The UK's Wealth Management Association delineates the problems that private banks and asset managers will face when the European Union's Markets in Financial Instruments Directive (Mark II) comes into force. Expensive systems upgrades will be the order of the day.

In the last few
days ESMA, the European Union's overarching markets regulator, faced
questions from banks and trade bodies about the Markets in
Financial Instruments Directive, Mark II, at a meeting in
Paris. Among the questioners was Ian Cornwall of the UK's 14-man
Wealth Management Association. Yesterday, he and his
colleague John Barrass told Compliance Matters aboutthe WMA's concerns over this upcoming 720-pagedirective and its accompanying regulation, MiFIR.

 

The two regulatory
experts were understandably worried about the costs that they expect
the directive, when completed, to impose on their 250 member-firms,
which consist of discretionary fund or portfolio management
businesses, wealth management firms and the professional firms that
serve them. At this stage, said Cornwall, “there's not enough
detail for us to determine costs”. This did not, however, stop the
two experts from pointing out the likely areas of additional expense.
Cornwall added: “MiFID II is not as great as MiFID I in terms of
headlines, but there is a massive series of projects that firms will
have to manage.”

 

When good
Europeans attempt too much

 

On the general
subject of how wealth management firms should treat customers, the UK
is facing some confusion because three overlapping regimes: “treating
customers fairly” or TCF, with its six principles; the Retail
Distribution Review which began to bite a couple of years ago; and
MiFID with its impending upgrade. Cornwall asked an often-asked
question and came up with his own answer: “Will there be an RDR II
to clean up the mess? In my own view, we ought to change the RDR to
match what's happening in Europe. We're all good Europeans now.”

 

The EU has come out
with many directives (laws which have to be enshrined in the law of
member-countries) and regulations (laws which take immediate effect
without such transposition) under Michel Barnier, an EU commissioner
who deals with financial supervision, but as he is to be replaced in
November, Barrass regarded him as a 'lame duck' and expected no new
policy until then. On a critical note, Barrass noted that the EU had
plenty of legislation still outstanding, notably the fourth
money-laundering directive; some data protection legislation;
money-market funds legislation; and a regulation to do with
benchmarks, i.e. indices (statistical measurements) such as LIBOR,
'calculated' (i.e. fabricated) from underlying data, that are used as
reference prices for financial instruments or to measure the
performance of investment funds. He took all this to mean that “too
much is being attempted.”

 

On the other hand,
the WMA's literature credits the European Parliament, which most
people do not see as a proper parliament, with being the “first
ever EP with real legislative power” and says that it has not only
voted MiFID II and an accompanying regulation (MIFIR) into EU law,
but also PRIIPS (packaged retail investment and insurance-based
investment products) rules, MAD/MAR (the second market abuse
directive and an accompanying regulation) and CSD/R (the central
securities depository regulation), all of which are “key for our
sector.”

 

In the almost
impenetrable double-talk of the European Union, the MiFID legislation
has now reached 'level 1' with the enactment of vague principles and
rules that will, after 30 months or so, be binding on all relevant
entities. 'Level 2', on which ESMA has been consulting interested
parties, will consist of “non-essential technical details and
implementing measures.” Once the responses – including the WMA's
– are all in, new regulations will come. The deadline seems to lie
in August. Cornwall commented: “we only got the first 'level 2'
paperwork two months ago. There are bits of what we want to re-write
even now. We've had to race through this lengthy stuff and it's very
hard to get the firms engaged because they have the day job.”

 

The impact of
MiFID II and MiFIR

 

On the subject of
rules to protect investors from sharp practice, the new law will make
things even tighter for firms than its predecessor MiFID I, which
came into force in 2007. Unlike its predecessor, however, the change
it engenders will not be 'iconoclastic', in Barrass' words.

 

“People shouldn't
be frightened. It's not as dramatic as its predecessor, although it's
quite tough in some areas. On the market side, more is new – it
covers organised trading facilities [Europe's rough equivalent of the
US swap execution facility], consolidated tape [a speedy electronic
system that reports the latest price and volume data on sales of
exchange-listed stocks] and the handling of dark pools [electronic
alternative trading systems, very similar to stock exchanges but
secretive, as allegedly abused by Barclays]. Even here, fundamental
changes to create competition between trading venues were in MiFID I.
Some of MiFID II/MiFIR is a response to market fragmentation and
information distortions thrown up by MiFID I, including the
industry's request for consolidated tape. This is for the larger
firms but doesn't affect us a lot.”

 

“Our top five
problems”

 

Barrass and Cornwall
had a list of the top five problems that they had identified in the
new legislation. In other words, they had identified the areas in
which changes to administrative and IT systems were probably going to
be the most expensive. These were, in no particular order:

• trading
  volumes;

• transaction-monitoring;

• telephone
  recordings;

• disclosures of
  costs; and

• loss thresholds
  of discretionary managers.

Let us deal with
each in turn.

 

The execution of
orders: what are 'trading volumes'?

