The key focus of today’s conference is on the impact of MiFID II on the wholesale markets, reflecting the preparations that firms in that sector need to be making now. But, in focusing on the wholesale markets today, we are by no means intending to downplay the importance of the changes that the revised MiFID will bring to the retail sector. My name is David Geale and I am the FCA’s Director of Policy in the Strategy and Competition Division – and implementation of the retail aspects of MiFID II falls to my department. I want to use this speech as an opportunity to highlight key areas of MiFID II for the retail market and touch on the practical steps and preparations that we already know that firms need to make.
As David Lawton noted earlier, various different implementing measures are on the horizon for MiFID II. These are split between directly applicable technical standards, which mainly cover markets issues, and other implementing measures that tend to focus on conduct requirements. We expect the European Commission to publish an implementing regulation or directive towards the end of the year covering many of the conduct issues. David has already highlighted the challenging implementation timetable that this presents for us as a regulator and for many different firms that need to prepare for, and deliver, the required changes.
As we don’t yet have the final implementing measures, which will set many of the detailed requirements that firms will face, we are not yet able to consult on or finalise our policy approach in all areas. But this does not mean that firms should simply sit back and wait. We can be confident about both the direction of travel and some of the key changes that are on the horizon – particularly those that are already hard-coded into the new directive and regulation. And, by examining these new requirements from first principles, we can get much of the flavour of the main areas of change.
Of course, it is also important to consider the domestic environment in which MiFID II will need to be implemented – both in terms of understanding the impact that previous initiatives have had and with an eye to the continuing impact of changes such as the recent pension reforms on the investment landscape. Today, I’m going to talk about MiFID in this wider context, in order to try to offer you a coherent picture of the drivers for change – and the challenges facing the retail investment market – when it comes to MiFID II.
MiFID and investor protection
The investor protection framework set out in MiFID II aims to ensure that investment firms act in the best interest of their clients, using a number of different approaches. It seeks to:
- improve governance and organisational requirements for firms
- strengthen conduct of business rules that cover firms’ relationships with all categories of clients
- introduce new powers to supervisors at both national and European level.
These measures aim to deliver changes that will ensure that industry culture is sufficiently oriented towards clients’ interests, and that conflicts of interest are managed.
The investor protection framework set out in MiFID II aims to ensure that investment firms act in the best interest of their clients.
Implementing legislation will set out more granular requirements to support this overarching framework. More detailed governance, organisational and conduct of business obligations are aimed at delivering improvements in a whole range of different areas. For example, detailed requirements will seek to target:
- improvements in the attention paid to product design
- more complete and clear information about investments
- better assessment of the suitability of products recommended to clients
- an improved framework to achieve best execution
- strengthened protection of investors’ assets
- fair and efficient treatment of their complaints.
While these areas are all important, few of them can really be said to be brand new. Some reflect concerns identified under MiFID I, while others are familiar from domestic initiatives. Perhaps the most familiar changes are those that that are similar to some of the requirements brought in by our Retail Distribution Review (or RDR), including curbs on inducements and requirements on firms that give independent advice. Similarly, tougher powers to ban products and requirements for product governance should not feel entirely new to firms in the UK.
As firms prepare for MiFID implementation over the next year, we will continue to examine the application of our existing conduct requirements.
While it would be easy to conclude that the UK is ahead of the game, and UK firms should already be ready for many of the MiFID reforms, to do so could mean that we underestimate the extent of the changes expected. As firms prepare for MiFID implementation over the next year, we will continue to examine the application of our existing conduct requirements, reinforcing key messages through our policy and supervisory work. But we will also challenge firms about whether they have in train the changes needed to ensure their future compliance. For example, firms may need to make changes to deal with new requirements like:
- the application of RDR-style rules on inducements to portfolio managers
- the shift from domestic guidance to tough new rules on product governance
- the introduction of new requirements governing frontline staff remuneration.
The changes that MiFID II brings seek to reflect supervisory experience and practical implementation challenges on the ground since the original directive came into force – so they may well feel like evolution rather than revolution. Given this, I think it is well worth re-examining some of the thematic work that we have conducted and guidance that we have issued in recent months and years to understand better some of the drivers for the changes being introduced, as we have witnessed them in the UK.
The need for change
Product governance
Let’s start by turning to a topic that should be familiar to you from our domestic work: product governance. The new MiFID requirements will reinforce existing messages that we have sought to communicate, both through our guidance on the responsibilities of product providers and distributors for the fair treatment of customers (known as the RPPD) and – more specifically – through our thematic work on structured products.
