MiFID II – the countdown continues




By 3 January 2018, MiFID II is set to form the legal framework governing the requirements applicable to investment firms, regulated markets, data reporting service providers, and third-country firms providing investment services or activities in the European Union. The ‘level one’ legal texts were published in June 2014, but the initial deadline has already been delayed by one year as regulators and businesses alike have struggled with this extensive and ambitious reform. The ‘level two’ delegated legislation was not finalised until this year, and there are over 40 final drafts of ESMA technical standards and a number of pending implementing technical standards. ‘Level three’ measures (ESMA Guidelines, Q&As) are numerous and ongoing.

Although MiFIR as an EU Regulation will take effect directly, the MiFID Directive will need to be implemented into UK law. The FCA has pushed back publication of its final rules until 2017, and despite having published its consultation paper in 2015, HM Treasury is unlikely to finalise its implementing statutory instruments for some time. Changes to the PRA rules will also be required.

The complexity and cost of MiFID II, coupled with the numerous quantities of incomplete official documentation, has meant that the level of preparation by firms is inconsistent. The financial services industry may be accused of hesitation, but building on quicksand has never been easy, especially when faced with incessant waves of EU reform.

Asset managers in particular will be significantly impacted by MiFID II reform. Investment management activities will undergo change spanning front, mid and back office functions, ranging from trading and product development to HR and IT. The legislation directly captures firms carrying out advisory and individual portfolio management activities, as well as indirectly capturing AIFMs or management companies that distribute products through MiFID firms.

Furthermore, the alignment of the AIFM, UCITs and MiFID II regimes is simply a question of time. This article will focus on the impact on asset managers and highlight the key changes that the investment management industry will face.

Investor protections

The legislation sets out new provisions on independent advice. Clients must be informed whether advice is provided on an independent basis, and if so, the firm must comply with additional requirements, including a prohibition on accepting inducements.

Firms providing portfolio management or independent investment advice are prohibited from accepting and retaining fees, commissions or any monetary or non-monetary benefits paid o provided by a third party or person acting on their behalf. Firms must have a policy in place for accounting for all such commission to the client, although minor non-monetary benefits may be permitted. Firms not providing independent investment advice or portfolio management must comply with the existing inducement rules for all types of third-party payments.

Research unbundling

One of the most controversial aspects of MiFID II for asset managers has been its requirements on research unbundling. The FCA is consulting on whether to apply these requirements to MiFID exempt UK authorised firms carrying out investment management of collective investment schemes.

Investment firms providing both execution and research services will have to price and supply these services separately, and confusion remains over the permissibility of traditional Commission Sharing Arrangements (CSAs) and their relation to RPAs (pre-funded research payment accounts). The delegated legislation published in 2016 provides that a client research charge may be collected alongside a transaction commission and delegation of administration of the research payment account to a third party is permitted (provided certain conditions are met). However, the research charge must be based on a research budget and must not be linked to the volume and/or value of transactions.

If a firm is unable to use an RPA it is likely to have to bear research costs itself. As investment firms must provide specific information on costs and associated charges to the client, including an itemised cost breakdown upon request, such increased costs transparency may prevent firms from transferring increased cost to investors. This burden has led to concern over reduced research functions causing both increased execution charges from banks and a decline in firm performance.

Product governance

Increased costs will also result from the introduction of new product governance rules, which ESMA state is aimed at protecting investors by requiring firms to take responsibility for ensuring that products and services are only offered in the interest of clients. Products and services should not be offered in a way that is prejudiced by a firm’s own commercial, funding or prudential needs.

Firms must cooperate in order to meet new obligations placed on manufacturers and distributors, which will include the need to share information on the characteristics and identified target market of each financial instrument. The FCA proposes to apply product governance requirements to third-country firms in the form of rules rather than guidance, in order to ensure that they are treated ‘no more favourably’ than EU/EEA firms.

