The MiFID II (Markets in Financial Instruments Directive) is the EU legislation that governs firms (like banks, investment companies, interdealer brokers, stockbrokers, etc.) which provide services to clients connected to financial instruments and the places where those devices are dealt with.
The new legislation ought to have come out in early 2017, but it has been delayed to January 3rd, 2018. Briefly, the major changes involve;
- an increase of transparency in markets;
- more structured markets;
- orderly trading behaviour within markets;
- clearer and plainer costs of trading and investing
This new legislation will have possibly the greatest impact on the financial advisory sector: in fact, the directive in question presents new content with regard to the requirements to be able to provide financial advisory (namely, to have the permission of the local authority which simply proposes what the European authorities have legislated), how financial advisors are paid (especially regarding the theme of the inducements will be clarified later in the article), the information to be provided to clients and to the assessments of adequacy (this part is linked with the new legislation on product governance which, briefly, states that the financial advisor must evaluate the customer for whom the product is intended, the client’s objectives and the client’s needs).
Financial Advice in MiFID II
In the new legislative framework, the provision of investment advice can be given in different ways: which is why the intermediary is obliged to inform the customer of the nature and type of the advice and, in particular, is called upon to explain in a clear and concise way, if and how the advice is seen as independent, as well as the restrictions that apply to it.
In addition to new product governance and product intervention, the most important and significant news related to the world of financial advice is about the so-called inducements. This term refers to any funds, goods or services (other than normal commissions or fees for service) offered or received by an investment firm or one of its members in connection with activities for a client, with or through another person, both on a prepaid basis, continued or retrospective.
Going step by step, it is useful to recall that the compensation mechanism in the field of asset management is normally based on the customer’s payment of the subscription fees and the maintenance of the investment in a financial product that is picked up by the operator and subsequently distributed: this system is called rebates.
Doing Away with Inducements
This type of compensation had already been regulated by the first MiFID directive because it could make financial advisors choose financial products that could carry more profitable returns for them or products managed by their group, with an obvious conflict of interest.
For this reason, in 2007, the MiFID I has aggregated the inducements to the framework of the general principles enshrined in art. 19, which obliged intermediaries to operate “honestly, fairly and professionally in accordance with the best interests of our customers.”
Revisiting the topic of inducements in more detail, it’s clear that MiFID II makes it impossible to receive these incentives, with the aim of increasing customer protection by limiting conflicts of interest as much as possible.
Bringing Inducements Back In
Only in cases explicitly highlighted by the legislation itself is it possible to obtain inducement benefits. These are namely when the benefits that derive from obtaining inducements have the aim of increasing the quality of service provided to the client and do not jeopardise compliance with the duty to act honestly, fairly in the best interests of the client.
Not only that, the Technical Advice issued by ESMA clarifies that the consultant (either independent or not) has an obligation to return to the customer, as soon as practicable, any monetary benefit obtained by a third party in connection with the service in question.
If financial incentives are granted (if the quality of service provided increases) for the non-independent consultant, the absolute prohibition on perceptions of inducements remains if the advisory service is provided on an independent basis (except for minor non-monetary incentives if they fall on the list communicated by ESMA).
Another significant innovation is that of so-called ‘best execution’ that is “the obligation to execute orders on terms most favourable to the client.” MiFID II introduces a greater degree of transparency concerning this aspect by requiring the publication, at least annually, of the data relating to the quality of the implementation of the operations at each site of order execution: this is to ensure the impartiality and objectivity of evaluations between one trading venue and another.
Public Transparency and Accountability
In fact, the provision of reception and transmission of orders will require the annual publication of the first five intermediaries that were sent orders and assessing the quality of execution. Brokers also cannot perceive compensation discounts or non-monetary benefits to execute their orders through a venue of execution or specific negotiation, otherwise violating conflict of interest laws or inducements, as mentioned before.
Changes in fees charged by the investment firm, depending on the venue of execution used, must be communicated to clients to enable them to understand both the advantages and the disadvantages of choosing a venue of execution than another. It is also a required that the intermediary refrains from inducing the customer to instruct the execution of an order if it is likely to give the customer subpar results.
Also, any structural changes must be notified to customers. MiFID II will make it possible to identify a single seat of order execution in case the intermediary, backed by sufficiently convincing data, is able to show that that forum is the best to comply with the obligations relating to best execution.
Finally, it is stated that the best execution policy shall be provided to customers by obtaining their prior consent. This consent must also contain the list of factors used to select the venue of execution, and it will have to explain how the seats were selected, how the quality of execution is evaluated and how the actual best execution is monitored and verified.
It’s evident that there is a willingness to regulate an industry left for too long to its own devices. Will it pay off? Only time will tell.
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