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Articles and opinion

First published in Law 360 on 17 January 2018

In an article first published in Law 360, Rosalyn Breedy considers a number of long-term strategic issues facing the financial services sector.

Before and beyond Brexit, the UK financial sector prepares for MiFID II

While Brexit negotiations continue, behind other closed doors in the City of London, strategy teams are working on plans for various post-Brexit scenarios.  How will the UK retain top talent?  How will we secure our competitive position as the second largest asset management centre in the world?   How can we harness AI capabilities to nurture our innovative FinTech sector?

These are long-term strategies that will take us well beyond Brexit.  In the meantime banks, asset managers, consultancies and law firms have embarked on a hiring spree for the sort of people, who can help to prepare for the introduction of the second Markets in Financial Instruments Directive (MiFID II) in January 2018.

A European Directive, MiFID II is essentially about improving investor protection and market integrity across Europe.

Comprising more than 1,400,000 paragraphs of rules, it directly affects banks, asset managers, exchanges, brokers, wealth managers and high frequency traders in the (current) 28 EU member states. 

It also has indirect implications for US and other non-EU asset managers who offer market investment management services in the EU and /or trade on EU fixed income and equity markets.

Investor protection

MiFID II aims to deliver a much more comprehensive investor protection regime, derived from the lessons learnt in the last decade about the culture and conduct of firms and individuals and the delivery of complex products to investors who didn’t understand them. It also addresses the EU regulators’ concerns about the transparency and level of fees.

The key investor protection principle is that firms within the scope of MiFID II will be required to act honestly, fairly and professionally in accordance with the best interest of their clients. 

In practice the rules mean that:

·         MiFID II restricts the payment or receipt of all fees, commission and non-monetary benefits (inducements) unless these enhance the quality of service provided to a client, and do not impair an EU investment firm’s duty to act in the best interests of its client. However, there is an exemption for any inducement that is a minor, non-monetary benefit – for example, macro-economic analysis which is openly available and generic in nature i.e. it doesn’t explicitly or implicitly suggest an investment research strategy.

·         Firms will be obliged to disclose to each client all fees, commissions and non-monetary benefits received by them in connection with any investment service provided by them to that client.

·         Conflicts of interest must be clearly disclosed to the client. In circumstances where the mechanisms for detection and reporting of conflicts are not sufficient to prevent a risk of damage to the clients’ interests, the general nature and/or sources of conflict and the steps that have been taken to mitigate the risks should be disclosed to the client before undertaking the business on the client’s behalf.

·         Employees must not be remunerated, or assessed, in a way that conflicts with the duty to act in the best interests of clients.

·         Advisers cannot claim to be independent if they cannot demonstrate independence, for example, by not accepting inducements.

·         Complex products cannot be sold without advice to retail investors.

·         Firms must manufacture products having regard to the type of client for whom the product is designed, their knowledge and experience, objectives and needs, financial situation and ability to tolerate losses, their risk tolerance, the compatibility of the product’s risk and reward profile, and target distribution to the identified target market.

·         Firms have to publish best execution data related to pricing structures and disclose to their clients prescribed information on commissions, execution costs and research-related expenses.

Market integrity

MiFID II has broadened the category of financial instruments caught by transaction reporting requirements from equities traded on an EU regulated market plus any over-the-counter contract which derives its value from any such financial instrument.  From January, it will also cover equity-like instruments and non-equity instruments such as bonds and structured products.

Reports have to be made pre and post-trade, as close to real-time as possible. The transaction reports will also require legal entity identifiers for counterparties.

Firms who previously relied upon MiFID authorised brokers to report transactions have found that this exemption has narrowed and that they need to provide certain data, put in place written transmission agreements and take reasonable steps to verify the completeness, accuracy and timeliness of reports.

Impact

The key benefits of MiFID II are to investors, as it aims to ensure that products are not mis-sold. Investors should receive clear information on fees and conflicts of interest which should then inform better decision making and, hopefully, better take up engagement in investments.

Regulators will receive better information on the activity of the investment management market which should enable them to better support the integrity of the markets. 

MiFID II has not solved all the problems for investors in that, by itself, will not reduce investment costs or solve the advice gap for middle-wealth investors.

While in the short term it is creating more compliance work for UK law firms and consultancies, in the longer term MiFID II will drive the development of better targeted offerings by UK-based banks and asset managers.

Beyond Brexit

According to the 2016-2017 Investment Association annual survey, the key issues for asset managers in regard to Brexit was to ensure continued delegation of portfolio management to the UK, whether or not passporting was removed.

This is because many UK asset managers who distribute in Europe do so from a fund range located either in Dublin or Luxembourg. This is the same for many US managers and, accordingly, it makes sense for US managers to continue to capitalise on the large domestic UK market, with access to UK talent, innovation in alternatives and fintech expertise.

What next for investor protection?

The Financial Conduct Authority (FCA), in its 2017 Asset Management study, has warned the industry to cut costs and improve returns to investors. The FCA also recommended that funds appoint two independent directors to boards to look after investor interests. The regulator is also concerned about the competitiveness of the investment consultant market and plans to look at fund platform charging.

Securing the UK’s position as an attractive location for international investors

To retain its position as one of the top locations for international investors, the UK needs to focus on its strengths in financial talent, product development, AI and fintech to help asset managers develop solution-oriented investment products, efficient operating models and targeted distribution channels to meet the pension needs of the European market.

To do that, asset managers will need to invest in data analytics and AI, and outsource non-core activities.

Solution providers and advisers will need to work to together to help asset managers do this.

Non-differentiating activities such as know your client account opening should be standardised using technologies such as blockchain.  Terminology and contracts should be simplified to make it easier for investors to invest.

The government and the City need to continue to engage constructively with their European counterparts on the basis that a fully effective investment management industry, which meets the needs of European savers, is in the interest of every European economy.  To do that, the UK will need to acknowledge that investment management regulation needs to remain compliant with EU rules.

Law360 subscribers can also read the article here.