MiFID II

The Markets in Financial Instruments Directive (MiFID) was first introduced in 2007. It aimed to provide consistent regulation across the member states of the European Economic Area while improving and increasing consumer protection in financial services. The 2018 MiFID II is a revision of the regulation and is designed to strengthen the level of investor protection and increase transparency across the industry.

What is 2018 MiFID II?
Target market
Aggregated costs and charges
Call notes
Drop in portfolio value
Legal Entity Identifier (LEI)
Financial Advisers and Investment Firms – the key obligations

What is 2018 MiFID II?

MiFID II (Markets in Financial Instruments Directive) aims to:

• make financial markets more efficient and resilient
• improve transparency of both equity and non-equity markets
• strengthen investor protection and reinforce supervisory powers.

The Markets in Financial Instruments Directive (MiFID) is a legislation that has been in force across the European Union (EU) since 2008 and increases the transparency across financial markets and standardises the regulatory disclosures required. MiFID came into effect prior to the 2008 financial crisis - the directive has been revised to consider the financial crisis and to improve the functioning of financial markets as well as to strengthen investor protection. This revised and amended legislation is known as MiFID II and includes a new Markets in Financial Instruments Regulation (MiFIR) with the changes that took effect from 3 January 2018. Any firm that meets the definition of an ‘investment firm’ must comply with all MiFID and MiFID II requirements - even if certain exemptions apply to firms still the spirit of the new rules have to be applied across various aspects.

Target market

MiFID II requirement:

MiFID II requires all manufacturers and distributers of products to define a target market for that product. The European Securities & Market Authority (ESMA) has set out six cumulative criteria to be used by manufacturers to define the target market, as follows:

1. The type of clients to whom the product is targeted
2. Knowledge and experience
3. Financial situation with a focus on the ability to bear losses
4. Risk tolerance and compatibility of the risk/reward profile of the product with the target market
5. Clients’ objectives
6. Clients’ needs.

Aggregated costs and charges

MiFID II requirement:

MiFID II requires investment firms to provide information about all costs and charges, in connection with the investment service and the financial instrument. This information should be aggregated to allow the client to understand the overall cost as well as the cumulative effect on return of the investment. Where the client requests an itemised breakdown it should be provided and such information shall be provided to the client on a regular basis during the lifetime of the investment.

All identified costs need to be disclosed, and where post-sale disclosure is to be provided on a regular basis it should also be provided on a personalised basis.

These figures need to include the following costs and are to be broken down into the following sub-sections - Costs relating to the service:

• All one-off costs paid at the beginning or end  of an investment service
• All ongoing charges paid to firms for their services
• All costs relating to transaction as performed by the firm or third parties
• Any costs and charges that are included in ancillary services that are not included in the above.

Incidental service costs - Costs relating to the financial instrument:

• All costs relating to the management of the  financial instrument
• All costs paid at the beginning or end of  an investment
• Costs associated with the acquisition or disposal of investments (broker commissions, exit charges paid by the fund, stamp duty)
• Performance fees.

Call notes

MiFID II requirement:

MiFID II states that, “records shall include the recording of telephone conversations or electronic communications relating to, at least, transactions concluded when dealing on own account and the provision of client order services that relate to the reception, transmission and execution of client orders.”

These recorded telephone conversations or electronic communications intending to result in transactions or in the provision of client order services that relate to the reception, transmission and execution of client orders are also included (even if the transaction is not concluded).
Investment firms should take reasonable steps to record relevant conversations and electronic communications.

Drop in portfolio value

MiFID II requirement:

In line with the Article 25(6) of MiFID II, to provide clients with adequate reports on the service provided, the MiFID II delegated regulation sets out the requirement for investment firms that provide the service of discretionary portfolio management shall meet additional reporting obligations in the form of ‘depreciation reporting’. Clients should be notified when the overall value of their portfolio, relative to the value at the beginning of each reporting period, depreciates by 10% and multiples of 10% thereafter. Clients should be notified no later than the end of day in which the threshold is exceeded.

Firms providing the service of discretionary portfolio management need to ensure that clients’ portfolios are being valued and reported on as set out by MiFID II.