Earlier this year, we published a Thematic Review which identified weaknesses in the way some firms approach product design and governance for structured products. We made clear that more effort is needed by firms to match product design with customer needs, demonstrate product value through robust stress-testing and provide potential customers with clear, balanced information on the products. If you have not already read this paper, TR15/2, I would commend it to you as a way to begin your thinking on preparing for the new MiFID standards on product governance.
MiFID II will codify product governance requirements into rules for the first time. And, importantly, it will bring a new focus on management bodies taking responsibility for approving and overseeing policies towards product governance. These are responsibilities to which we will expect firms to pay more than just lip service – especially as the directive sets out clear new requirements that will see Boards and Executive Committees getting involved in product approval, the selection of target markets and the ongoing review of how products are distributed.
Suitability of advice and due diligence
I want to move on now to the related issues of ‘due diligence’ and suitable advice. A couple of years ago, we undertook a supervisory exercise to understand the root causes of unsuitable advice. We examined cases where inappropriate advice was given and identified three key reasons for this: inadequate consideration of costs, poor risk profiling or mapping and – importantly – inadequate due diligence on products and services.
We are currently in the middle of a thematic project on due diligence – a discovery exercise to understand current practice, and potentially to provide guidance on good and poor practice to help improve standards. We have looked at the roles of the different players in this market, including unregulated third-party providers of what might be called ‘due diligence solutions’, as well as advisers and product providers. Although the project is a discovery piece, we have also been assessing firms against current suitability rules.
This work is particularly important in the context of MiFID II, because the implementing legislation is set to introduce more specific requirements for firms to conduct due diligence and ensure the products they recommend are suitable for their clients. Firms will be required to have policies and procedures in place to ensure they understand the nature and features of the products they select for their clients, and they will be required to assess whether alternatives are available that would better meet their client’s objectives. This is a clear signal that advisers really need to understand the products they are recommending – something that we feel we will be well placed to help firms to understand, in line with our own work in this area.
Inducements
Another area of our domestic supervisory work that I want to talk about is inducements. As you may well know, MiFID will introduce a new inducements regime for firms providing independent advice or portfolio management, banning all payments from third parties, apart from certain ‘minor non-monetary benefits’. For independent advisers, these new measures should feel similar to requirements we introduced in the UK through the RDR to address the risk of advice being biased by commissions – and, of course, our rules cover both independent and restricted advice.
But this new European level commission ban will still be of interest in the UK – not least because it will also extend to portfolio managers, something that we did not do with the RDR. And, equally as important is the fact that MiFID II will refocus our attention on inducements more generally – both for firms that give advice or manage portfolios and for those that do not.
Since the introduction of the RDR, we’ve maintained a supervisory focus on inducements, carrying out thematic work and continuing to communicate our expectations. While we are encouraged by many advisory firms changing their practices to ensure their advice is not influenced by payments from product providers, we remain concerned that some firms may still be receiving benefits and payments that have the potential to bias the advice they provide – in other words, that their culture may have remained unchanged.
As with the other areas I’ve mentioned, MiFID allows us to reflect on our domestic work and to ensure that we have effective and clear standards of inducements for all firms. For advisers, we will continue to focus on ensuring that firms are not incentivised to sell inappropriate products to their clients, while for other firms MiFID II is likely to prompt us to question whether the receipt of an inducement is genuinely designed to enhance the quality of the service to the end client.
Research
The inducements framework also has important implications for the research market, which many of you will be very keen to hear more about. MiFID II will, for the first time, bring in a European regime governing the way that asset managers purchase and consume third-party research. At this point, we are still waiting to see the final implementing legislation that will determine the exact shape and operational details of the new regime. So, unfortunately, we will not be able to say much today about inducements and research. That said, we would encourage investment managers and brokers, in particular, to continue to focus on driving improvements based on the findings from our dealing commission review, which we reported in Discussion Paper 14/3 last year.
Remuneration, performance assessment, and reward
I want to move on from the issue of inducements to the issue of staff remuneration. There is a great deal of European legislative reform on the horizon when it comes to remuneration – not only in MiFID, but across all sectors – for example, in the Insurance Distribution Directive. But this is also an area where you will have seen us focusing our supervisory attention in recent years.
When it comes to remuneration of frontline staff, we have tended to focus on the importance of the management and control of firms. In January 2013, we completed a review of sales staff incentives in firms from across a range of different sectors and issued guidance on the risks that can arise from financial incentives. Follow-up work was positive, suggesting that firms had increased their awareness of the risks and focused on financial incentives. But we felt the need to highlight the importance of ensuring that this progress is not undermined by the use of other worrying performance management practices in place of financial incentives, which could also harm outcomes for consumers.
