After ten years of extensive revision, debate and delays, the revised Markets in Financial Instruments Directive II (MiFID II) will finally come into force in January 2018. MiFID II is one of the most complex and wide reaching changes to financial market regulation the industry has ever seen, so it should be no surprise that UK financial firms face a one-off bill of as much as £225m and ongoing annual costs of £180m (see boxout).
The 148-page EU directive has 97 articles, two annexes and countless clauses aimed at resolving weaknesses in the functioning and transparency of financial markets exposed by the 2008–2009 global financial crisis. It has six broad goals (see boxout), however its impacts on firms – and the areas they should focus on – are best understood in terms of six key themes.
MiFID II will codify product governance for the first time. The rules cover firms that manufacture new products then decide on the range of products and services they plan to offer to clients.
Firms must assess the target market under six specific categories, such as the type of market, clients’ knowledge and experience, their financial situation and ability to bear losses, and clients’ objectives and needs.
They then need to take reasonable steps to ensure the financial products are distributed to the identified target market. This must be done via a distribution strategy, which uses best efforts to select a distributor, whose clients and services are compatible with the target market.
There are tight client information requirements covering the type of advice, conflicts of interest disclosure, and marketing material for products that are ready to be sold. To avoid falling foul of MiFID II, firms that want to provide independent advice must make sure they design a selection process to compare a range of products whose number and variety is in proportion to the scope of investment advice offered. It must take into account aspects such as risks, complexity and costs of the product, and the client’s requirements. The law firm Arthur Cox has produced a detailed briefing, while the legal wording can be found at clauses 70–73 of the directive.
The one-off bills UK financial firms could face as a result of regulation laid out in MiFID II
MiFID II puts a greater emphasis on risk tolerance and includes more explicit references to “ability to bear losses”. Investment firms and advisers will be required to report to clients where the value of their portfolio depreciates by 10% between valuation points in any quarter.
3. Trading and execution
Trading and execution covers market structures, best execution and transaction reporting. MiFID II extends the scope of firms' reporting requirements significantly by obliging firms to report on nearly all instruments traded on regulated markets. In order to be compliant in time for January 2018, firms need to do two things: assess their current communications set-up in order to see which areas will be subject to MiFID II and which require extra investment; and identify any technical problems with their call recording systems and rectify those.
Furthermore, the volume of information that needs to be reported is larger than under MiFID I. While the first directive applies only to financial instruments admitted to trading on a regulated market, MiFID II expands trading venues to include multilateral trading facilities and a new category of organised trading facilities that includes a wide range of instruments set out in Paragraph 23 of Article 4 in the directive. The details of what needs to be reported are laid down in ten clauses in Article 26 of the Markets In Financial Instruments and Amending Regulation (MiFIR). As noted in ‘Making sense of MiFID’, firms may need to revamp their IT systems to provide a continuous price for pre- and post trades.
MiFID II also transfers responsibility of transaction reporting from brokers to asset managers.
For more on brokers' research and inducements, see ‘The role of asset owners in the market for investment research’ by Edinburgh University’s Alistair Haig in the July 2016 Review of Financial Markets 4. Fees and inducements
MiFID II compels firms to unbundle the costs of trade execution and investment research, which must be disclosed separately. Firms providing investment advice on an independent basis or portfolio management will, in most circumstances, be prohibited from retaining any fees from third parties. While UK independent financial advisers must do this under the Retail Distribution Review, the directive extends this to portfolio managers. According to business advisers EY, firms need to prepare by: seeing what fees are potentially at risk; checking how the ban on inducements will affect the product landscape; and drawing up the most appropriate fee structure post-MiFID II.
Costs and key issues
The key issues that MiFID II seeks to tackle are:
– Increased investor protection.
– Improved corporate governance.
– Streamlining of regulations across the EU.
– Increased competition across the financial markets.
– Strengthening supervisory powers at national and supranational levels.
– Regulating market access for third country investment firms.
It is estimated to impose total compliance costs of €512m–€732m (£433m–£620m at May 2017 exchange rates) and ongoing costs of €312m–€586m. The UK Government estimated in 2015 the UK would bear 36% of the estimated total cost of MiFID II of which:
– One-off compliance costs: €184m–€264m.
– Ongoing costs from 2017: €112m–€211m.
However, consultancy Opimas in 2017 put the cost for firms at €2.5bn (£2.1bn), of which banks will account for 83%, with an annual industry spend of €720m over five years. A report by IHS Market and Expand, a Boston Consulting Group company, says preparations alone will cost investment banks and asset managers $2.1bn in 2017.
5. Corporate governance
MiFID II is more detailed than MiFID I in setting out the role and responsibility of the management body to ensure good corporate governance. It must set out the firm’s corporate governance arrangements, and fully scrutinise them at the time of implementation. This must specifically include: the skills, knowledge and expertise required by personnel; and the resources, procedures and arrangements for the provision of services and activities.
Last but not least is trade transparency – probably the most significant change from the regulatory regime. It applies pre- and post-trade transparency to all over-the-counter markets. Companies must record all telephone conversations and electronic communications that lead to a transaction, including communications intended to result in a transaction – no matter what the final outcome. These regulations will apply equally to companies dealing on their own account, as well as those providing services to external clients. Firms must ensure they have systems to keep all recordings for a minimum of five years, during which period they should be readily available to clients and enforcement authorities upon request.
In all these areas the European Securities and Markets Authority is drafting technical standards. In April 2017 it published answers to 54 commonly asked questions on many of the issues mentioned in this article. However, a survey conducted in April 2017 by corporate finance advisory firm Duff & Phelps notes that 64% of financial institutions are not confident about meeting the January 2018 compliance deadline. With some six months to go, firms must ensure they have completed their gap analysis and impact assessment and be well advanced in developing policies and procedures to ensure compliance.