An examination of the new investor protection requirements that MiFID II will bring, comparing them with existing UK regulation and identifying the practical challenges they will pose.
MiFID II will create a whole raft of requirements that are designed to shape the way that firms conduct business, up and down the supply chain. Some of these will be brand new to firms, while others contain and codify messages that are likely to be fairly familiar, at least in the UK, from our domestic policy and supervisory work.
When we look at the Directive, we see a range of requirements that aim to influence conduct in different ways.
- Some are top-down requirements, based around the idea that senior management should take on clear responsibility for investor protection.
- Some are detailed organisational or conduct of business requirements; specifying – or prohibiting – particular responsibilities and practices.
- Some involve direct regulatory intervention in the market; notably the product intervention powers given to national authorities and to ESMA.
- And some focus on changing the experience of consumers directly, such as by giving them more information. This last category reflects a desire to strengthen consumer engagement and competition - particularly in the retail investment market.
There are many trade-offs to be made when it comes to both retail and wholesale conduct of business. We will need to avoid assuming that all firms (and, for that matter, all consumers) will respond to the new requirements in the ways that we hope or imagine. Luckily, MiFID equips us with a range of different tools for the job.
Also, as David said, MiFID 2 is a massive project. It seeks, by turns, to persuade, cajole, instruct and intervene in the market. I am going to use my time this afternoon to talk about some of these different tacks – and what they will mean for firms and consumers.
I should also make it clear that, for us, the 27 months to go will not only be about working with ESMA in regard to MIFID’s implementing measures. We will be working with the industry, and with other organisations like consumer groups, to try to understand – and in some cases to direct or guide – implementation decisions. And, in those areas where MiFID leaves discretion about some of the details to individual authorities, we appreciate that you will be looking to us for clarity about what is required as soon as possible.
Looking at the origins of the new requirements on investor protection
Before getting stuck into the detail, I think it is worth taking a moment to consider how the new investor protection standards measure up against the markets that they seek to regulate.
When it comes to conduct of business, it is not so clear (as it is in other areas) that the new standards are really a response to the financial crisis. But we can pick out some aspects of the Directive that we might view as responses, at least to problems that came to light because of the downturn. These include:
- the attention paid to structured products – many of which look set to be classified as ‘complex’
- the desire to protect local authorities across Europe from the attractions of high-risk instruments that they do not really understand
But many of the new requirements on investor protection were not driven so much by the crisis as by more general regulatory concerns. We see reflected in MiFID a desire to improve areas like:
- firms’ oversight and governance of products
- the incentive structures that they create around their sales staff
- the quality of their advice and sales processes more generally
These subjects are familiar. Product governance, incentives structures and sales standards are all themes identified quite clearly in our supervisory work – and in the mis-selling scandals that have played out publicly in recent years. In these, and other areas, the new directive provides a real opportunity to consolidate the progress we have made and to make our regulatory expectations much more explicit.
Looking at the fit with the retail investment market as a whole
But I also wanted to talk about an area in which progress in the new Directive has been less than we might have hoped. If we go right back to October 2007 – almost a year before Lehman Brothers went bankrupt – you may remember that the European Commission issued a call for evidence on what it called ‘substitute’ investment products. The Commission had become uneasy about the inconsistent rules introduced by the European institutions for different pockets of the retail investment market. They criticised what they called the ‘sectoral’ approach to investment distribution.
Yet if we fast forward to June this year – when the new Directive and Regulation were written into the Official Journal – we see that the ‘sectoral’ approach has not been eliminated. It’s true that on the retail side, structured deposits have been added into MiFID. But when it comes to insurance, MiFID merely dangles the hope that the Insurance Mediation Directive may be able to finish the job and replicate some of its new standards for insurance-based investments
Seven years ago, the Commission recognised the blurring of the profiles of insurance, investment and saving that had already taken place. But this has not resulted in any real improvement in consistency of the European regulatory framework. So, in the UK, one of the jobs that we face in the coming months is to determine exactly how to use the new tools that MiFID brings, given that, in general, we can and do want to address the whole of the retail investment market with our conduct of business rules.