Suitability and appropriateness

Firms may decide to reconsider the kinds of products that they offer as a result of changes to MiFID suitability and appropriateness assessments. The MiFID II Directive places obligations on firms providing investment advice or portfolio management services to obtain information about the client’s risk tolerance and ability to bear losses as part of the assessment on product suitability. For firms that are subject to the appropriateness requirements, the range of non-complex products which are needed to meet the ‘execution-only’ exclusion are narrowed and a shift toward products falling under the revised classification may therefore be seen.

Client categorisation

Public and local authorities must be classed as retail clients, although they can elect to be treated as professional clients. The FCA has discretion to adopt alternative or additional criteria in order to assess the expertise and knowledge of local authorities who wish to become ‘elective professional clients’, and it has stated that it is keen to ensure only those with the requisite expertise can be treated as professional clients, especially given concerns over alleged mis-selling in recent years. Firms will need to review their current client categorisations, which may impact internal systems, and AIF/UCIT asset managers should be aware that the FCA proposes extending the scope of these provisions to non-MIFD scope business.

Transparency and reporting

The MiFID transparency and reporting regimes are expanded to capture more asset classes and to cover all trading venues. In addition to coming under increased pressure for greater detail in reports, buy-side firms will become more restricted in relying on their broker to meet reporting obligations on their behalf. MiFID II obligations have also been made personal: there is a requirement to identify the persons responsible for the investment decision and the execution of the transaction, and recordkeeping requirements will intrude into the recording of telephone conversations and electronic communications.

Best execution

Investment firms face the increased burden of taking all ‘sufficient steps’ (as opposed to ‘all reasonable steps’ under MiFID) to ensure best execution, and this requirement is extended to cash bonds, derivatives and FX forwards. Investment firms that execute client orders will need to summarise and make public on an annual basis, for each class of financial instruments, the top five execution venues in terms of trading volumes where they executed client orders in the preceding year and information on the quality of the execution obtained. Order execution policies shall include information on the different venues where the investment firm executes its client orders and the factors affecting the choice of execution venue.

Although the legislation aims to strengthen front office accountability and systems and controls, the extension of transparency requirements has led to concerns over liquidity, particularly in relation to OTC fixed income securities.

Market transformation

The impending market transformation under MiFID II will impact all those dealing on an EU market. Key market change includes a volume cap on dark pool trading, specific provisions for the regulation of multilateral trading facilities (MTFs) and OTFs, and an enhanced Systematic Internalisers (SI) regime. There are also new requirements on firms providing direct electronic access (DEA) and algorithmic traders.

In line with G20 commitments, the derivatives market has come under particular scrutiny. Based on separate liquidity and venue tests, ESMA will determine which derivatives subject to the clearing obligation under EMIR will be required to be traded on a regulated market (RM), multilateral trading facility (MTF), organised trading facility (OTF), or a third-country trading venue deemed to be equivalent. The FCA will set limits on the size of positions that a person can hold in any commodity derivative traded on a venue, and the legislation also provides for increased market transparency by introducing OTFs as a new category of venue for trade of non-equities.

Brexit – the clock has not stopped

The FCA has confirmed that Brexit will not postpone implementation plans, and even once Article 50 is triggered, Britain will still remain subject to EU legislation for at least two years. MiFID II passporting provisions enable a non-EU firm to provide investment services to eligible clients and per se professional clients within the EU provided the third-country regime is deemed to be equivalent by the Commission. ‘Hard Brexit’ dialogue and current EU negotiations mean that MiFID II’s third-country passporting provisions are yet another reason to keep an eye on the clock.

Faced with an incoming tide of change, firms have no choice but to act now to build their defences. Robust IT infrastructure, clear record-keeping procedures, adequate remuneration, cost and complaints handling policies, and a compliant corporate governance system will all need to be in place prior to the 3 January 2018 deadline. Although niche and large firms may well be best placed to endure such upheaval, no firm will escape the hands of time. In the midst of such uncertainty one thing is clear: the one-year countdown is creeping ever nearer.


William Younge is a partner at Morgan Lewis. He can be contacted on +44 (0)20 3201 5646 or by email: william.yonge@morganlewis.com.

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William Younge

Morgan Lewis

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