Hacking through the Mifid 2 jungle

The Mifid 2 Level 2 guidance is now available for digestion by the asset management industry, clarifying a variety of issues. Sheenagh Gordon-Hart provides the initial Fund Radar take on the latest chapter of the forthcoming directive.

Mifid 2 – at last from the Commission, the text of key elements of the Level 2 rules has been published. This covers inducement, product governance and client assets. There’s not much to surprise us but of course now the work to meet the deadline for compliance begins in earnest.

Inducements: Advice model

The first element of the inducement rules changes the advice model: if independent advice or portfolio management is on offer then inducements are banned or, if received, must be paid back to the client. Where inducements are received then it is a requirement that they can only be accepted if the inducement results in an enhanced quality of service to the client. Examples would be the provision of investment advice on and access to a wide range of suitable financial instruments including an appropriate number of instruments from third-party product providers, or the provision of non-independent advice combined with either an annual suitability review or another ongoing service that is likely to be of value to the client. Once again the wording is a bit muddled but you get the point. The question is: whither open architecture? It’s unlikely that a massive advice gap will open up across Europe as it did with the advent of RDR in the UK. It is rather more likely that banks and other distributors will find ways to meet the ‘enhanced quality of service’ test and may well accompany that with a bias in favour of in-house product.

Inducements: Research

The second element of the inducement rules concerns research. After much heated debate, the Commission confirms that costs of research must be unbundled. Where research is not paid for from the firm’s own resources, a research payment account must be set up and funded by a specific research charge to the client and cannot be linked in any way to transaction volume or value.

The rules also require that firms have appropriate governance arrangements on research budgeting and spending. There is mounting evidence that firms are already preparing to realign their research payments, with a number of fund groups deciding to take the cost on themselves while others have allocated a research budget to each of the funds they manage. How this will all play out hangs in the balance. Serious concerns have been raised that smaller companies may not get the coverage they need and of course the capital-market funding of SMEs is central to the Commission’s flagship CMU project. Like so many other initiatives, methinks this one will need rewriting.

Due diligence

The product-governance requirements treat investment firms that create, develop, issue and/or design financial instruments, eg funds, as manufacturers while investment firms that offer or sell financial instruments and services to clients should be considered distributors. If a firm both creates and distributes investment products, the product-governance rules for both manufacturers and distributors will apply, although there is no requirement to duplicate the target-market assessment and distribution-strategy exercise. The level of granularity of the target market and the criteria used to define it and determine the appropriate distribution strategy should be relevant for the product and should make it possible to assess which clients fall within the target market, to assist the ongoing reviews after the financial instrument is launched. For simpler, more common products the target market could be identified with less detail, while for more complicated products the target market should be identified in more detail.

The rules require distributors to provide the data that will enable the manufacturer to review the product and check that it remains consistent with the needs, characteristics and objectives of the target market defined by the manufacturer. The rules suggest what ‘could’ constitute relevant information, for example data on sales that occur outside the target market, the types of clients and a summary of complaints.

What to do then if it is discovered that sales are reaching some investors not originally identified as part of the target market? The rules say that firms will need to ‘reconsider’ the target market and/or update the product governance arrangements if they become aware that they have wrongly identified the target market for a specific product or service or that the product or service no longer meets the circumstances of the identified target market. They also require a firm’s compliance function to oversee the development and perform periodic reviews of product-governance arrangements in order to detect any risk of failure to comply with the product-governance obligations.

Client assets

The rules on the safeguarding of client assets will not be difficult to comply with, although the diversification rule and limit on depositing client funds with intra-group credit institutions will require a change of practice in some jurisdictions and there will likely be some impact on profitability as a result.

The implementation of Mifid 2 may have been delayed by a year but clearly there is plenty for groups to chew on in the meantime – and no doubt further questions will arise in due course.