Legal Entity Identifier (LEI)

From 3 January 2018 firms subject to MiFID II reporting obligations will not be able to execute a transaction on behalf of a client who is eligible for a Legal Entity Identifier (LEI) and does not have one. To allow regulators to police market integrity, the reporting firm should obtain an LEI from the relevant entities, before executing a transaction in a financial instrument, so that complete and accurate details of transactions can be reported to the competent authority

MiFID II requirement:

The ‘Know Your Customer’ process is initiated when entering into a business relationship and should be maintained for the duration of these relationships and for as long as any long-term data requirements need to be addressed. Parties involved in financial transactions need to be identified within these transactions and ISO 17442 is the international standard which specifies the elements of a LEI which is used to identify entities entering into a financial transaction. An LEI is specific to legal entities (which may include charities and other not for profit organisations) and must be provided for all relevant transactions (relating to traded financial instruments) and all parties involved. MiFID II mandates that all entities trading with EU counterparties across all asset classes will be required to obtain an LEI that needs to be renewed yearly.

Financial Advisers and Investment Firms – the key obligations

Following on from the 2012 RDR (Retail Distribution Review) financial advisory forms now have enhanced obligations much of which is aimed at suitability, client reporting and transparency.

• Product Governance

The objective is to deliver the right products to the right clients. New requirements consist of implementing a thorough product governance process covering the three stages of product lifecycle: design, go-to-market and distribution. The obligations are applicable to manufacturers and distributors. When designing products, manufacturers are required to identify the target markets and a compatible distribution strategy, perform stress testing of the products and apply appropriate and transparent fee structures. They must define a go-to-market appropriate to the product and provide all necessary information to distributors. Distributors also have to identify their own target markets and look for appropriate products. They will be responsible for distributing products to the appropriate target clients. Manufacturers keep an ‘after-sales’ responsibility, by having to monitor their products and making sure that they are distributed within the target. It is the entire relationship between the manufacturers and distributors that are impacted, with real challenges in terms of monitoring. Manufacturers of structured products, fund management companies and asset managers, banks as distributors, PSF, all are impacted.

• Inducements

Firms offering portfolio management or independent advisory services are prohibited to accept or pay any fee, commission or non-monetary benefits from/to third party in relation to the provision of services to clients, except for minor non-monetary benefits. In the other situations, i.e., non-independent advisory or execution services, the inducements will be subject to an ‘enhancement test’ which shall concretely demonstrate that the inducements retained are necessary to enhance the quality of services provided to clients and that they do not damage the interest of the client. Those firms are required to clearly disclose the nature and amounts of inducements kept before and after the provision of service, as part of the disclosure and the a new inducement reporting. Inducements include kickbacks or discounts received in the context of brokerage agreements and are prohibited and the ‘free’ investment research received from brokers without payment in return is also considered as an inducement. Also, the enhancement test and the transparency requirements are applicable to other situations, like the commissions paid to business introducers.

• Information to Clients

MiFID II requires firms to provide more information to clients, especially related to the nature of the advisory services, the financial instruments and risks along with the costs and charges. All clients are concerned, not only retail clients, with more general requirements to guarantee the quality of information. In particular, investment firms are required to inform clients about the nature of advice offered. Firms have to explain the scope of services offered, the analysis conducted, the range of instruments considered, whether or not it is limited to their own products. Information about the financial instruments, services and risks shall be more comprehensive. The information on costs and charges is the most challenging aspect: firms shall disclose all costs and charges in an aggregated way to all clients, before the provision of service, in GBP and in percentage, and after the provision as part of the reporting. More details are required and new information is needed, such as a look through in the transaction costs or the cumulative effect of costs on return.

• Suitability & Appropriateness

MiFID II re-emphases the Suitability & Appropriateness principles with more scrutiny on the clients’ profiling and the Suitability & Appropriateness assessments. When profiling clients firms shall consider the ability of clients to bear the losses (capacity for loss) and their risk tolerance (attitude to risk). With regards to the suitability of investment, the assessment is carried out for every recommendation to buy, sell as well as to hold an investment. When considering switching positions, the firm demonstrates that the benefits are higher than the costs. Moreover, when providing advice, firms are required to provide a suitability statement which will outline the advice given and how it matches the objectives of the clients. Appropriateness tests are impacted too, meaning more instruments will have to be tested because of the broadening of the scope of complex instruments. Such instruments will now include any instruments (shares, bonds, money markets) when they incorporate a derivative or a structure which makes it difficult for the client to understand the risk involved - structured deposits, instruments that incorporate a condition, instruments with any features which would make them illiquid in practice, structured UCITS and non-UCITS and any instrument when financed by a loan. This calls for more robustness in the overall Suitability & Appropriateness approach, in the profiling, the testing and the monitoring.

