The European Union's heavy MiFID II raft of regulations - which are to be delayed for a year, so reports say - bring a number of challenges for wealth managers. This article examines some of them.

The European Union’s Markets In Financial Instruments Directive, in its second iteration – known by the clunky acronym of MiFID II - is designed so its framers say to give investors more protection and promote competition and market efficiency. Whether these goals are achieved is another issue. As with all such regulation, the obvious risk is that the pain is not worth the gain, and quite possibly, sets industry backwards without aiding the end-consumer. Another challenge is ensuring that European legislative moves are, as far as possible, congruent with what national lawmakers can achieve. 

This article, by Dr Anthony Kirby, head of regulatory reform, wealth and asset management at EY, could not be more timely. Last week it was reported that European lawmakers are considering delaying the rollout of MiFID II by a year so that it would kick in at the start of 2018 instead of 2017. The delay is designed to give the financial sector more time to adapt to what has been looking like a tight schedule.

The editors of this publication are very pleased to share this article with readers and as always, invite readers to respond. 

The European Securities and Markets Authority published its latest batch of 28 final rules (called Regulatory/Implementing Technical Standards - RTSs) last week, covering the operating of the markets and the reporting requirements under the revised Markets in Financial Instruments Directive (MiFID II). We are aware that over the last few days there has been fresh uncertainty as to the degree and scope of MiFID II delays. While the European commission and ESMA discuss the implications and provide clarity, there is sufficient clarity in certain areas of the regulation for organisations to perform impact assessments and proceed with implementation plans in those areas

The Regulatory Technical Standards feature technical elements, showing how the MiFID II legislation will deliver on its promise of greater market transparency, better investor protection, and improved safety and resilience of the financial markets across Europe. 

They also describe how the measures would apply in practice to market participants, market infrastructures and national supervisors. ESMA's recommended rules will require approval by both European Parliament and the European Council later this year, and further need endorsement by the European Commission before coming into force as early as 3 January 2017. 

We know that MiFID II has a wider scope than MiFID I, impacting a broader range of instruments, venues, and activities, and will change the balance between the buy-side, sell-side and established/new entrant client service intermediaries. As far as private banks and wealth managers are concerned, there will be important revisions to products (classification, governance, manufacture and distribution), to suitability and appropriateness arrangements, to transparency surrounding costs and charges, to best execution evidencing, and to record-keeping. There could also be new areas of complexity to manage as investor protections and product measures may vary from country to country, including the treatments for investors located in/wishing to invest in third countries such as the US, Switzerland, Asia-Pacific or offshore.

1. New client classifications/product treatments:
The client classifications under MiFID I transfer into MiFID II, with the exception of public sector bodies, local public authorities, municipalities and private individual investors. These latter entities may be allowed to waive some of the protections afforded by the conduct of business rules (and thus treated as professionals on request) – otherwise, they would be treated under a per se retail classification. MiFID II will also introduce greater product governance process to ensure that products offered are suited to the characteristics, objectives, and needs of the target market investors (private clients). 

Product manufacturers will need to provide extensive information (including product characteristics, end consumers the product is intended for and more comprehensive costs) to distributors to enable ongoing assessments of target market suitability. In relation to third country manufactured products, private banks and wealth managers will need to ensure that the level of information obtained is reliable and of adequate standard to ensure that MiFID II required suitability and if relevant appropriate assessments can be completed ahead of sales.

2. Suitability and appropriateness arrangements
Determining product suitability and providing advice to clients were on the regulatory agenda since MiFID I took effect, but since 2007, they have been increasingly a focal point on regulators’ agendas. However, not all wealth managers tracked their clients’ risk appetites and therefore there was a real risk of clients continuing to invest in products that didn’t meet their investment objectives. The fines for poor systems and controls documentation or for miss-selling have focused the minds of risk professionals as to the reputational challenges and cost implications when things go wrong.

MiFID II stipulates that suitability reports must be provided to the client at the onset of the private client relationship and periodic suitability reviews must be undertaken by the distributing firm taking into account the products on offer in the market. Firms also have to perform an appropriateness test for selling any complex products on a non-advised basis (i.e. these cannot be sold through execution only route). It is expected that the final Delegated Acts will provide more colour on expectations of how firms will demonstrate how their products might be more suitable for the private investor compared to similar products in the market. 

3. Disclosure of costs and charges
MiFID II will likely introduce greater prescription when it comes to disclosing fees and charges. It is worth noting that the suitability assessment must take the costs and charges of comparable products into account - a potentially heavy lift area for private banks and wealth managers. At the time of writing (and pending clarification from the Delegated Acts), firms would need to aggregate their own costs plus all costs from all other sources when providing the overall cost figure to clients for investment and ancillary services, with costs shown as cash amount and a percentage. There is likely to be a differential focus pre- and post-trade. The focus post-trade will be on ranges and numbers (e.g. likely in the form of a per cent), including price bands and consideration for "best efforts" for less liquid instruments. In contrast, ex-ante disclosures (which are far from certain) might be on factors that influence a price in a meaningful manner. Third party payments made to the investment firm should also be shown on the statement.

