MFSA updates on MiFID II

Dr. Priscilla Mifsud Parker co-authored with Gabriella Chircop | Published on 06 Sep 2017 | Updated on 03 Aug 2018

MFSA updates on MiFID II

MFSA updates on MiFID II

On the 4th August 2017, the Malta Financial Services Authority (the ‘MFSA’ or ‘Authority’) issued a circular providing an update on important documents issued by the European Securities Markets Authority (‘ESMA’) which concern regulatory compliance with the soon-to-be implemented MiFID II Directive (‘MiFID II’ or ‘Directive’).

ESMA’s documents tackle the following specific areas:  

  1. Final Report on MiFID II Product Governance guidelines;
  1. Consultation Paper on the Guidelines on certain aspects of the MiFID II Suitability Requirements; and
  1. MiFID II/ MIFIR Investor Protection Q&A.

The circular summarises the most fundamental points raised by the above-mentioned documents and provides a guideline as regards the main requirements MiFID firms should heed to in order to ensure full compliance with the Directive.

Investor protection emerges as the main priority through MiFID II new and extensive product governance requirements. It sets the necessary foundation for firms to act ‘throughout the entire life cycle of their products and services, in accordance with the best interests of their clients’.[1]

The manner in which MiFID II firms design and distribute financial instruments must essentially be revised seeing that both manufacturers and distributors are caught by the regime.

ESMA, in its final report[2], makes a differentiation between the two entities as follows:

  1. “Manufacturer” refers to a firm that “manufactures an investment product, including the creation, development, issuance or design of that product, including when advising corporate issuers on the launch of a new product”.

 

  1. “Distributor” refers to “a firm that offers, recommends or sells an investment product and   service to a client.”

The report also identifies the specific arrangements in place for the individual entities as well as those arrangements common to both. Some flexibility is inherent in the system, whereby such arrangements founder applicability in a more proportionate manner and ‘taking into account the nature of the instrument, the investment service and the target market for the product’[3]

Product Governance obligations for Manufacturers

  1. The manufacturer must identify a target market for each and every financial product it designs and develops.

            Due to a lack of direct manufacturer-client contact, the target market must be defined generally, based on the manufacturer’s theoretical knowledge                   and experience of the product.

 

  1. The suitability of the market must be assessed taking into consideration:
  • quantitative and qualitative criteria;
  • five cumulative categories[4];
  • the characteristics of the product including its complexity, risk profile, innovation and liquidity;

 

  1. Articulation between the manufacturer’s distribution strategy and its definition of the target market.

            The distribution strategy must be well-defined making available to distributors all appropriate information on the investment product, including the                       identified target market.

 

Product Governance obligations for Distributors

  1. The distributor is also under the obligation to identify an actual target market for its products, after reviewing the boundaries of the potential target market set by the manufacturer. In this respect, distributors should gather all the relevant information from the manufacturers.

The Target Market must be defined in a more concrete basis owing to the distributor’s specific knowledge of individual clients.

 

  1. In determining the potentiality of the market, similar considerations applying to manufacturers must be taken into account:

 

  • Same five categories;
  • Nature of the product including complexity, risk profile, liquidity and innovation;

 

  1. New considerations also emerge in identifying and assessing the market.

Interaction with investment services, the compatibility between the product and the respective target market depends not only on the nature of the product, but also on the type of investment services the firm provides.

 

  1. Regular review by the manufacturer and distributor to respectively assess whether products and services are reaching the target market;

 

  1. Distribution of products manufactured by entities not subject to the MiFID II product governance requirements are subject to an appropriate due diligence on the manufacturer to ensure adequacy of information received.

 

  1. Products manufactured and distributed before 3rd January 2018 should not fall within the scope of the product governance requirements as defined by MiFID II.

Products which were manufactured before 3rd January 2018 but which are distributed to investors after 3rd January 2018 should fall within the scope of product governance requirements applicable to distributors.

 

Guidelines on issues applicable to both manufacturers and distributors

  1. Identifying whether the product would be incompatible with certain target markets – the negative target market;
  1. Same categories and principles as mentioned in (1) and (2) are applicable;
  1. Application of the target market requirements to investment firms dealing in wholesale markets (i.e. with professional clients and eligible counterparties).

Where an investment firm engages in both the manufacturing of the product and also in its distribution, then product governance rules for manufacturers and distributors will apply.[5]

Licence Holders manufacturing or and distributing products will be expected to adhere to these requirements which will be transposed locally in the Conduct of Business Rulebook.

 

The suitability requirements introduced under MiFID and further strengthened under MiFID II’s new legislative framework, once again seek to ensure that an investment firm acts in its clients’ best interests.

The assessment of suitability applies to firms and competent authorities subject to Directive 2014/65/EU of the European Parliament and of the Council (MiFID II). In particular, this applies to firms providing:

  1. Investment advice (independent/non-independent); and
  2. Discretionary Portfolio management.

A firm providing any one of the two above-mentioned investment services must strive to ensure that a suitable personal recommendation is made to the client. In the event of investment advice which recommends a package of services or financial instruments, the overall combined package has to be suitable.[6]

A suitable personal recommendation may only result when an investment firm undertakes to request all the necessary information from clients prior to assessing the suitability of a particular investment.

