The deadline for MiFID II is fast approaching. Tasmin Little, Partner, Financial Regulation at Reed Smith LLP discusses implementation strategy and argues that the regulation may yet prove to be beneficial for the relationship between customers and their banks

Most retail banks doing business anywhere in the European Union – unless their business is strictly restricted to deposit taking and lending, without so much as an interest rate or currency swap added to the simple handling of money – are well aware that 3 January 2018 marks the date for compliance with MiFID II, the revised Markets in Financial Instruments Directive and all its associated legislation and regulation.

Indeed, most should have had implementation programmes running for the last three years.
As the deadline approaches it may be useful to step back from the detail and consider how effectively banks’ implementation plans and operational changes address some of the biggest topics in this all-encompassing revision of EU regulation of investment business.

For retail banks many of these revolve around mis-selling. MiFID II requires a range of overlapping new policies and procedures which are designed both to reduce the risk of mis-selling in future and to make it easier for regulators to take disciplinary action for procerdural failure without needing to prove that there has actually been any mis-selling or investor losses.

Relevant new, or greatly increased, obligations include those relating to remuneration, product governance, identifying the status of advisers, restrictions on third party payments and benefits, and disclosure of these costs and commissions.

Remuneration policies must be revised again. They must cover not just senior management, risk takers and the highly paid but also all those who deal with customers or otherwise have an impact on investment services or corporate behaviour.

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The key MiFID II requirement is that remuneration must not create any incentive for staff to favour their own interests or those of the firm to the potential detriment of clients.

Product governance requires both the “manufacturers” and the distributors of financial products falling within MiFID to put in place procedures to make sure that the financial products they sell are consciously designed to meet the needs of an identified target market of end clients and that the distribution strategy operates in a joined-up way to bring them into the hands of the right type of end client.

Senior management must take full responsibility. Compliance and marketing teams must co-operate. All those involved in design and distribution must be trained to make sure they understand the characteristics of the products and can properly assess compatibility with the needs of the target clients.

Ongoing review and monitoring will be required after the event to see whether the products did in fact reach the intended target market or whether they were distributed to others for whose needs they were not compatible. If not, corrections and improvements may need to be made.

Product governance obligations will run throughout the distribution chain, both professional and retail.

They are separate from and additional to any obligation there may, or may not, be to give investment advice or ensure suitability for a particular investor at the end of the chain. One of the biggest challenges banks have been wrestling with is the passing of “post sales” information up and down the distribution chain to enable the required monitoring and follow up to be carried out.

If any advice is given to customers they must be clearly told first whether that advice is independent, whether it is based on a broad or a more restricted range of investments, and whether the range is limited to investments provided by the bank itself and its related parties.

Independent advice must involve review of a sufficiently diverse range of financial instruments and providers to ensure that the client’s investment objectives can be met. It cannot be limited to investments provided by the bank and related parties (including those related by contract).

Moreover, no third-party fees, commissions or other monetary or non-monetary benefits can be accepted and retained in relation to independent advice, apart from some very minor non-monetary benefits which are fully disclosed to the client and meet much more stringent tests to ensure the quality of service is enhanced without damaging the client’s interests.

Considerable difficulty is being experienced in handling the complex provisions relating to payment for research, particularly by global groups and others dealing with US brokers who are unwilling to receive payment for research lest they become “investment advisers” in US regulatory terms.

If advice is not to be given then MiFID II further restricts the types of investment which may be sold on an “execution only” basis.  In all cases disclosure obligations have been greatly increased. Direct and indirect costs, charges and commissions, including mark ups embedded in the product, and third-party payments and benefits will all have to be disclosed in advance and on an ongoing, at least annual, basis.

Costs disclosure must aggregate the costs and charges relating to the production and management of the investment itself and those arising for related services and must be expressed both as a percentage and in cash terms, with a detailed breakdown available for those who request it.

All clients will have to be given an illustration, before and after sale, showing the effect of the overall costs and charges on the return from investment and any anticipated spikes or fluctuations in those costs and charges. This is clearly a massive exercise, both in terms of gathering the required information, frequently from several different firms, and in terms of presenting it to customers in a user-friendly compliant manner.

If all of this is done successfully the result could be very positive for the relationship between retail banks and their customers in the EU. It remains to be seen how many banks find it possible to carry out all the required work in the time available and to implement these and all the many other requirements of MiFID II on a continuing basis to achieve its theoretical goals.

A period of regulatory calm in which these changes can be assimilated by the industry without more disruption would be welcome but seems unlikely to occur.

Tasmin Little is Partner, Financial Regulation at Reed Smith LLP