We are now a step closer to understanding how the EU landscape for capital markets and investment services is set to change following the publication last month of a bumper package of MiFID II / MiFIR implementing measures by the European Securities and Markets Authority (ESMA). On 19 December 2014, ESMA published final technical advice to the EU Commission and two consultation papers on regulatory technical standards (RTS) and implementing technical standards (ITS) (part 1 covers ESMA's commentary and part 2 sets out the draft technical standards).
Totalling over 1,600 pages, it is easy to get lost in the detail of these documents, which cover a range of topics including investor protection, transparency, transaction reporting, algorithmic and high-frequency trading, commodity derivatives, and non-discriminatory access to trading venues and central counterparties (CCPs). Below we pick out two issues from ESMA's technical advice that we think investment firms need to keep at the top of their agendas: product governance and the unbundling of dealing commission.
Product governance
MiFID II will introduce extensive product governance requirements on both manufacturers and distributors of investment products. Generally speaking, manufacturers will need to identify, and take reasonable steps to distribute to, a target market of end clients. They will need a product approval process and to review periodically the target market and performance of the investment products they offer. Distributors will need sufficient understanding of manufacturers' products and product approval process so as to identify and sell to their own identified target market.
The scope of the rules is wide. ESMA has clarified that the rules apply to shares and bonds, and where investment firms "create, develop, issue and/or design" investment products to be launched on the primary market. ESMA has also suggested that the Commission should align the relevant UCITS and AIFMD articles with the MiFID II product governance obligations for manufacturers, although it's not clear if the Commission will accept this recommendation and, if it does, on what timeline this work would be done.
Client segmentation is likely to prove challenging for firms. Despite requests from industry, ESMA will not be providing further guidance on the level of granularity required for the identification of target markets. However, for "simpler, more mainstream investments, such as ordinary shares, it is likely that the target market will be identified with less detail". In many cases, these products could be considered compatible with the "mass retail market". Manufacturers designing products that are distributed through other investment firms should identify the target market on a "theoretical basis". Distributors should use the manufacturers' target market assessment (unless it is unavailable i.e. in the event the manufacturer is not subject to MiFID) together with existing information on their clients to identify their own target market for a product. If the investment firm acts as both manufacturer and distributor there is no need to duplicate the target market assessment and distribution strategy exercise, although the firm should ensure it undertakes these activities in sufficient detail to meet both the manufacturer and distributor obligations.
As many of the product governance requirements are already finalised in the level 1 text, there is much that firms can be doing now. A key challenge will be managing the dual responsibility between manufacturers and distributors and ensuring that arrangements are in place to exchange the necessary information. This will be particularly important where the manufacturer or distributor is a non-MiFID or third country firm. While ESMA set out to make the rules proportionate, there is also still uncertainty around how the rules should be applied in the context of execution-only business.
Unbundling dealing commission
Despite significant concern expressed by the industry in consultation responses, ESMA has pressed ahead with its ban on bundling research costs together with dealing commission. According to ESMA's advice, portfolio managers will only be able to accept broker research where they pay for it directly (e.g. through their own resources or through an increase in portfolio management or advice fees) or from a ring-fenced research account that is funded by a specific charge to their clients, agreed upfront and subject to appropriate controls, oversight and disclosure. As an important addition to the text, firms providing execution services will need to charge for execution costs, research and any other good or service through separately identifiable charges. This is in keeping with the general MiFID II drive to enhance transparency of costs and charges. To address concerns of an unlevel playing field between different categories of asset managers, ESMA also suggests that the Commission assess the extension of the proposed regime to the UCITS and AIFMD regulatory frameworks. Again, it is unclear if and when the Commission will do this.
The aim of unbundling dealing commission is to address potential conflicts of interest and increase transparency for clients. It will mean a substantial shift for many in the industry and is likely to lead to increased scrutiny of the quality of research, as well as of other services that may previously have been bundled alongside dealing commission. Many in the industry argue that it could increase costs for asset managers and reduce the diversity of investment research, particularly disadvantaging smaller asset managers and research providers and reducing coverage of small and medium-sized enterprises. Some asset managers could choose to bring their research in-house. On the sell side, the proposed rule changes are likely to mean significant changes to processes and pricing. In addition to the regulatory angle, unbundling of charges is also likely to have VAT implications for both asset managers and research providers.
What's next?
The final technical advice has now passed to the Commission. The Commission will use these to draft and adopt Delegated Acts, which will enter into force within three months (which can be extended to six months) if no objection is raised by either the EU Parliament or Council. So while this paper is accompanied by the word 'final' it may actually be another nine months or so before these rules are actually finalised. And it might not be smooth sailing for ESMA's advice on unbundling of dealing commission, as some key MEPs have reportedly voiced concerns about these rules. Turning to the technical standards, ESMA will have to deliver the RTS by July 2015 and the ITS by January 2016. Again, there will be further hoops to jump through in the EU process before these enter into force, which looks likely to be around Q2 2016.
Firms should also look out for a Treasury consultation paper and an FCA discussion paper, expected this quarter, which will set out initial views on how the Directive will be implemented in the UK.
What should firms be doing now?
The process of responding to ESMA's consultation – either individually or via trade associations – should be well underway. Although this will be a mammoth task, it is vital that firms' input helps to shape the implementing measures. While there is still much to be finalised, firms should be in the process of conducting their high-level impact and gap analysis work. They should be looking to develop more detailed implementation plans if they are to meet the 3 January 2017 application date, particularly given the level of infrastructure changes required.
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