 

Under the new
directive, investment firms that execute clients' orders will have to
make public (annually, for each class of financial instrument) the
top five execution venues in terms of trading volumes where they
executed clients' orders in the preceding year and information about
the quality of execution obtained. Cornwall was full of doubt about
this.

 

“Our problem here
is going to be the sheer cost of producing the data. What is meant by
the terms 'each class of financial instrument', 'trading volumes' and
'quality of execution obtained'? That last is a pretty tricky one.
What is the time period to produce the data? There are potentially
huge system costs with little benefit for retail clients.”

 

Transaction
reporting

 

This is one of the
areas of MiFIR that appears to be set in stone already. Cornwall
said: “What's in the regulation is pretty much what's going to come
in. There's not much wiggle-room.” Andy Thompson, the WMA's
director of operations, then led Compliance Matters through
three main issues.

 

1. The
transmission of an order. An investment firm that transmits
orders to another investment firm will still be able to rely on that
firm to report the transactions but – and it is a big but – the
transmitting firm will be obliged to provide much more information to
the receiving firm than ever before and there must also be a written
agreement between the two regarding the obligations that both parties
have over this. Thompson added: “There's much more ownership. There
has to be a contract between the two about who does what...or the
manager can report it himself.”

 

2. 'Client
identifiers'. This is problematic in a country such as the UK
that still lacks some of the trappings of a police state. On the
continent of Europe, governments of an authoritarian frame of mind –
which was practically all of them – forced their citizens to carry
papers during the war and never managed to kick the habit afterwards.
The UK gave up national ID cards in 1954 and is still having trouble
trying to force the next generation of them on Britons. Thompson
remarked: “For natural persons the obvious substitute for a
national ID number is likely to be a national insurance number, but
some firms don't collect these. A passport number might do. For legal
persons, there has to be a 'legal entity identifier' and the client
must apply for an LEI before it can commence or continue trading.
This has been in the press over the last year or two, but trusts
aren't defined as 'legal persons' – they're 'legal relationships',
according to STEP.” STEP is the Society of Trust and Estate
Practitioners.

 

MiFID is not clear
on the subject of trusts – in the words of a senior client advisor
at Stanhope Capital, “the French don't 'get' trusts. They don't
understand them.” A discussion paper that ESMA published on 22 May
admitted that the organs of the EU must apply further consideration
to the question of how to identify joint accounts, power of attorney
and accounts held on behalf of minors. As Thompson put it: “They
themselves [the Europeans] haven't come up with an idea of how to
report these transactions. At the moment there are 23 fields I think
in a transaction report. About 90+ will be in a transaction report
when this comes in. Some existing fields will change. This is
definitely in the 'top five' of system changes.”

 

3. Trader ID.
This, said Thompson, is going to be problematic not just for firms in
the WMA's audience, but “right across the piece.” There are two
areas where people or entities have to be allotted IDs.

(i) For
execution-only and advisory trades, there has to be identification
for the “trader who pressed the button to initiate the execution.”
One example of this is the person who presses the button to submit
the order to the order management system.

(ii) For
discretionary trades, the person responsible for making decisions has
to be identified. If a committee makes the decision, there has to be
a separate trader ID for each committee.

“

A recent paper from
the accountancy firm of Deloitte's states: “The discussion paper
sets out 93 data attributes which firms may need to populate when
submitting a transaction report, an increase from the current 25
attributes. Previous experience from MiFID I implementation
demonstrated the difficulties firms can face in reporting accurately.
There will be an increased dependency on static data for reporting
(e.g. the identification of the trader or the algorithm). Firms
should be thinking about the adequacy of their existing data systems
now.”

 

Recording of
telephone conversations or other electronic communications

 

MiFID II sets out a
new regime here for communications regarding client orders.. On this
topic Cornwall began: “It's not that new for us. We do it already.
The main concern is cost. Rather than recording 6 months you're
probably going to have to record 7 years. Indexing the data to make
it possible to find this-or-that call from 7 years ago – that's
where the money is. You might have to find out if Bill took that call
at that particular desk in the building across the road years ago.”

 

This was an allusion
to the MiFID policy that records of telephonic interactions with
clients must be recorded for 5 years and not the current 6 months;
the regulators can ask firms to retain them for 7 years if it so
pleases. Many 'new' requirements – written recording policies,
staff training, the monitoring of records – are already built into
firms' existing arrangements.

 

There are to be
notes of face-to-face meetings between wealth management firms and
clients. ESMA is proposing that clients should be made to sign such
notes, which the WMA thinks is probably going to be burdensome for
firm and client alike.

 

Lastly, every client
ought to receive relevant records if he asks for them. The WMA
suspects that this might not be practical and that there are
implications here for complaint-handling and interaction with the
Financial Ombudsman Service.

 

Information to
clients about costs and charges

 

MiFID calls for the
disclosure of all costs and charges in connection with the investment
service in question. Each firm will have to disclose its own charges;
the costs and charges associated with the client's investment
holdings; and any receipt of any third-party payments, i.e.
inducements.

