The compliance splurge continues with the European Union's programme designed (so the framers claim) to protect investors. This article looks at how fund management is affected.

One of the most important lumps of financial regulation to hit Europe is the Markets In Financial Instruments Directive, known rather more pithily as MiFID. The second iteration of this legislation has already been delayed by a year (now due to take effect from the start of 2018). Wealth management will be affected. One angle is the impact on distribution of investment funds. Calastone, the global funds network, weighs on the debate about the directive. This article is Rob Swann, managing director, data services, at Calastone. We hope readers find this article valuable and invite responses. 

The first iteration of the Markets in Financial Instruments Directive (MiFID) was primarily aimed at the sell-side and sought to heighten transparency and boost competition. MiFID II has far more scope than its predecessor and regulates across numerous areas including commissions to pay for sell-side research, high frequency and algorithmic trading, best execution, pre and post-trade transparency, transaction reporting, inducements, client money, and of course product governance. In short, MiFID II is all about a regulatory desire for greater transparency. It is highly detailed and all-encompassing and impacts a wide range of financial institutions to which MiFID I did not apply. 

The rules have been subject to repeated delays. Initial implementation of MiFID II was meant to be in January 2017. However, warnings from the European Securities and Markets Authority (ESMA) and industry participants that financial institutions would struggle to have the necessary infrastructure, personnel and technology in place to make right on their MiFID II compliance obligations, forced policymakers to agree to a one year implementation delay until January 2018. This was confirmed and formalised in the European Parliament in February 2016. 

The first Delegated Acts for MiFID II were published recently. These Delegated Acts have sought to address and provide more clarity around MiFID II. While the Delegated Acts have not made any material changes to the original provisions around product governance, the fact that its status has been somewhat clarified by the EC is welcome. But what exactly are the rules around product governance under MiFID II?

The rules
The rules cover the entire product lifecycle, although many of these are already part of a number of firms’ best practice. However, there are many new elements to the directive, with target market being one of the major ones. Fund manufacturers will now need to define the intended target market for their products and then ensure they are distributed in line with this. This will require fund manufacturers to identify relevant distributors for their products and ensure they understand the product and have in place sound approval processes. This is a reaction to pre-crisis product mis-selling and it is hoped MiFID II will correct these failures.
 
Traditionally, it was just the fund distributor’s responsibility to ensure that the correct products were being sold to the correct investors. This onus has shifted now to the fund manufacturer as well. This will force fund manufacturers to obtain huge swathes of information to gain insight into their distribution chain and assess whether their products are being distributed as intended. This is going to pose a huge operational challenge for fund manufacturers and fund distributors.

Fund manufacturers must also have systems in place to notify investors outlining any material changes to their products’ risk profile and to regularly review their products are aligned with their target market’s needs. Again, this is a significant operational undertaking and compliance is likely to be tricky given the antiquated, manual processes that are often prevalent at these organisations.

The rules are extra-territorial and not just confined to EU investors. If a UK-based Open Ended Investment Company (OEIC) or Luxembourg SICAV sells its product to non-EU investors via a distributor, then both manufacturer and distributor must conduct a thorough look through to assess distribution is as intended in these locations. Distribution channels vary across jurisdictions with clients purchasing products from a diverse array of organisations including private banks and independent financial advisors (IFAs). Identifying the end distributor may require looking through several intermediary layers, a particular challenge as many firms are multi-channel and there is a specific focus on identifying execution only distribution. Understanding these arrangements and processes is crucial at the fund manufacturer level. A failure to comply can have major regulatory consequences and administrative sanctions. 

The rules are far more granular and in-depth than previous requirements. MiFID II will encourage fund manufacturers and distributors to automate systems and technology given the sheer volume of data required. This has the potential to be operationally complex and costly. Data needs to be provided by the diverse set of distributors and then collated and standardised into a single view by the fund manufacturers. This may prove challenging for some distributors and manufacturers with poor technology processes.

Even once this process is perfected, firms will need a market overlay to create an efficient process and comply with the regulations. This has led many to explore whether there is a centralised market utility which can collect, collate and report this information seamlessly to manufacturers in a timely fashion. 

Harnessing this data could even prove an effective tool for sensible business decisions at the manufacturer level. The information will be granular and could enable fund providers to identify investor trends and preferences in given markets. For example, they could align their resource better to specific market and products, or inform the creation and launch of new products. Using data intelligently can help the industry improve their businesses.  

The level of preparation for MiFID II across the EU is varied. The majority of fund managers have devoted time, effort and resources to understanding the precise (and still unclear) rules around unbundling research costs from trading commissions and the provisions around transaction reporting. The industry has yet to fully comprehend the implications of MiFID II’s product governance requirements and what it means for their businesses. This is especially true for distributors who, in many senses, will feel the effects more keenly.

This is not abetted by the lack of harmonisation in the rules around product governance and inducements across the EU. Some jurisdictions, however, are ahead of the curve and have been for some time. The UK introduced the Retail Distribution Review (RDR) in 2012 following a spate of product mis-selling incidents. RDR removed inducements while requiring investment firms to implement better oversight on their clients overall suitability. The UK Financial Conduct Authority (FCA) has also focussed heavily on product governance in subsequent thematic reviews of the industry.  

Meanwhile, The Netherlands passed detailhandel beoordeling (retail assessment) provisions in January 2014 banning inducements between fund manufacturers and fund distributors following similar mis-selling scandals. While these requirements posed administrative challenges for manufacturers and distributors in both countries, it has put those managers in good stead to attain compliance with MiFID II. 

The one year time delay was welcomed by affected financial institutions. However, the scale and breadth of MiFID II is significant. Its reach impacts near every facet of financial services in some shape or form. It is crucial that affected firms start conducting gap analysis and consulting with service providers about where improvements need to be made to their businesses around MiFID II compliance. 

Regulators are unlikely to look kindly on firms which have not built systems and processes to look through the distribution chain when MiFID II comes into force.