Allen & Overy: Mifid II lacks clarity on obligations of providers and distributors
Following the European Securities and Markets Authority (Esma) publication of its final technical advice (TA) and consultation on its draft regulatory technical standards (RTS) to kickstart the implementation of the Markets in Financial Instruments Directive (Mifid II) and Regulation (Mifir), SRP spoke to Annabelle Whitby-Smith (pictured), senior professional support lawyer, and Andrew Sulston partner, at Allen & Overy about the most important issues for the structured products industry addressed by these regulations.
What are the areas the structured products industry should look into now that Mifid II is on its way?
Whitby-Smith: There are several areas where MiFID II will affect retail structured products, one of which relates to the new product governance requirements. The industry raised concerns in relation to the product governance provisions in its responses to Esma's May 2014 consultation.
Looking at the technical advice Esma issued in December on product governance requirements for manufacturers and distributors, there aren't that many substantive changes to the draft technical advice issued in May 2014. One change is the addition of introductory wording stating that product governance requirements apply in a way that is "appropriate and proportionate, taking into account the nature of the investment product, the investment service and the target market for the product", which is helpful although a lot of the detail hasn't changed and the concerns raised by the industry back in May still remain.
Has the distinction between manufacturers and distributors been addressed in the Mifid II RTS?
Whitby-Smith: A key concern in relation to product governance was that the requirements for manufacturers and distributors are not clearly delineated and targeted appropriately to take into account the diversity of origination processes. Mifid II does not define the terms "manufacturer" and "distributor". The Esma technical advice refers to product manufacturers as "those firms that create, develop, issue and/or design investment products", but it does not make clear how different parties performing different aspects of this role should apportion responsibilities. The UK FCA's handbook "The Responsibilities of Providers and Distributors for the Fair Treatment of Customers" (the RPPD), by contrast, uses the terms "provider" (defined as persons such as portfolio managers as well as those who develop, manage or package products) and "distributor", but recognises that whether a particular role or function is fulfilled by the distributor or provider (or both) may vary depending on the product or service, or particular arrangements in place, and it may be possible for a financial institution to act as both provider and distributor at the same time in respect of different products or services.
The RPPD recognises that the respective obligations of providers and distributors should flow from the actual roles or functions undertaken in each transaction (and not the label given to a firm), which should be taken into account when considering which responsibilities apply to it. In allocating responsibilities, it also distinguishes between "pure manufacturers" (who create a product to meet criteria or designs specified by another party eg. the distributor) and "retail manufacturers" (the commissioning distributor) and permits product providers and distributors to agree between themselves how to apportion the various responsibilities under the RPPD in certain circumstances. This is something that is missing in Esma's Technical Advice.
Is there anything new in the RTS the industry should be aware of?
Whitby-Smith: In the context of the preparation of the technical advice on possible delegated acts concerning Mifid II and Mifir, a data gathering exercise was also conducted. This was published on December 15, 2014. One of the questions asked of stakeholders as part of the data gathering exercise was to what extent they were compliant with the proposals made by Esma on product governance. Only 11% of respondents indicated that they were "fully compliant" (fewer than in other areas of the data gathering exercise - indicating that complying with the product governance requirements would necessitate substantial adjustments to current practices). However, the answers were not evenly split across countries: 78% of German respondents answered that they were not compliant, versus 6% of UK respondents. This discrepancy between countries is likely to be due to the fact that the UK regulator has been ahead of the regulatory curve for some time (with the RPPD and RDR for example), and some of the rules proposed at a European level are not unfamiliar in the UK market.
The industry has expressed concerns around the provision of performance scenarios pointing at the overlap between Priips and Mifid II. How can the industry address these?
Whitby-Smith: The technical advice modifies Article 31 of the Mifid Implementing Directive such that investment firms are required to inform clients about the functioning and performance of financial instruments in different market conditions (including both positive and negative conditions). Any requirement for mandatory illustrations of performance is of concern for the industry because ultimately any such illustrations must be based on numerous assumptions (the unreliability of historical data to reflect future performance is well publicised) and have the potential to be more misleading than helpful to the end investor. The industry wants to provide information that is meaningful and easy to follow for the end investor.