Implementing the new MiFID investor protection standards
It’s not clear to me why many of the new, higher level standards should not be seen as equally relevant to other areas of the retail market – to sales of personal pensions, for example, or investment bonds – as they are to funds and securities. I could argue for consistency on the basis that it would avoid prejudicing competition between different sectors of the retail investment market. But for many firms faced with the challenge of implementation, the desire to have simple, clear and workable standards may also argue for consistency.
We will be thinking carefully about what kind of rulebook should exist by the time 2017 comes around. A strict copy-out of the new MiFID standards could create a regime that, in many areas, makes incredibly fine distinctions between different instruments, services and clients and the precise details of the requirements placed upon them. A simpler approach may be possible – in some cases, we might be able to strip away domestic rules and apply the same standards across the retail investment market as a whole – if we are prepared to make some pragmatic decisions. I would also ask firms to think carefully about this issue in the coming months – and not to jump to the conclusion that any deviation from a pure copy-out approach to MiFID is necessarily a bad idea.
Considering the range of new tools that MiFID brings
The theme of pragmatism will, I am sure, be important in lots of areas when it comes to implementing MiFID. Equally important will be communicating clearly about what we expect. For example:
It will be very important for us to articulate clearly the new requirements that MiFID will bring for senior management, if we want to see real change in firms’ organisation and governance. We need senior staff to be able to understand and engage with the new standards in practice.
- At the other end of the spectrum are the requirements for consumer information. We have learned a lot about the way that consumers use information in recent years and, despite the fact that MiFID contains an ambitious new approach to costs and charges disclosure in particular, we must not forget the limitations of disclosure.
Senior management responsibilities and other ‘top-down’ approaches : firm and product governance
If we think about MiFID in terms of senior management responsibility, we see that the directive brings new requirements on management bodies. Many of these standards will be familiar from the Capital Requirements Directive.
But MiFID should also force firms to rethink their governance when it comes to product design and distribution. We have, in the UK, already sought to highlight the need for firms to take responsibility for the design of their products, and how they are sold – but MiFID will see us codifying these expectations into rules.
Firms will need to be confident that they have clear processes in place when it comes to:
- approving the financial instruments that they manufacture
- assessing the risks of selling into particular markets and to particular types of consumers
Equivalent requirements for investment advisers and managers, and other firms that distribute investments, build on the basic idea that firms need to conduct due diligence. Firms need to ensure that the instruments they sell match up with the categories of clients who are their customers. In fact, for both manufacturers and distributors, I would put it even more simply than that: the key question that MiFID requires an answer to is who is actually buying what?
But product governance in MiFID is not simply about new systems and processes. The Directive introduces governance responsibilities, making senior management responsible for product oversight and design. For example, ESMA’s consultation paper suggests that there should be requirements on a firm’s management body to endorse the range of products and services to be offered and the target markets for the different products and services.
As preparations for MiFID get under way, firms will – understandably – need to focus attention on the IT and systems changes that they will need to build in time for 2017. But I would very much encourage you to bear in mind that the new requirements are not simply about systems. In many ways, what is much more important is taking responsibility, at a senior level, for what you make or what you sell; what it does; and in whose hands it ends up. This is potentially one of the most significant changes to conduct that MiFID will bring.
Other organisational requirements: remuneration of front line staff, taping and conflicts management
I also want to look at other organisational requirements. The ways that firms organise themselves comes under scrutiny in a range of different areas of MiFID, both through the introduction of new requirements and modifications to existing ones.
We see the new directive as raising the bar in two different ways:
- First, it increases the focus on senior management taking responsibility for the behaviour of their firms (which is in line with proposals in our recent consultation paper on Strengthening accountability in banking).
- Secondly, it increases the focus on the systems and practices firms need to have in place to identify and manage risk.
And, as the new Directive makes very clear, where the avoidance of risk to consumers is within a firm’s gift, it will need to be very clear why risk is being taken at all.
