform, advises.
This means advisers will really have to know their target market, and ascertain whether a particular fund is suitable for a particular client.
Target market
A fund manager under Mifid II must state what the target market is for a fund the firm creates.
For these firms, this means a far greater focus on product, target market, cost and appropriateness. It also means providers need to give more information to advisers to make their recommendations in the first place.
In practical terms, under Mifid II, providers must define the target market for each one of their assets, and should have done so well before 3 January 2018.
They will need to be crystal-clear about what their funds are supposed to do, and at whom the funds are targeted. Advisers will need to make sure the product and the target market are in line.
According to Richard Janes, spokesman for Brewin Dolphin: “There are requirements on manufacturers to identify the risks of their investments, and define the appropriate target market.
“There is an onus on distributors who will need to consider the target market alongside their overarching suitability obligations.”
Under Mifid II, manufacturers of products will have to pay attention to the investor at every point in the process – from design to distribution.
With the proliferation of funds across Europe, it becomes imperative under Mifid II for product providers to be open and transparent about the funds they create, and for whom.
If, for some reason, a financial adviser chooses to use a fund for a client, who is not considered part of the target market, the adviser must be clear in reporting back upstream to the provider.
Fund managers and advisers with discretionary permissions fall within Mifid II’s catchment area; even if advisers do not produce and run their own funds, it is best practice to check a third-party manager’s funds are meeting the requirements.
Call recording and reporting
Alex Mawson, product director of voice networks at Daisy Group, warns that all firms, large and small, will need to pay attention to whether their current call recording processes go far enough.
“What Mifid II does is bring a whole new level of mandatory transparency, expanding the remit to mobile calls and text messages, on both company-provided and personal devices.
“And with the stakes being so high, this is not something businesses can assume is already within their capabilities.”
According to Ian Hook, vice-president of European business operations at Smarsh, some IFAs may be unaware of the onus Mifid II will put on their communications.
This could include Facebook Messenger or LinkedIn conversations where recommendations might be perceived to have been given – all of this will need to be recorded and stored somewhere.
He warns: “If you are going to capture your digital communications, whether because your business falls under the regulations, or you have decided to voluntarily comply, then make sure you know what comes under the umbrella of ‘communication’.”
Costs and charges disclosure
From 3 January onwards, asset managers will be forced to break down costs clearly and simply into four key categories for each fund.
In a nutshell, these are:
- The ongoing charge.
- One-off fees such as entry and exit charges.
- Incidental fees, such as performance charges.
- Transaction fees relating to the investment product.
Mifid II is clear about what cost information must be made clear to investors.
As outlined by Ms Altkemper, this is: “All costs on an aggregated basis, relating to both the service or ancillary service provided, plus the costs incurred in relation to the investment recommended or marketed.
“Disclosures must also cover any third-party costs.”
Under Mifid II, all costs must be expressed in two ways: as a percentage, and as a cash amount.
Moreover, all retail clients will be given an illustration showing the cumulative effect of costs on returns, and any anticipated spikes or fluctuations.
To add to all this documentary information to clients, any previous disclosure requirements on cost and charges will be enhanced with the obligation for firms to provide the client with a comprehensive illustration of all expected point-of-sale (ex-ante) costs and charges, including their overall effect on investor returns.
The purpose of this is to ensure the client gets a specific and tailored breakdown of all the costs and charges they have paid out.
Says Ms Altkemper: “While clients will benefit from an increase in transparency, firms will need to develop compliant costs and charges disclosures.”
This will involve advisers having to collate data internally, and even from external sources, such as other firms in the distribution chain.
Jackie Beard, director of manager research services for Morningstar, is an advocate for this change: “The increase in fee transparency, brought about by Mifid II, is welcome, in our view.”
Adviser platforms
Under Mifid II, the onus on platforms will increase, in terms of the burdens of disclosure of risk, remuneration and assets, as well as carrying out enhanced reporting.
Firstly, costs and charges will mean platform fees come under the spotlight. Heather Hopkins, head of Platforum, explains: “Clients will have a clearer view than ever before of all costs and charges, including the investments.”
Then there are the pre-sale valuations, which have to show estimated costs for the fund, and now the cost of the platform, advice and even the cost of investment research.
There will be a need for a post-sale illustration with actual and anticipated costs provided.
Investors will also need to receive valuations at least quarterly, and an annual statement of costs, while providers using platforms must still ensure the products are reaching the right customers.
All this means more information and more data-sharing between adviser, DFM, platform and provider.
The 10 per cent rule
Under Mifid II, there is a requirement for those running a discretionary managed portfolio to notify clients quarterly every time there is a 10 per cent drop in the value of that portfolio.