Obtaining all the necessary information essentially impinges upon the firm’s duty to investigate the Client’s investment background comprehensively. Several factors specific to the client must be taken into account in gathering the information, including the client’s knowledge and experience in the specific investment field, the client’s investment objectives as well as the client’s financial situation including risk tolerance and ability to bear losses.[7]

The table below gives an overview of the distinct elements to be examined by investment firms when collecting information in relation to a particular Client.

Assessing Suitability

 Information to be obtained 

Client’s Knowledge and Experience[8]

  • the types of service, transaction and the regulated investments with which the client is familiar;
  • the nature, volume, frequency of the client’s transactions with regulated investments;
  • the level of education and profession of the client 

Client’s financial situation[9]

  • the source and extent of the client’s regular income;
  • the client’s assets, including liquid assets, investments and real property;
  • the client’s regular financial commitments;
  • the ability to bear losses

Client’s investment objectives[10]

  • the client’s risk preferences, including the client’s risk profile and risk tolerance;
  • the length of time for which the client wishes to hold the investment,
  • the purposes of the investment

 

ESMA has published a consultation paper on draft guidelines for certain aspects of the suitability requirements under the MiFID II.  The Consultation Paper includes proposals on the draft guidelines which confirm and broaden the existing guidelines issued in 2012.  

The Suitability Report

One of the main obligations introduced imposes upon firms the requirement to provide clients with a suitability assessment in the form of a suitability report, detailing how the advice given meets the client’s circumstances in terms of costs and complexity of products. Most importantly, clients must be presented with the latter report prior to the conclusion of any recommended transaction.

It is also to be pointed out that the suitability assessment kicks in not only when giving a recommendation to the client for the purchase of a financial instrument, but for all decisions whether to trade, including also whether or not to buy, hold or sell an investment.[11]

More specifically, ESMA advises that Suitability reports must include:

  • an outline of the investment advice given;
  • an explanation of why the recommendation is suitable, including how it meets the client’s objectives and (personal) circumstances, with reference to attitude to risk and capacity for loss;
  • a statement informing the client where they may need to seek a periodic review of suitability arrangements;
  • a statement to the effect that where reports are provided on a periodic basis, any subsequent report may be in the form of an update to a previous suitability report, and address only what has changed since the last report.

Switching Investments

Firms must necessarily undertake a cost/benefit analysis before being in a position to recommend a particular course of action which will involve switching investments. Such analysis aims to ensure that the benefits of switching outweigh the costs of such move.[12]

Electronic systems

ESMA’s consultation paper also clarifies that where a firm relies on the use of electronic systems for the provision of relevant services, its responsibility for suitability is in no way diminished. This would apply, for example, where a firm uses an automated system to provide web-based advice or portfolio with agreement services.[13]

ESMA will consider all comments in relation to its consultation paper and other questions asked, by the 13th October 2017.

 

In light of the vicinity of MiFID’s implementation on the 3rd January 2018, and owing to the Directive’s strengthened vision for investor protection, ESMA has issued a Question and Answers (‘Q&A’) document which congregates detailed information and clarification with respect to prevailing investor protection topics.

Focusing on topics such as:

  • best execution;
  • suitability and appropriateness;
  • record keeping;
  • investment advice on an independent basis;
  • underwriting and placement of a financial instrument;
  • post-sale reporting; and
  • recording of telephone conversations and electronic communications;

the Q&A aims to promote ‘common supervisory approaches and practices in the application of MiFID II/MiFIR for investor protection topics.’[14]

Having already generated responses to questions posed by the general public, market participants and competent authorities, ESMA seeks to continue developing the Q&A further; firstly, by adding questions and answers to the topics already covered and secondly by introducing new sections for other MiFID II investor protection areas not yet addressed in the Q&A.

In connection to suitability, as discussed in the previous section, ESMA clarifies that the suitability report must be provided to a client when such has been provided with investment advice, regardless of whether or not the advice is followed by a transaction. MiFID II specifies that the report must be given ‘before the transaction is made’, however, this does not entail that the recommendation must be followed by a transaction.[15]

Furthermore, the suitability report must be provided in durable medium, including also an electronic medium form.[16] Lastly, in the scenario where a client is unwilling to fully disclose his/her financial situation, the firm is under the obligation to forgo recommending any investment advice or financial instruments to the client or the potential client. [17]

 

[1] ESMA Final Report, Guidelines on MiFID II product governance requirements p.8

[2] Ibid.

[3] MiFID II Delegated Regulation, Article 9(1)

[4] (i) type of clients (ii) knowledge and experience (iii) financial situation & ability to bear losses (iv) risk tolerance & compatibility of risk profile of product with target market (v) clients’ objectives & needs

[5] MiFID II Commission Delegated Regulation Article 17

[6] MiFID II Article 25(2)

[7] Ibid.

[8] MiFID II Commission Delegated Regulation, Art. 55(1)

[9] Ibid. Art. 54(4)

[10] Ibid. Art. 54(5)

[11] Recital 87 of the MiFID II Delegated Regulation

[12] ESMA Consultation Paper, Guidelines on certain provisions of the MiFID II suitability requirements, Guideline 10

[13] Ibid. Recital 2

[14] ESMA Questions and Answers on MiFID II and MiFIR investor protection, Introduction

[15] Ibid. Suitability and Appropriateness, Question 1

[16] Ibid, Question 3

[17] Ibid. Question 7

 

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Dr Jean-Philippe Chetcuti

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Dr Priscilla Mifsud Parker

Senior Partner - Corporate, Trusts & Fintech

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Mr Colin B German

Chief Executive Officer

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