To tackle investor protection issues, the new Directive spells out risks that we will expect firms to tackle through their systems and controls. But, of course, no matter how specific the Directive is, firms should not lose sight of their overall responsibilities to have in place appropriate policies and procedures to manage their risks and ensure compliance much more generally.
Let’s also pick up on some of MIFID’s new organisational requirements:
- One area that we have been focusing on domestically in recent years is the remuneration of salesforces and other front line staff. In fact, in March this year, we published TR14/4 - an update on our thematic work on risks to customers from financial incentives. So, for firms preparing for the new MiFID standards, the remuneration requirements should not be too much of a shock. As with product governance, firms will see us codify our expectations in rules – starting with a basic requirement not to remunerate, or assess the performance of staff in way that conflicts with a firm’s duty to act in the best interests of its clients. In response to the Parliamentary Commission on Banking Standards, we have also made clear that when we implement MIFID we will take a look at our approach to financial incentives for sales staff as a whole.
- MiFID also introduces a new organisational requirement to record telephone conversations and electronic communications, for certain trading activities and dealing on own account. This requirement is aimed at addressing investor protection and market integrity concerns. For many UK firms this requirement will not be new. Since 2009, firms carrying on certain trading activities have had to record telephone conversations and keep copies of all relevant electronic communications – and in 2011, the requirement was extended to mobile phones. However, firms like some financial advisers and brokers that are currently exempt from MiFID – so long as they do not want to operate across borders and do not hold client money – will find that the terms of their exemption have been tightened and some organisational and conduct of business requirements will now apply to them. This includes the taping rule. While this change will undoubtedly involve some costs for some firms, it will bring benefits too: acting as a deterrent to or helping to identify breaches of regulatory requirements, and providing evidence where an error is alleged.
One of the most important areas of the current organisational requirements is, of course, the requirement to manage conflicts of interest. With the new Directive focusing on the importance of either preventing or managing conflicts, ESMA is keen to make sure that firms are not able to choose to simply disclose conflicts that they could easily have prevented altogether. This is something that we certainly welcome.
Conduct of business measures: suitability of advice and appropriateness of sales
I want to move on now and talk about a few of MiFID’s specific conduct of business requirements. MiFID has traditionally made a distinction between organisational and conduct of business obligations. This distinction can blur – as illustrated in the new Directive by the inclusion of product governance requirements in two different chapters – but it is worth thinking about the different approaches being reflected.
While the organisational requirements tend to focus on the responsibilities, systems and procedures that firms adopt to manage risk, the conduct of business requirements generally prescribe – or prohibit – a range of more specific practices. And there is also the added complication in MiFID that branches of firms from within Europe will generally face regulation from their home state regulator for organisational requirements, but from their host state regulator for conduct requirements.
The new Directive tightens up the conduct of business requirements in a number of areas, including the rules on both giving suitable advice and selling investments without advice. The responses to ESMA’s consultation on a requirement for advisers to assess whether a less complex and lower cost instrument would better meet a client’s needs show that many firms and associations regard this as controversial. My own initial reaction to the complaints I have heard is to wonder at why this is a problem: after all, would it not be something already covered by a firm’s usual suitability assessment?
As we get into the detail of the conduct of business standards – both those now set in the new Directive and those that ESMA is advising the Commission on for the implementing measures – we see a range of standards that reflect particular experiences and concerns of governments, regulators and consumer bodies across the EU. And concerns about sales of overly complex products are something of a theme, in the standards applying to both advised and non-advised sales.
The so-called ‘appropriateness test’, which requires firms to check whether investors are likely to be capable of understanding more complex products before a purchase can be made, will now be required for a wider range of instruments. This seems like a measure that should be complementary to sensible product governance, and yet I get the sense that some firms would move heaven and earth to get particular products moved back outside of the scope of the test.
It feels like we need to understand why the appropriateness test is seen as such a high hurdle for firms. It may be that there is more we can do to allay fears, to some extent, by working with industry to consider what sorts of checks are needed in practice, to comply with the requirement.
Conduct of business measures: RDR, inducements and research
Before I finish talking about the changes to the MiFID conduct rules, I think it is worth talking a moment to consider the extent to which some of these measures will rely on consumers to drive change.