• Execution Landscape

The organisation of the execution infrastructure is central in MiFID II. The overall objective is to bring trading in financial instruments back on organised venues, which must be appropriately regulated and transparent as well as capture operators of dark pools, brokers dealing systems and internal crossing systems. MiFID II fully reorganises the execution landscape. Besides the standard way of accessing the market, High Frequency Trading and Direct Market Access are now regulated from both the firm and the market perspectives, with new controls and limits. Regulated Markets (RM) and Multilateral Trading Facilities (MTF) are put on an equal footing as Trading Venues and completed with a new venue, the Organized Trading Venue (OTF). Systematic Internalisers (SI) are redefined with more substance. Trades in shares admitted to trading must take place on a RM, MTF or SI, never over-the-counter (OTC), which should be limited to non-liquid instruments only. Other instruments, like eligible OTC Derivatives should be traded on trading venues (RM, MTF, OTF). Off-market trading should take place and be organised as SI (bilateral) or OTF (multilateral). The new OTF will be organised to capture all types of organised execution which are not taking place in existing venues (RM, MTF, SI) - bonds, structured finance and some derivatives. This is completed by new pre- or post-trade reporting requirements to a broad scope of instruments, to foster transparency in the market.

• Best Execution

Investment firms are expected to provide a more exhaustive and a more practically focused execution policy to clients, explaining clearly how orders will be executed by the firms, per instrument class. On an annual basis, a list of top five execution venues for each class of instruments in terms of trading volumes in the preceding year should also be available to clients, with the related execution quality obtained. A concrete monitoring of execution quality, backed with figures, must be organised. In the case where a single execution venue is used, investment firms must demonstrate, through supporting data, how it satisfied the best execution requirements and the results must be at least as good as with other entities. They have to specify all circumstances in which client’s orders will be executed outside a trading venue (RM, MTF, OTF).

• Transaction Reporting

Transaction Reporting refers to the regulatory reporting of transactions to the supervising authorities. Several changes also affect the reporting. The scope of instruments was broadened to nearly all financial instruments. The range of data is much larger (65 fields) and goes further than the trade information to include such information like clients’ identification, adviser or trader identification and all trading circumstances. It can be done directly, through an Approved Reporting Mechanism (ARM) or via the trading venue to CSSF no later than the close of the following working day. Given the extent of information, the obligation will no longer be only on the firm facing the market, but on any firm initiating an order. This analysis is complex.

• Client reporting

Firm’s obligations are strengthened for more transparency to all clients. The periodic reporting frequency is down from every six months to every quarter. The content of the reports is aligned for retail and professional clients, with some arrangements possible for eligible counterparties. The content will be enriched with for instance details on the amounts of inducements paid or received in the context of the investment services to the client. The information on the costs and charges related to the investment services and the financial instruments is much more detailed and will lead to new dedicated reports. The discretionary portfolio management report must be enriched with suitability information. This remains optional in case of investment advice. Investment firms are required to notify the client by a written report when there is a significant decline on the overall value of the portfolio when doing portfolio management (loss thresholds on portfolio) or on any position in contingent liability transactions or leveraged financial instruments (loss thresholds on positions).

• Safekeeping

The safeguarding of financial instruments and funds has been strengthened to offer more protection to clients through a better governance and more transparency. Firms will have to appoint an officer with sufficient skill and authority to take responsibility of the oversight on safeguarding assets (can be delegated to an existing function in smaller firms). Their responsibility will also cover the support in case of insolvency to practitioners and authorities. MiFID II brings also additional obligation in case of securities lending to the benefit of the client protection, prohibits any title transfer collateral agreement with retail clients and set conditions for such arrangements with professional clients. The approach and the selection of third parties for depositing clients’ funds and securities is becoming a focus. Banks must take into account the diversification of clients funds among third parties in the due diligence for the selection, appointment and periodic review of correspondent banks. MiFID II imposes a limit of 20% intra-group deposit, unless the firm can demonstrate that, in view of the nature, scale and complexity of its business, and also the safety offered by the parties considered, the requirement is not proportionate. This conclusion should be periodically reviewed and should be notified (initial and reviewed assessment) to CSSF.

• Governance & Supervision

Governance requirements follow on from what was established under MiFID I or with the CSSF circulars. The objective is to guarantee a trained, competent and independent staff, with a strengthened management body and with more power to CSSF, ESMA and EBA for a better supervision, with effective sanctions. Among others, new requirements will be imposed to staff to demonstrate their knowledge and competence to inform or to advise clients, going progressively towards a certification. Remuneration aspects are highlighted, as well as a proper organisation of the management body and the supervisory functions. Moreover, MiFID II imposes to record all relevant conversations with clients, including face-to-face meetings with the clients (meeting minutes). Additional power is granted to national and European authorities with direct product intervention power on local markets and a clear framework for sanction.