New legislation on the European financial markets, MiFID II, is expected to come into force on January 3rd 2018 and will impact Fintech’s future. Through regulating trading activities and enhancing investors protection, it will aid the creation of more transparent and robust financial markets. It will also extend the regulatory coverage to non-equity products, including cash and derivative instruments in fixed income, foreign exchange and commodities.
The amended directive will also apply to more industry stakeholders engaged in investment services, such as investment banks, portfolio managers, brokers and market makers.
Impact of New Rules
The new rules will impact existing financial markets’ practices as well as the rapidly evolving field of financial technology. Currently, the general classification of FinTech includes a plethora of aspects. These include automated advice, high-frequency trading, blockchain and cryptocurrencies, digital payments, peer-to-peer lending, crowdfunding, artificial intelligence and big data analytics.
Some of these activities already follow a harmonised regulatory framework, such as the Payment Services Directive (PSD2) for digital corporate payments. Furthermore, some of the services such as blockchain, cryptocurrency, P2P and crowdfunding follow national laws, while some activities such as AI and big data analytics are unregulated.
Among the variety of services, robo advisory and high-frequency algorithmic trading will be directly influenced by the new directive and thus will be regulated at the EU level. Hence, the investment firms engaging in these activities will adopt new rules and follow new guidelines for their innovative technologies in order to deliver their services, while ensuring investor protection.
The increasing use of robo advisory services has created a need for enhanced suitability guidelines to ensure that firms provide suitable personal recommendations to their clients or make suitable investment decisions on behalf of their clients. In addition, the European Securities and Markets Authority (ESMA) believes that automated robo advisors might endanger investors protection and has identified three main areas where specific needs for protection may arise:
- The quality of and manner of providing the information (electronic disclosure or human interaction) to clients of the automated investment advisor or portfolio manager
- The assessment of suitability with specific attention to the use of online questionnaire with limited, or without, human interaction
- The organisational arrangements that firms should implement when providing robo advice.
MiFID II has reinforced the existing MiFID I requirements on the assessment of suitability. The updated suitability rules have recently been incorporated in the more detailed consultation paper named ‘guidelines on certain aspects of the MiFID II suitability requirement‘ before a final report is released by the second quarter of 2018.
The consultation paper, which aims to enhance clarity and foster convergence in the implementation of certain aspects of the new suitability requirements, is intended for firms and institutions engaging in fields such as investment advice and portfolio management services. The paper replaces the existing 2012 guidelines on suitability requirements, taking into consideration the results of supervisory activities conducted by National Competent Authorities (NCAs) on the application of suitability requirements, the development in the financial technology markets and recent studies on behavioural finance.
Automated Robo Advisory
According to the updated suitability requirement under MiFID II, firms engaging in robo advisory services will have to consider additional regulatory requirements. ESMA has proposed 12 general guidelines which relate to:
- Information for the clients on the purpose of suitability assessment
- Knowledge of the client and product
- Matching clients with suitable products
- Other requirements for staff and record keeping.
ESMA has included robo advice examples to its draft guidelines which are intended to help companies better understand the regulatory environment.
High-frequency Algorithmic Trading
Algorithmic trading is already an established activity in numerous financial institutions, investment firms and trading venues, with little or no human interaction. These can cause risks, excessive volatility and market distortions unless they are regulated. According to MiFID II, investment firms that engage in algorithmic trading should have effective systems and risk controls suitable to the business in order to ensure that the trading systems are resilient. The investment firms should also have effective business continuity arrangements to deal with the failure of their trading systems.
In order to enhance the resilience of markets in an environment with rapid technological developments, the regulatory measures should build on the technical paper issued by ESMA in 2012, which details guidelines on systems and controls in an automated trading environment. Moreover, it is preferable that all high-frequency algorithmic trading firms are authorised, which would ensure that such firms are subject to the MiFID II organisational requirements and are properly supervised.
Investment firms and trading venues should have robust measures to prevent algorithmic or high-frequency algorithmic trading techniques from creating disorderly markets or engaging in abusive activities. Moreover, the structures of algorithmic trading venues should also be fair, transparent, non-discriminatory and should not lead to disorderly market conditions.
The use of advanced financial technologies such as algorithmic trading, automated investment advisory and portfolio management brings a variety of services to clients, with different levels of human engagement, need for interaction and assistance. The complexity that arises from the unique nature of the technologies will create a requirement for thorough understanding of the new MiFID II rules and universal adherence to the guidelines published by ESMA, which will secure investor protection and market efficiency.