The challenge of using regulation to get customers to change their behaviour can be illustrated with an example from home: the Retail Distribution Review. In the past, many of the FCA’s predecessor regulators sought to ensure that commission payments could not bias sales of packaged products through the use of prescriptive disclosure requirements. Some of you may also remember the FSA’s menu of costs and charges, which was designed to allow consumers to compare the commissions they might pay against market average figures.
When the RDR was launched it proposed an end to adviser remuneration set by product providers, reflecting the idea that more than just disclosure was needed to solve the problem. Commission is such a powerful incentive – and research had shown that consumers were unable to comprehend and make use of information designed to assist them in challenging their advisers.
The RDR prescribed changes to the way that firms operated, rather than just more disclosure. Similarly, the new Directive seeks to tighten up on the payments that can and cannot be accepted. MiFID’s new inducements rules extend, in some areas, beyond the RDR – particularly in banning investment managers from receiving and retaining commissions from product providers and other third parties.
For independent investment advisers and portfolio managers, the restriction on inducements - which allow only ‘minor non-monetary benefits’ to be accepted - has attracted much debate, particularly in regard to the use of dealing commission to acquire research. We set out in our Discussion Paper in July that we support ESMA’s approach in this area, based on our own recent supervisory review and analysis. We continue to welcome any comments on our DP by the end of October.
This area will be subject to further intensive debate at ESMA following the Consultation. It remains our preference for any further UK changes to be in step with the final EU-wide approach.
Conduct of business measures: looking to consumers to drive change (covering costs and charges and best execution)
While the inducements rules do not rely on information disclosure to drive changes, this is not the case in other areas of MiFID.
- On costs and charges, MiFID – together with the anticipated PRIIPs Regulation – will bring a new, comprehensive disclosure regime, designed to foster openness and comparability of charges across products and services. This will involve disclosure of the total cost of an investment, in a way that shows the cumulative effect of costs on the investment return. As the details of these disclosures develop, we will (in cooperation with other regulators) seek to draw on insights from behavioural economics, which considers how consumers think and make decisions. We are not assuming that the new requirements on cost and charges will be easy to deliver, but we are aiming to implement new standards that are workable for firms and result in useful and meaningful information for consumers. Instead of focusing on the mere provision of information, behaviourally-informed regulation should, in future, lead to a smarter and better disclosure regime.
- When it comes to best execution, the Directive introduces a requirement on firms to publish the top five venues where they executed client orders – with the idea that increased transparency will bring increased scrutiny. The driver for these new obligations is obvious – our own supervisory work has, like studies in France and Ireland, exposed weaknesses in firms’ ability to monitor the quality of execution achieved – and we have made it clear that we expect firms to do more to monitor and review their execution quality. But, in practice, the requirements will present technical challenges, owing to the relatively granular reporting of execution quality obtained that will be required. As with other areas of MiFID, we remain conscious that more disclosure and more transparency is not a panacea – we need to get the balance right.
Conclusions
To sum up, I would like to go back to where I started – with the range of new tools that MiFID brings. For firms, I would like to stress that the importance of understanding MiFID is not simply about prescriptive sales standards or new systems – it brings changes throughout the business. The mindset of senior managers, system designers and staff at all levels throughout different organisations will need to reflect the new responsibilities being created when it comes to areas like product governance and staff remuneration. Implementing MiFID’s investor protection requirements should be about ensuring that both the standards of conduct and the organisation of firms reflect the interests of consumers and the duties owed to them.
And, when it comes to more specific requirements – like those on inducements, or sales of complex products – I think it will be important for firms to understand the drivers for change if they are to successfully implement them. Those firms that have been unhappy with the inducements standards that we have articulated since the RDR, for example, will need to keep in mind that standards are set to rise, not fall under MiFID, reflecting a desire for real and sustained change in this area. While large parts of the UK market have, in recent years, already seen their regulatory requirements rise, the new Directive will still bring important changes – consolidating, codifying and broadening out what we expect of firms.