4. Best execution
The newly-issued RTS 27 and 28 propose improved levels of disclosure to strengthen the current best execution regime of MiFID I. To ensure that firms execute orders in the most favourable conditions for their clients, ESMA holds to the view [Final Report §9.1(9)] that execution quality information on factors such as price, speed, and likelihood of execution has to be captured for each instrument for each trading day in order for the data to be comparable and to be of value for users. This will have a significant bearing on the costs of data processing systems in order to receive, analyse and benchmark such a volume of information. 

The harder legal best execution definition under MiFID II Art 27(1)’ firms must “take all sufficient steps…”’ will need to take account of other strands under MiFID II Art 27, for example, the requirement under Art 27(6) that all investment firms publish data on the top five venues where they executed client orders, and information on the quality of execution obtained. Firms will need to attune their best execution policies to ensure that their evidencing can be supported by the appropriate transaction cost analysis (TCA) tools for each asset class. They might also need to take a view on whether to name executing brokers or ultimate trading venues in their policy.

5. Record-keeping/client reporting
The record-keeping requirements under MiFID II are onerous. All telephone conversations and electronic communications will need to be recorded when orders are received and transmitted (even if incomplete), when orders are executed on behalf of clients, or when firms deal on own account. All internal conversations and communications about client orders should also be recorded, including face-to-face conversations which should be recorded and stored as minutes, and local regulators may require records to be kept for seven years in a durable medium. 

The client reporting requirements are equally prescriptive. Execution reports need to be issued no later than the first business day following execution, with the content of the reports similar as applicable for private clients electing for retail classification. Portfolio management reports must be issued on a quarterly basis through a durable medium, and portfolio managers will need to report to clients where the overall value of the portfolio depreciates by 10 per cent or multiples of 10 per cent.

It is clear that the amount of information that business, operations and compliance professionals will need to assimilate, process and report is stupendous. ESMA (European Securities and Markets Authority) chairman Steven Maijoor was quoted last Monday as saying: “The magnitude of this change should not be underestimated." Whether private banks and wealth managers are servicing the mass affluent, affluent, high net worth and ultra HNW client segments, they will need to manage the tension of maintaining client privacy and data protection on the one hand and the desire for transparency and meeting requests for information from the tax and regulatory authorities on the other.

Some firms will need to upgrade their systems and data handling (including the processing of unstructured data) and evaluate the knock-on impacts on legal, with a degree of “re-papering” inevitable (especially around use of “consistent language”). Most firms will also need to determine the implications of impacts on third country arrangements as described above.

Business leaders in private banking and wealth management also need to understand how to manage MiFID II with respect to strategic choices, including opportunities to monetise behind new service offerings, such as financial planning analytics, robo-advice or stress testing as a service. Large majority of firms are aiming to begin their MiFID II implementation work by January 2016 in view of the significant implications for their business and operating models, their reporting requirement and the changes to their market, reference and meta-data architectures. The critical trade-off is the need to remain competitive, yet not incur costs from rushing to comply with draft measures, resulting in "throw-away" work. 

Furthermore, several private banks and wealth managers have begun to look over the parapet of complying with MiFID II alongside other current regulations such as CRDIV (capital requirements regulation and directive), UCITS V, AIFMD (Alternative Investment Fund Managers Directive) or MLD IV (fourth money laundering directive), as well as applying the requisite controls to meet the expectations of the UK’s Financial Conduct Authority in areas where its thematic reviews are focused. Exam questions are already being posed – for example:

-    Which business, operations and technology areas will feel the greatest impact of MiFID II?
-    What are the specific areas of impact likely to impact non-equity business lines in particular?
-    What are other firms doing?
-    What are the likely impacts on revenues and anticipated levels of spend?
-    Where are the opportunity areas to monetise?
-    How might complying with the disruptive impact of MiFID II pave the way towards innovations, such as digitisation, use of the cloud, social networking, robo-advice, blockchain etc.?

It should be pointed out that there are several “known-unknowns” which will need to be tackled through the issue of further RTSs, most likely during November 2015. Areas for clarification include selective bond market transparency arrangements, fees and charges, research, the treatment of "third countries", and arrangements for distribution in each country given different specificities when it comes to advice and distribution arrangements.

Given the absence of formal certainty pending the issue of the Delegated Acts, relating to investor protection, it is important that firms utilise the certainty indicators that are available, and accept uncertainty as a key characteristic of this change management programme. Firms lived through similar uncertainty in their AIFMD implementation.

This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Member firms of the global EY organisation cannot accept responsibility for loss to any person relying on this article.