Introduction
The implications of the Markets in Financial Instruments Directive II (MiFID II) should not be underestimated. Its breadth and depth will impact nearly every facet of financial services. At the heart of MiFID II lies investor protection and transparency. Fund distributors and fund providers will not be excused from this incoming regulation, and should start to take note and prepare for the imminent changes MiFID II will bring.
The modus operandi of fund distribution is going to face a radical upheaval when MiFID II comes to fruition on January 3, 2017. Given the sheer scope and ambition of MiFID II, attaining compliance within this tight time-frame will be challenging for the funds industry. A number of market experts predict MiFID II will face implementation delays but this is by no means guaranteed. As such, fund distributors and fund providers need to work quickly to ensure their businesses do not contravene any of the stated objectives of MiFID II when the regulation comes into play.
How does MiFID II impact fund distributors?
MiFID II seeks to shift the emphasis onto fund providers and their distributors to ensure they are not selling investment products, which are beyond the understanding or risk parameters of their retail investors. While the UK’s Retail Distribution Review (RDR) required investment firms to assess whether the products they were selling to their end clients were compatible with their suitability, MiFID II introduces suitability criteria on a pan-EU basis. As such, MiFID II lays out a plethora of requirements around transparency, post-trade data reporting, inducements, product governance and investor protection.
One of the most significant areas of change surrounds mitigating the risk of mis-selling investment products to unsophisticated investors. This is not an unreasonable objective, and market participants should support the principles behind this proposed investor protection mechanism. The ways by which regulators expect market participants to prevent mis-selling do, however, present operational challenges. Historically, fund distributors were primarily responsible for verifying that investors met the suitability and eligibility standards of the products they were buying. MiFID II will require both fund provider and distributor to undertake this verification process going forward.
Properly assessing the suitability criteria of end investors will require fund providers and fund distributors to obtain information as to whether the client has sufficient knowledge and understanding of the product offering, the ability of the investor to weather losses as a result of their exposure to the investment product, and risk tolerance. These assessments must be undertaken on an-ongoing basis. In other words, fund providers must now accept equal responsibility to those distributing their products when analysing whether end clients are suitable. Investors must also be routinely kept up-to-date on any changes to the product lest it affects their suitability.
The extraterritorial impact of client suitability should not be underestimated either, particularly given the diverse investor base of many European structured and domiciled fund vehicles. The Luxembourg SICAV and Irish UCITS, for example, are frequently used to solicit and raise capital from Asia-Pacific investors. As such, fund distributors will be required to obtain information on these allocators’ suitability, and provide it back to fund providers. This presents a new and potentially significant operational challenge.
The penalties for non-compliance are unknown, but past experience of other regulations has shown sanctions are non-trivial from both a financial and reputational perspective. Product providers must now ensure their distributors are selling to the correct investors. This will introduce a reporting and data burden on distributors, who will be expected to give the pre-requisite information to providers on their end clients. Regulators have said this information must be supplied by distributors to providers at cost.
The operational and technological investment in building these data gathering and reporting systems at distributors will be substantial, and will require major upgrades from existing manual systems so as to ensure this data can be aggregated and formulated in a straightforward manner. This could be expensive potentially given MiFID II’s ban on inducements for client-facing distribution platforms, which in itself will bring about a host of cost challenges. It is believed that few fund distributors have yet to assess the full implications of this reporting exercise.
Going forward – Opportunities?
Simplifying the communication and information gathering channels between distributors and providers is central to attaining compliance with MiFID II, and the sheer scale of this task should not be underestimated. It is a project that will take many months to complete and consume huge amounts of internal resources. Undertaking this work in a timely fashion means fund providers and distributors need to start thinking about an action plan for compliance now.
While this work can be done internally, the administrative and operational challenges of reporting and monitoring this disparate client data will be a huge challenge for fund providers and fund distributors. A more cost-effective mechanism could be to outsource data aggregation and reporting to a global provider which has the technological infrastructure to undertake this work seamlessly.
Harnessing this client information could reap significant commercial opportunities. The information will be bottom-up and will give fund providers substantial amounts of data on their client base. This globalised insight can provide valuable analytics around performance including fund flow, investor intelligence and suitability as well as more wholesale distribution market insight.
It is crucial that fund distributors and providers adopt a forward-thinking approach towards ensuring they have the correct processes in place to attain MiFID II compliance. Most importantly, it is those organisations which make these changes soonest that will stand to gain significant competitive advantage.