Of course, we do have rules in this area in our Remuneration Code – and although the code is often thought of as focusing on prudential risks, it requires firms to have remuneration policies in place that are consistent with effective risk management. But MiFID II will codify other remuneration matters into rules for the first time, including requirements designed to ensure:
- that firms do not create remuneration policies that could incentivise staff to recommend a particular financial instrument when it is inappropriate for the client
- that a firm’s management body is responsible for defining and approving remuneration policies that encourage fair treatment of clients and avoid conflicts of interest
- that firms need to prevent or manage conflicts of interest caused by their own remuneration structures.
These new requirements will be important new tools for us to use in ensuring that staff remuneration does not drive bad outcomes for consumers. These new rules fit with our desire for firms to continue to focus on both the design and control of their remuneration schemes, especially as new products and new pressures will continually arise.
Other conduct issues
I want to move on now to other conduct matters. In focusing on our recent domestic work, we have already addressed a wide range of different issues that will be tackled by MiFID – but there are three others that I am also keen to cover: appropriateness, costs and charges and adviser independence.
Appropriateness
MiFID’s appropriateness requirements apply where firms sell products without advice. MiFID II will expand the types of products that are to be considered complex for investors to understand. Defining a product as ‘complex’ is important, as it means firms selling these products without advice will need to assess whether a potential purchaser has the necessary experience and knowledge to understand the product they wish to purchase – this is the ‘appropriateness test’.
This test is currently applied to products such as contracts for difference, spread bets, and bonds that embed derivatives – products with the potential to be difficult for the average investor to understand the potential risks involved in investing. MiFID II treats more products as ‘complex’, including all non-UCITS collective investment schemes (which are often known as NURS in the UK) – for example, property funds. So, in future, non-advised sales of these sorts of products will also, at some stage, involve a test of the consumer’s ability to understand what they are buying.
We are very alive to industry concerns in this area, because of the need to make practical changes to distribution strategies. We don’t yet know how easy it will be for these tests to be adopted and operated by online distributors – but we do know that firms are unlikely to be able to meet the appropriateness requirements when selling complex products through direct offer financial promotions, meaning that this channel will no longer be available for distributing some products.
Most importantly, firms will need to assess what sorts of knowledge and experience may be sufficient for a firm to rely on when selling particular instruments. We recognise that some complex products are more complex than others. So we’ll be looking at how we might be able to differentiate our expectations between products. After all, a consumer is unlikely to need the same level of knowledge to understand a property fund as they would to understand a CFD.
Costs and charges
Moving on, I want to talk about the new MiFID requirement for firms to disclose all costs and charges associated with a client’s investment. This, along with the separate European regulation on packaged investments (the PRIIPs Regulation), will introduce greater transparency for investors. For example, costs that may not typically be disclosed to consumers today, such as transaction costs, will need to be disclosed in the future.
By embracing these changes wholeheartedly, the industry has an opportunity to tackle accusations that have been made in the media that some costs are being hidden from investors. We will be looking for the new cost information to be simple and clear – to show all costs in a way that people can understand, so that they can make effective decisions about their investments. And, building on our recent work looking at smarter consumer communications, I would challenge all firms to consider which methods of communication will best meet the needs of clients.
Independence
Focusing once more on the advisory sector, I’ll move on to talk about adviser independence. For the first time, what it means to provide ‘independent advice’ will be defined across the European Union, with MiFID introducing requirements to ensure that independent advisers consider products from a range of different providers before making a recommendation to their clients. As with some other MiFID reforms, this means that the MiFID standard will in future be more similar to the approach we took domestically when introducing the RDR.
MiFID requires firms describing themselves as independent to consider a ‘sufficient range’ of products from a ‘sufficiently diverse’ range of providers. Our current domestic standard refers to independent advisers conducting a ‘comprehensive and fair’ assessment of relevant ‘retail investment products’ – a group of products which includes both MiFID and non-MiFID investments. We’ve had plenty of feedback from the industry on this: some people consider there to be important differences between the two standards, but others see little clear water between them in practice. This is something we will need to come back to once the implementing legislation is finalised.
It’s clearly important that standards of independence match the service that consumers expect to receive when they go to an independent adviser, but we also know that ensuring good quality advice means more than simply the range of products considered. Therefore, standards for independent advice need to be seen alongside MiFID’s other reforms, including the new obligations on suitability, inducements, and product governance.