We hope that by including performance scenarios in the Priips Kid, the obligation under Mifid II to provide performance scenarios to clients can also be satisfied although it remains to be seen how far overlapping Priips and Mifid II obligations (eg. in relation to disclosure of costs and performance scenarios) will be aligned at Level 2. A further challenge is that for products that are not Priips performance scenarios and stress testing (which applies more to the governance side of things, than disclosure to investors) will also be needed and when you add all these elements the picture becomes very complicated.
What about the issues around early-exit or disinvestments? Can the industry really provide meaningful illustrations of an early exit outcome?
Whitby-Smith: In the context of information that must be provided to clients about financial instruments, the Esma Technical Advice requires the description of risks to specifically address the risk of financial instruments involving impediments or restrictions for disinvestment (eg. where there is a fixed investment term) and an illustration of the possible exit methods and their consequences. The industry continues to be concerned about providing illustrations of the possible outcome for investors if they decide to exit an investment early, however, because the consequences of any exit will depend on the market conditions at the time of exit, which are unknown when the product is issued and any illustration could therefore be misleading. The industry is committed to provide disclosure of the risks of early exit and the potential loss (ie. that sales in the secondary market may be at prices that are below the amount payable on the product at maturity, the original offering price, or the price at which investors acquired the product), but providing an illustration of that is a different question and it would be difficult to illustrate.
What other areas structured products providers should look into following Esma's December Technical Advice?
Whitby-Smith: From a structured products perspective, there are few substantive changes in the final technical advice as compared with the draft technical advice published in May 2014 and issues of concern highlighted by the industry back in May remain. These were around product governance, additional disclosure requirements (including performance scenarios), costs disclosure, ensuring consistency between overlapping requirements in Mifid II and Priips and Ucits (eg. in relation to disclosure of costs and performance scenarios and requirements to keep information provided to retail investors up-to-date). In relation to overlapping Mifid II and Priips requirements regarding costs disclosure, for example, there's a statement in the Mifid II technical advice that if you have a Ucits Kiid or Priips Kid and you provide sufficient information on costs and charges in the Kiid/Kid, it should be regarded as appropriate for the purposes of providing information to clients under Mifid II. The issue here is also that you don't need only to provide a Kiid/Kid, but you need to provide sufficient information on costs and changes in the Kiid/Kid. It will be interesting to see how the obligations for costs disclosure in Mifid II and Priips pan out and interact and what constitutes "sufficient information".
The product intervention powers granted in Mifid II to Esma, European Banking Authority and the competent authorities have also been objected to by the industry and the final technical advice relating to the range of factors and criteria relevant to assessing when these powers can be exercised is substantively very similar to the draft technical advice published in May 2014. The industry is concerned that the technical advice gives the European supervisory authorities and competent authorities a wide discretion to exercise intervention powers based on factors and criteria which in some cases would appear to have no clear correlation to the existence of a significant investor protection concern or threat to the orderly functioning and integrity of the markets.
Do you think these rules will trigger further market consolidation?
Sulston: We do expect further consolidation of the market. It certainly makes it more difficult and expensive to ensure you have in place the new Mifid II requirements - in particular the requirements for product governance which impose specific oversight, control and governance obligations for investment firms manufacturing financial instruments and for firms distributing those products. However, we have already seen some similar requirements in the UK under the RPPD and the RDR, for example, which shares some aspects of the Mifid II provisions around product governance (as well as independent advice and inducements). The UK market shows that we shouldn't underestimate the readiness of the industry and more specifically the major players to meet any regulatory requirements.
There are issues that need to be addressed and calibrated specially around manufacturers that are non-Mifid firms but use a Mifid distributor. This has been taken into account on the text of the Technical Advice. The bottom line is that regulation should not be underrated.
Is the technical advice final?
Whitby-Smith: Esma received a formal request from the European Commission (EC) in April 2014 to provide technical advice to assist the EC on the possible content of delegated acts required by several provisions of Mifid II and Mifir. The technical advice published by Esma In December 2014 is final and will be used by the EC to produce the delegated acts. [These are expected to be adopted by the Commission such that they enter into application by 30 months following the entry into force of Mifid II and Mifir, taking into account the right of the European Parliament and Council to object to a delegated act within 3 months (which can be extended by a further 3 months).]