 

Disclosures should
be 'before the event' ('ex ante') and 'after the event' ('ex post').
Each should be an “illustration showing the cumulative effect of
costs on return when providing investor services.” Cornwall
commented: “The ESMA advice provides no illustration of what the
illustration should contain, so we don't know about this. It's
difficult from the wording to identify exactly what has to be
reported and in what format.

 

“This is going to
be a huge cost to firms. The system costs are likely to equal
telephone numbers. And, as I say, it has to be disclosed annually to
the client.”

 

This is actually
what point 59 of the ESMA 'consultation paper' (ESMA/2014/549) of 22
May states.

 

“ESMA considers
that an investment firm should be obliged to provide its clients both
ex-ante and ex-post with an illustration showing the cumulative
effect of costs on return when providing investment services, such as
portfolio management and investment advice. The illustration should
help the client to understand the overall costs and should increase
the client’s understanding of the cumulative effect of costs and
charges on the investment. The illustration can be a graph, a table
or a narrative and should be provided at the point of sale. When
providing the illustration the investment firm should ensure that the
illustration meets the following high level requirements:

i the illustration
shows the effect of the overall costs and charges on the return of
the investment;

ii the illustration
shows any anticipated spikes or fluctuations in the costs, such as
high costs in the first year of the investment (upfront fees), lower
costs in the subsequent years (on-going fees) and higher costs at the
end of the investment (exit fees); and

iii the illustration
is accompanied by an explanation of what the illustration shows.”

 

Far from being
confusing as the WMA supposes, this appears to be quite
well-expressed. It may, however, have been mangled since 22 May in a
European parliamentary re-write.

 

Cornwall concluded:
“One point is that a lot of the investor-protection is not just
retail-focused like us. Some of the investor-protection provisions
have been widened to take in professional clients. Also, PRIIPS is a
document you have to hand to clients. That'll happen in 18 months'
time.”

 

Reporting to
clients, including loss thresholds

 

Cornwall disclosed:
“Most clients already whinge about the volume of papers they get.
They can't opt out of reports. At the moment, if the client wants it
annually he has to write to ask for it annually. If he doesn't, it's
six-monthly. Now it's going to quarterly.”

 

This is an allusion
to the new rule that reporting must be quarterly as regards
valuations and safe custody statements. The focus will have to be on
performance and not costs. There is to be no client opt-out this
time. The regime, furthermore, is to use loss thresholds for
discretionary accounts that are agreed with the client – 10% or 20%
or 30% etc. – in multiples of 10%. The way Cornwall put this made
it sound as though the client was to have even more control here:
“you have to have them in accordance with what the client elects.”

 

Article 42 of the
MiFID Implementing Directive currently requires additional reporting
where “investment firms provide portfolio management transactions
for retail clients or operate retail client accounts that include an
uncovered open position in a contingent liability transaction”. The
application of these requirements has raised some uncertainties over
the scope and the effects of this obligation.

 

In note 20 of its
letter, ESMA says that it thinks that this requirement should be
modified in order to “clarify that the agreement of loss thresholds
triggering the reporting obligation is an obligation and not an
option for firms. Specific predetermined thresholds could also be
identified (e.g. 10 % (and multiples of 10%) of the initial
investment or the value of the investment at the beginning of each
year.”

 

Cornwall believed
that this proposal lacked detail, especially as regards cash
movements, individual holdings as opposed to whole portfolios,
transfers between spouses and transfers to individual savings
accounts or ISAs.

 

Target markets

 

The ESMA
'consultation paper' mentions the phrase 'target market' 40 times.
Firms will have to ensure that each product they manufacture and/or
offer and the distribution strategy they adopt for each are
consistent with the identified target market, both from the outset
and from time to time thereafter.

 

One example among
many states: “Member states should ensure that the investment firms
which manufacture financial instruments ensure that those products
are manufactured to meet the needs of an identified target market of
end clients within the relevant category of clients, take reasonable
steps to ensure that the financial instruments are distributed to the
identified target market and periodically review the identification
of the target market of and the performance of the products they
offer.”

 

The WMA's problem
with this crucial phrase, despite its repetition, is that it is
ill-defined: “We're at a loss as to what that term means.”

 

A lack of clarity

 

Plenty of other
things in the MiFID II/MiFIR legislative process are ill-defined as
well. The WMA's experts told Compliance Matters that terms such as
'costs', 'switch', 'suitability' needed further elaboration, as did
things such as the amount of reliance a firm might place for
compliance on other parties such as internal auditors. The UK's
Financial Conduct Authority is not planning to publish any
determination about how it will handle MiFID's relationship with RDR
until the autumn of next year.

 

A dismal year

 

Whatever the ESMA
papers say at the moment, the eventual outcome of this legislative
exercise is going to be a series of expensive systems upgrades. Ian
Cornwall predicted: “There will have to be a lot of prep on the
part of firms, mainly starting in the last six months of 2015.
They'll have to do some prep then. John Barrass added: “The best we
can do is to say the sort of things you'll have to think about. 2016
is going to be a pretty dismal year for firms.”