Current UK context
So far, I have focused on the changes that MiFID II will bring directly to the firms within its scope. But I know that many of you will also be interested in how it will affect the wider retail investment landscape in the UK.
This March, we published a Discussion Paper asking for views on the areas where we knew we are likely to have choices to make when it comes to implementation – and, in particular, we asked questions about whether we should seek to deliver consistent standards across the retail investment market as a whole. Responses to the paper tended to be supportive of consistent standards across MiFID business and insurance-based investments in many areas – though there was also recognition that the uncertainty surrounding MiFID’s detailed requirements, and also other European legislation, makes it difficult to reach a definite view about what will work.
We will publish feedback to our Discussion Paper next year.
We will publish feedback to our Discussion Paper next year and continue to engage with industry about the practicalities of introducing or retaining cross-cutting standards in the coming months. Of course, in talking about the importance of standards for financial advice more generally, I am also conscious that many of you may be interested in how we will link together our plans for MiFID II implementation with our domestic Financial Advice Market Review (or FAMR). The review was launched by the FCA and HMT in early August and it will examine how financial advice could work better for consumers, looking at how access to advice could be improved, particularly for those who do not have significant amounts to invest.
The review will look at whether there is an ‘advice gap’ for those people who do not believe that they can afford financial advice, how to encourage people to seek financial advice generally, and whether firms have enough clarity about the regulatory and legislative environment to compete and innovate in this area. The review published a call for input on Monday last week for feedback by early December, and proposals will be published next year, ahead of the March 2016 Budget.
As part of the review, we have committed to look afresh at EU legislative obligations – both those in existing directives and those coming with future changes, like MiFID II. If appropriate, the review could even consider recommending that representations be made to the European institutions in respect of those obligations. But while the review will invite feedback on whether there are aspects of EU legislation that could be changed to improve the UK advice market, it will principally make recommendations that do not depend on such legislative changes.
As the review has the potential to make recommendations about different types of advice services, we will need to consider how to take it into account when implementing MiFID II. If appropriate, we will address any potential overlap when we consult on the retail aspects of implementation – for example, we’ll need to think about how the practical implementation of the new MiFID rules on independence and inducements will fit with any recommendations that the review makes.
Of course, there are many other initiatives on the horizon, or already underway in the retail investment market, that will need to be thought about alongside MiFID II. At the FCA, we continue to provide support to firms wanting to develop lower-cost advice services through our Innovation Hub. The hub has guided a number of firms, from large firms to start-ups, on regulatory issues associated with their automated advice propositions, and we in turn have sought to understand the barriers they see. Earlier this month, given this increasing interest in alternative distribution channels, we also held a Robo-Advice Conference, to which firms were invited to bring their ideas and questions on automated advice.
There are many other initiatives on the horizon, or already underway in the retail investment market, that will need to be thought about alongside MiFID II.
Both the trend towards emerging advice models and the increasing levels of interest in non-advised sales are global issues. We continue to engage with regulators around the world to see what lessons we can learn from their experiences, and we are also currently working with our member states across Europe, through the ESA Joint Committee, on the regulatory framework around automated advice.
At the same time, it is important to acknowledge one of the most importance changes facing the UK retail investment market in recent years that falls outside of MiFID: the recent pension freedom changes. Not only have these changes given consumers greater choice over how to access and spend their pension, they are impacting on the investment advice market in ways that are continuing to evolve.
With more people needing advice on long-term investment decisions, the way in which they engage with the investment market is changing. The small sums that many people have to either invest or draw on in retirement are also creating new challenges, in terms of the need to find ways to serve the market economically and effectively. While MiFID II does not cover the retirement market directly, the focus that it places on the suitability of advice and the importance of product governance, in particular, are just as relevant in the pensions arena. Overall, it will be important to ensure that we set rigorous standards, while also fostering new advice and distribution models – whether they are aimed at customers coming to retirement or at the retail investment market covered by MiFID.
Conclusion
In the next twelve months, we’ll consult on and make rules to implement MiFID II, creating significant changes in some areas of our retail investment framework and refocusing attention on the importance of others. We’re aiming to have an active communications programme to educate and engage with firms throughout the consultation process, involving regular updates on our website, a targeted digital campaign and a series of events.
In the retail market, I think success will mean that firms have in place robust conduct and organisational standards that reflect the interests of consumers, with management bodies having a strengthened role. But success will also involve implementing the new legislation in a way that recognises other changes affecting the industry, and that supports firms as they develop and refine new and innovative ways of engaging with consumers.