The Markets in Financial Instruments Directive II (Mifid II) is widely cited by fund managers as being one of the most impactful pieces of regulation following the financial crisis.
MiFID II covers numerous facets of fund management including restrictions around using equity commissions to pay for research from their brokers; disclosure obligations around pre and post-trade transparency; transaction reporting; increased reporting requirements for algorithmic traders; and the introduction of tough rules on product governance. These are just a few examples.
There has been speculation that UK-based financial institutions will not be bound by Mifid II obligations in light of Brexit. This is untrue. The UK continues to remain a member of the EU and will do so until negotiations have concluded and exit has been instigated.
Negotiations are supposed to take at least two years following the UK’s decision to invoke the Treaty of Lisbon. Assuming this were to occur in the next six months, Brexit would not be realised until the latter part of 2018 or early 2019 and that is conditional on the talks going smoothly. As such, Mifid II will already have been enacted and the UK government and its regulator – the Financial Conduct Authority (FCA) have stated compliance with incoming EU rules is mandatory. Mifid II compliance will not be an exception to this.
The Impact of Mifid II delays
Repeated delays to Mifid II have frustrated market participants, and these have undermined their planning processes. This uncertainty – coupled with a lack of clarity over various Mifid II specificities – have caused issues among fund distributors and manufacturers.
Mifid II was supposed to be enacted in January 2017. Industry pressure succeeded in pushing implementation back by one year until January 2018. Most market participants including fund managers acknowledged that acclimatising their systems and technologies to Mifid II obligations was going to be a protracted (and costly) process and the original time-frame was too ambitious. The delay, which was confirmed earlier this year by the European Commission (EC), has given firms more flexibility to build or update their systems and processes, but it has also had unintended consequences.
A survey commissioned by Calastone found that nearly a quarter of respondents were aware of Mifid II and its impact. The survey also found that more than half were also aware of Mifid II but were “either concentrating on other legislation or trying to assess it [Mifid II] in conjunction with other legislation.” The delay in publicising the final details around Mifid II has clearly led to some fund managers sitting on the side-lines as they await further clarification on the Directive’s minutiae details. Fourteen per-cent told the Calastone study they were waiting for final details on Mifid II.
As is to be expected, this regulatory uncertainty has prompted firms to delay implementing compliance strategies. Only 13 per-cent of respondents contacted by Calastone have implemented measures designed to enable compliance with Mifid II, while 28% are in the planning stages but have yet to enact their strategies. The sheer breadth and depth of Mifid II is such that even with the benefit of the delay, fund managers still have enormous amounts of work to do. Gap analysis must be undertaken and working plans involving personnel and service providers must be acted upon.
Fund managers are also facing or have faced a barrage of global regulation including the Alternative Investment Fund Managers Directive (AIFMD), the European Markets Infrastructure Regulation (EMIR), the Foreign Account Tax Compliance Act (FATCA), UCITS V, Solvency II and Dodd-Frank, just as way of example.
This has posed many challenges, but it is important that Mifid II become a focus area for these managers now. A failure to be compliant with Mifid II come January 2018 will not be received well by regulators, particularly as they initiated a delay for the exact purpose of giving the industry more time and scope to attain compliance.
The Risk of Regulatory Arbitrage
Fund manufacturers and distributors have repeatedly complained that regulatory arbitrage undermines their ability to attain compliance and complicates their internal processes. It can add costs and confusion, and Mifid II is no exception to this.
Regulatory arbitrage is a challenge that affects nearly every EU directive. AIFMD and UCITS V are just two examples of directives where EU member states have implemented their own nuances and requirements, adding complexity to the compliance process. Mifid II is likely to fall into this trap as well.
A failure to ensure harmonised standards around Mifid II will inevitably lead to inconsistencies across different jurisdictions. This means managers distributing across the EU will need to be mindful of the individual rules on product governance across each member state. This will likely mean firms will have to liaise with legal counsel or local area experts at considerable expense at a time when margins have faced pressures.
As such, 33 per-cent of respondents told Calastone that harmonisation of Mifid II obligations across the EU was important while 37% confirmed it was desirable. The product governance provisions could be particularly vulnerable to multiple interpretations across the EU. Product governance is a regulatory reaction to product mis-selling. It is designed to put the onus on the fund manufacturer as well as distributor to ensure the target market is suitable for the fund product in question.
The UK – through its 2012 Retail Distribution Review (RDR) – and Holland have already implemented their own rules ahead of Mifid II on product governance. Jurisdictions such as Germany, France and Italy have taken a tough approach towards implementing other EU directives and they could adopt a similarly robust stance on product governance with heightened requirements over and beyond the original Mifid II text.
This uncertainty and potential for arbitrage is leading to industry-wide confusion and hesitation around implementing a meaningful product governance strategy. The Calastone survey found more than three quarters of respondents are awaiting final clarification from regulators or industry-wide agreements before proceeding with a Mifid II strategy on product governance. A handful (15%) have adopted their own standards on product governance although this carries obvious risks if regulators pursue a different path to the one which the aforementioned financial institutions have adopted.
Whether or not industry and EU-wide consensus is achieved on Mifid II product governance provisions is an open question. Some experts in the industry are confident that the reformist agenda currently underway at the European Commission could spell good news. The Capital Markets Union’s (CMU) core objective is to facilitate more non-bank lending into the real economy, but it also seeks to harmonise and streamline regulations across the EU where impediments may be hurting financial institutions.
A consultation exercise has already been launched on distribution challenges faced by managers running AIFMs or UCITS. Should discrepancies or divergences become evident in Mifid II product governance provisions (or other requirements for that matter), regulators may consult with the industry on a possible streamlining of the rules. As Mifid II has yet to be implemented, any consultation will likely be several years away.
