What is happening?
Proposals for the second iteration of the Markets in Financial Instruments Directive (MiFID II) first surfaced in 2011. After five years of intense debate and lobbying, MiFID II’s tumultuous passage towards implementation is nearing an end. In essence, the rules seek to bring about greater transparency across markets and financial institutions. MiFID II was initially meant to come into force in January 2017 but after intense lobbying, it has been pushed back by one year until January 2018. Regulators including the European Securities and Markets Authority (ESMA) recognised market participants would struggle to build the necessary infrastructure and technology to ensure MiFID II compliance. The rules have been mired with uncertainty but the European Commission (EC) published the first of its Delegated Acts on April 7, 2016, which provided further clarity on a number of outstanding issues.
The Delegated Acts look at a several areas including the rules on inducements, but also scopes out the provisions around product governance and client suitability. This will have a significant impact on European fund manufacturers and fund distributors going forward, and it is something they should start preparing for. MiFID II’s product governance provisions dictate that fund manufacturers ensure distribution is in line with the identified target market characteristics. This will require them to obtain information through their distribution chain. A failure to do so will have adverse regulatory consequences.
This is a marked change from the traditional distribution model. Historically, it was the role and responsibility of the fund distributor to check that products were being sold to the intended audience. MiFID II shifts this responsibility to the fund manufacturer as well as the distributor in what the EC hopes will result in enhanced protections and standards around product governance following a number of high-profile mis-selling scandals.
What needs to be done?
Fund manufacturers will now need to ensure that products are distributed in line with their intended target market. This will require fund manufacturers to identify and ensure they are targeting relevant distributors for their products and ensure they understand the product and have implemented sound approval processes, thereby mitigating the risk of mis-selling.
Identifying instances of good and bad distribution under MiFID II will require fund manufacturers and distributors to share sufficient information about products and distribution frequently and in good time. Regulators have the right to arbitrarily demand distributors and manufacturers provide evidence that this activity is being carried out correctly. With large and complex distribution chains and thousands of products, this is a huge operational undertaking for fund manufacturers and distributors.
This is not just applicable to EU-domiciled distributors but global distribution of EU-domiciled funds. For example, if a Luxembourg-based SICAV utilises a distributor which sells the product into core Asia-Pacific or Latin American markets, it is the shared responsibility of the fund manufacturer and distributor to look through the distribution chain and ensure distribution is in line with the intended target market. This will also require fund manufacturers to be mindful of varying distribution models across a diverse range of geographical locations. The requirements are highly granular and will oblige manufacturers to delve deep into their distribution chain not just to a nominee level such as the platform but at distribution level, which could be the adviser. Falling foul of the rules could result in harsh regulatory sanctions and the associated reputational damage.
The technology and infrastructure enhancements required will not be cheap and are likely to add complexity. Supplying the relevant data in a harmonised and succinct format to fund manufacturers will also be difficult for distributors, many of whom rely on manual processes and legacy technology. A number of European distributors are still seeing data sharing as a revenue generating exercise. As such, many distributors and manufacturers are looking towards a centralised market utility that can collect, collate, cleanse and report this data in a timely fashion. Having a market overlay to enable the orderly functioning of this process is critical for these requirements to work in practice.
How prepared are European fund manufacturers and distributors?
The rules governing product governance across the EU are not harmonised. As such, different member states are at varying levels of development. The Netherlands, for example, introduced detailhandel beoordeling (retail assessment) provisions in January 2014 which prohibited inducements between fund manufacturers and fund distributors following the discovery that some mortgage and insurance products had been mis-sold to end investors.
Meanwhile, the UK through its Retail Distribution Review (RDR) forced investment firms to verify that their products were in line with client suitability. Subsequent thematic reviews by the UK Financial Conduct Authority (FCA) have also referenced product governance as an area that needs improvement. As such, these two markets are probably ahead of the game in many respects as their laws already contain a number of points outlined within MiFID II.
Further Delegated Acts around MiFID II are expected over the course of 2016. Regulators need to clarify their individual interpretation while fund manufacturers and distributors need to determine how to adhere to this in this new market environment. One area of particular interest here will be how proportionality impacts the view on complexity and oversight requirements for individual products such as UCITS.
The one year delay to MiFID II’s implementation is a much welcome reprieve for financial institutions who feared they would be unable to meet the requirements in good time. However, the delay is not an excuse for complacency. The volume of work that needs to be carried out and tested is enormous and should not be downplayed. Firms should therefore be looking to implement MiFID II compliance as soon as possible and liaising with service providers about how they can ensure adherence with the provisions around product governance.
First appeared in InvestmentEurope, 19/04/16,