EU Directive on Markets in Financial Instruments
Author:
Marie Mangan
In a series of questions and answers, Marie Mangan sets out some key business implications of the Markets in Financial Instruments Directive (MiFID).
MiFID is one of the widest ranging and most important Directives to come from Brussels in many years. Essentially, it has two aims:
- The Directive seeks to enhance the ease with which consumers (in the widest sense) can avail of investment services across Europe. However, it recognises that before a French investor, for example, will feel comfortable dealing with an Irish investment firm; it must be clear to the investor that the same quality standards and delivery are observed no matter in which EU country the investment firm is based. MiFID seeks to achieve this by setting out detailed rules on how investment firms act on behalf of their clients. The Directive also seeks to ensure that there is a common high standard of investor protection and again to achieve this there are detailed rules imposed.
- The second main objective of MiFID is to seek much greater liberalisation of the European capital markets by introducing wide ranging changes in how many of Europe's stock exchanges and over the counter markets (OTCs) operate. These changes should result in more liquid and transparent markets thereby encouraging a true single European capital market.
WHO IS AFFECTED BY MIFID?
Any financial services firm which carries out investment type activities as defined by the Directive will be subject to the new provisions.
In practice, the Directive covers all stockbrokers but not all investment business firms. Multi-agency intermediaries are excluded from MiFID. Banks carrying out investment services are within the Directive's scope. In the Funds industry, investment managers are covered but management companies are not. Custodians and fund administrators are also likely to be affected but to varying degrees. Therefore, it is necessary to look at the business of each client to decide whether and the extent to which the client is affected.
It is also possible, if not likely, that all regulated entities will be subject to MiFID rules due to a proposal by the Financial Regulator to impose a single ‘Code of Conduct’ on all the entities that it regulates. The Code sets out how a regulated firm should interact with its customers and this is exactly the same detail that MiFID covers. If the regulator proceeds with its current proposal then many firms not affected by MiFID will nevertheless find themselves subject to the same requirements as a result of a unified Code.
WHAT ARE THE MAIN BUSINESS CHANGES?
Governance and Controls: There are new formal and detailed obligations imposed on the board and management of firms affected by MiFID. Larger and more complex firms will need to have independent internal audit, risk management and compliance functions. All firms must have internal audit, risk management and compliance procedures and controls, formal monitoring procedures and specified reporting to the board.
These changes are a significant step up from the current requirements which simply provide that firms have ‘adequate internal controls and procedures’ and where it is an entirely subjective issue for each firm as to what it considers ‘adequate’ in the context of its business.
Client classification: There will be three new classification of clients - retail, professional and eligible counterparty. Essentially, a different standard of service can be provided to each category. Therefore a firm’s systems must be able to identify and classify each client and each client’s transaction in order to ensure that the relevant rules are met. MiFID is likely to mean that many firms’ IT systems may need to be upgraded, a formal classification and notification process will have to be undertaken and in many cases a ‘re-papering’ of client contracts will be required.
Suitability: Firms will have to ensure that each product that they sell to a client is either ‘suitable’ or ‘appropriate’ - the main difference between the two is the amount of information which must be gathered from the client.
If a client will not rely on a recommendation from the firm then the firm must ensure that the product is appropriate to the client. In other words, the firm must ensure that the customer has the knowledge and experience necessary to understand the risks relating to the product.
Note that the firm can provide a service to a client even where it deems the service to be inappropriate to the needs of the client so long as the client is given adequate warnings.
A firm must establish the suitability of a product when providing services that entail an element of recommendation on the part of the firm i.e. investment advice or discretionary portfolio management. This means that a firm must gather significantly more information about a client’s financial situation and investment objectives. Note that the firm cannot provide an unsuitable recommendation.
Best Execution: This is probably the most important change to be introduced by MiFID. It requires firms to ensure that they get the best possible result, not price, for each client transaction.
While it sounds quite simple, before completing any client transaction, firms will have to ensure that they will achieve best execution by taking into account price, costs, speed, likelihood of execution, settlement size, nature and any other issue that is considered necessary.
This has to be done for every transaction and records must be held afterwards which allow firms to retrospectively demonstrate that best execution was obtained.
Trade and Transaction Reporting: Essentially, the change being introduced here is that the current information disclosure and transparency requirements of regulated markets (i.e. stock exchanges) are going to be extended to trades outside the regulated markets. If you are a so called ‘systematic internaliser’ then these rules will catch you. In other words, if you are a firm which on a systematic and frequent basis executes client orders outside a regulated market.
In practice, very few Irish companies are likely to fall under this. But for those who are caught, they will have to publish firm quotes in so called ‘liquid’ shares and maintain those quotes on a regular and continuous basis.
Post trade, for the first time, MiFID will require investment firms to publish the price and volume of all completed trades that they undertake outside a regulated market and on a real time basis.
Client Information: One of the key changes introduced by recent EU Directives is a significant increase in the volume of information which must be provided to clients. Under MiFID, retail clients will have to get general information on the firm, sufficiently detailed information on the nature and risk of the product they are buying, information on the costs and charges and also get that information in good time so that each client has had the time to read and understand the information before making an investment decision.
WHEN WILL MIFID BECOME IRISH LAW?
The final draft of the Directive only became available in February this year and it is expected that the Directive will be passed by the European Parliament this June. In Ireland, the Department of Finance is committed to implementing MiFID, by Statutory Instrument, by the deadline of 31 January 2007. Firms will then have until 1 November 2007 to ensure that their businesses are MiFID compliant
WHAT SHOULD COMPANIES BE DOING?
At this stage, companies should carry out a high level assessment which analyses the impact of MiFID on their businesses (Phase 1). This will allow them develop an initial view of the scale of change required and to establish a high level plan. For firms that find that MiFID will have a significant impact, the next stage (Phase 2) is likely to be to develop a MiFID project including scope, resourcing, budgeting and reporting. Phase 3 will entail carrying out a detailed analysis of the impact of MiFID across each business line. This will lead to Phase 4 which will require the design of a detailed plan to ensure that the firm will be MiFID compliant by 1 November 2007. Phase 5 will consist of the practical implementation of the plan including rolling out policies and procedures, implementing technology changes and completing internal training.
While MiFID can result in a major compliance/business change projects for firms, it should be borne in mind that it also represents opportunity, especially to those with first mover advantage.
Marie Mangan is a Director of Regulatory Advisory Services with KPMG.