What should managers be thinking about?
Mifid II’s implementation is around the corner and despite the delays, fund managers and distributors must be thinking about compliance. A failure to act accordingly will lead to regulatory and investor scrutiny.
Mifid II uncertainties have been well-documented by numerous service providers and lawyers. Now is the time for managers to start implementing practical solutions to overcome or at least demonstrate best efforts compliance with Mifid II. Mifid II obliges fund manufacturers to monitor and understand how their distributors sell their funds.
The majority of respondents to the Calastone study appreciate that enhancements to their know-your-distributor (KYD) protocols need to be enacted, although a sizeable minority (24%) have yet to work out quite what the new rules mean. Nine per-cent alarmingly told Calastone’s survey they have not given it any consideration. So what should fund manufacturers be doing in regards to bolstering their KYD?
Nearly one third of respondents to the Calastone survey are going to establish distribution support teams to assist with KYD. It is likely these managers will have sizeable assets under management (AuM) and sufficient resources at their disposal to build such internal infrastructure. Others may not have the stomach or resources to weather such costs given the volley of regulations coming their way.
A fifth of market participants told Calastone that KYD could be externalised or outsourced to a trusted third party. Thirty per-cent said jointly that a transfer agent (TA) or software provider could be entrusted with such a role, followed by an administrator (23%) and custodian (10%). The deadline for Mifid II compliance is creeping up rapidly, so fund managers need to devote greater thought as to how they will manage their KYD, or look for a service provider who might be able to offer such a utility. Calastone, for example, has a service which allows for the hosting of platform due diligence questionnaires, which can be used as a means to enable KYD.
Ensuring products are sold to the correct target market now falls within the remit of the fund manufacturer as well as the distributor. This will mean manufacturers will need to clearly define who their target market is. For example, an active asset manager focused on niche emerging markets transacting in bespoke derivative products would have to set the bar quite high in terms of end investors’ financial literacy requirements and risk profile. The manufacturer would have to look-thru the distribution chain to ensure unsophisticated retail clients have not bought units in such a complex investment vehicle.
A common industry standard on suitability could be created although such consensus can be tricky. Irrespective, fund manufacturers will be required to source client information from their distributors to make sure high-octane products have not been inadvertently sold to ordinary retail investors or to individuals with a limited risk profile or understanding of investments. Manufacturers must now go beyond the nominee level but have an insight into how their fund is distributed at a sub-nominee level.
Furthermore, there are strong elements of extraterritoriality within Mifid II. If a fund is distributed from the EU into Asia-Pacific or Latin America, for example, the manufacturer will still need to ensure that the end target market is appropriate for their funds in those regions.
Many fund manufacturers remain uncertain as to how this data collection exercise will operate, although some are exploring whether it can be internalised or delegated to a third party. Calastone currently is the only service provider to offer such a look-thru solution for its clients through its Data Services offering. Our tool grants clients transparency through the distribution chain and gives them an overview of subscriptions and redemptions and AuM across asset class, country and distributor. This can be used for business intelligence purposes – i.e. identifying which products are selling well and to whom. Equally, the data can also be aggregated enabling manufacturers to benchmark their offering against competition.
Ensuring compliance could be achieved internally although 33 per-cent of respondents to the Calastone study expect this task to be undertaken by a combination of internal and external management. The study found that fin-tech providers will be likely candidates for any outsourced compliance role in terms of product governance.
Where next for distribution?
Mifid II is going to profoundly change the distribution model. Equally technology and investor demographics and buying patterns will have a huge impact as well. Distributors must embrace this so as to maintain their position in the market.
The distribution model is likely to evolve over the coming years, especially after Mifid II becomes ingrained in the operating model. Calastone’s study found that 77% of respondents expected competition among distributors to increase, and 68% predicted increased consolidation.
To remain relevant in this rapidly changing technological and regulatory environment, distributors must embrace disruption. This is especially true given the evolving demographics of end clients. Investors are getting younger and are highly in tune with technological innovations such as apps. Distributors must remain relevant and some may look to gain a competitive edge through developing robo-advisory solutions.
Robo-advice is when an investor can be advised on their portfolios through computer-driven services. As commissions have been prohibited across a number of markets including the UK through RDR, robo-advice could be attractive for clients who do not have the disposable income or willingness to pay for investment advice themselves. These commission bans have led to concerns of an advice gap emerging and robotics could play a useful role in fixing this problem.
There has been enormous hype about major technology players – who possess massive amounts of data on their clients – making a tactical move into distribution. These include the likes of Amazon, Facebook or Google, the latter of whom has actually undertaken research into whether establishing an asset management business would make economic sense. Interestingly, only 22% foresaw these players as a threat in the Calastone study.
A study of asset managers by State Street broadly agreed with the Calastone findings. The State Street study found 25% of senior asset management executives believed it was highly likely they will face competition from a non-financial institution such as a technology giant within the next five years. More than half told State Street they suspected such a development would be “somewhat likely” though.
The future for distributors is not entirely clear-cut, according to the Calastone study. A large number of respondents feel distributors will become more selective about the asset managers they work with, or will adopt a strategic shift into the discretionary investment market. Nonetheless, more respondents reckon it is likely distributors will be “squeezed out by fund platforms and wealth managers or else shunned by a new generation of investors.”
Conclusion
Mifid II compliance is something manufacturers need to be giving due consideration to. The rules are complex, and detailed and non-compliance will not be looked kindly upon. The spate of product mis-selling in the run up to the crisis means regulators are taking the issue seriously. As such, product governance must be at the forefront of manufacturers and distributors’ agendas.
Rob Swan (pictured), managing director of Data Services at Calastone