This should be done within 24 hours of the drop occurring and it is the DFM’s responsibility to inform the client.
Therefore, any wealth manager discretionary permissions will need to ensure they have a mechanism in place to track portfolio performance and notify clients of a 10 per cent drop.
It also means advisers will have to provide up-to-date contact details to allow the DFM to contact the client. This means a third party will have access to an adviser’s clients – not a situation with which many advisers will be comfortable.
However, the notification only needs to be given for a discretionary managed part of a total portfolio. Should the overall portfolio drop 10 per cent, there is no need for a notification.
In a blog post for platform Nucleus, Phil Young, founder of support service Zero, commented the 10 per cent rule was “nuts”.
According to a spokesman for Novia, most financial advisers will not be affected “unless they have discretionary permissions – and very few do”.
That said, as with any regulatory change, it is worth checking permissions are up to date.
LEI and the Nino
There is also the need for some advisers with discretionary permissions to have a legal entity identifier (LEI) in place.
Under Mifid II, a new set of standards for investing in exchange-traded assets or exchange-traded instruments (ETAs or ETIs) are being put in place under new ‘transaction reporting’ rules.
Providers under Mifid II will need to know who is the beneficial owner of an ETI, and who is the decision-maker in respect of the transaction.
This means where advisers are dealing with legal entities, such as trusts, charities or corporates, they will need to have an LEI in place so they can continue trading in ETIs.
Any advisers who do not already have an LEI can get one from the Stock Exchange – for an upfront £115 initial charge and an annual £70, not including VAT.
Individual clients will need to provide their advisers with their National Identifier (Nino), to provide to platforms or providers. Without this information, platforms and providers will not allow any trades in ETFs after 3 January.
For the majority of advised clients in the UK, this will be the National Insurance number. Unless, of course, a client has dual citizenship.
Under the current EU rules, which seem rather bizarre, there appears to be an alphabetical quirk. So, say a client living in Hampshire, UK, has dual nationality – Austrian (A) and British (GB).
It is perfectly reasonable the IFA might only know about their client’s UK citizenship, so may assume this client’s Nino will be their UK National Insurance number. But no.
Austria is before GB in the list of EU countries drawn up alphabetically under Mifid II, so until the UK comes out of Europe, the National Identifier number the adviser must give to the London Stock Exchange for that client to be able to trade exchange-traded funds after 3 January, will have to be the Austrian one, not the UK one.
But when we come out of Europe, it is understood that this alphabetical order will not apply if someone has joint British and citizenship of another European country.
However, someone living and working and paying tax in the UK, who happens to be joint French and Italian citizen, might pose more problems for the IFA, as the Nino will need to be the French one.
This seems very arbitrary, according to one platform, and it is something that is apparently still needing to be ironed out before the rules come in.
Until there is more clarity, the platform suggests it is always best to check who holds dual citizenship, and work out which information will be needed to provide a national identifier for corporate and individual clients wishing to trade ETFs after 3 January.
Research costs
Research costs is another area being brought to the fore by Mifid II.
The measures under Mifid II are basically to unbundle the costs of research bought by the fund manager, so investment firms can show they are not being induced to trade.
They will, from 3 January, have to put in place systems that can manage unbundled payments for execution and advisory services, and be able to show the research and pricing models for those services.
Some fund managers are going to absorb the costs, a few will pass it onto their clients, and others just will not be affected, as they have always done their own research within their management teams and not relied on external analysts.
The main challenge, therefore, will be in how to break down the value chain to the client meaningfully.
Mr Janes says this transparency will reassure clients and advisers there has been “no undue inducement in that regard by their investment manager to use one firm over another”.
“They may still end up paying for the research if their firm employs research payment accounts, but it will be clear to them what the cost is and, if the firm pays for research centrally, it could end up in an overall reduction in cost for the client.”
However, there are still some concerns that, while investors will only end up paying for costs relating to their investments, and not to a share of all research bought by a firm, this could limit the choice or breadth of research available.
Only time will tell if the legislation does limit such research, and has a knock-on negative effect on people’s investments.
Education
Overall, the changes being brought in by Mifid II are largely an underscoring of what IFAs already do in the UK. But the additional changes are really a question of education – and making sure the providers are giving the right information to advisers and the end client.
Moreover, providers will need to demonstrate to distributors that they fully understand the products and its features, so that advisers and distributors can explain these adequately to the end investor.
With the emphasis on knowing the client, proper product design and appropriate distribution, there should be better documented analysis available to help make the distributors more knowledgeable about the fund universe on which they must advise.
This means advisers will need to be given more information for them to be able to make a more appropriate and suitable recommendation to clients.
Simoney Kyriakou is content plus editor for FTAdviser