ESMA Questions and Answers – On MIFID II and MIFIR Investor Protection Topics 17/19

4th October 2017

Introduction

On the 3rd October 2017 ESMA added 12 new Q&As to the Q&A document on the implementation of investor protections topics under MiFID II and MiFIR.

Best Execution

Question 16

How do the OTF best execution obligations apply when third-party brokers are clients of the OTF or when these brokers provide Direct Electronic Access (DEA) to the OTF (see Article 4(1)(41) of MiFID II)?

Answer 16 – OTF selected must allow compliance with best execution obligations

When an investment firm or a market operator operating an OTF receives orders or indications of interest from a broker acting on behalf of its own clients, the operator of the OTF should be implementing its own best execution policy when executing the order from the broker as it owes its user clients (the broker) the duty of best execution. The broker should determine that the OTF it selects allows it to comply with its best execution obligations towards its own clients. To that end, the broker should conduct a performance assessment of the OTF including how discretion is exercised.

In the specific case of DEA to an OTF, the DEA order is entered in the OTF client’s name (the broker) and the OTF operator should execute the DEA order as it would for any OTF client order. Alternatively, the operator of the OTF may decide not to permit DEA to its system.

ESMA notes that a DEA order could be considered as a client specific instruction to the broker providing the DEA arrangements to its clients.

Question 17

Should an investment firm using direct electronic access (DEA) services provided by an intermediary firm (such as a broker) list the execution venue selected via the DEA arrangement (under the RTS 28 reporting obligation), or the broker providing the DEA service (under the report to be published under Article 65(6) of the Delegated Regulation)?

Answer 17 – Obligation on investment firms to list the intermediary firm providing the DEA service

Article 4(1)(41) of MiFID II defines DEA as arrangements where a member or participant or client of a trading venue permits a person to use its trading code. ESMA considers that the provider of DEA is the firm executing orders. As such, an investment firm using DEA services to specifically direct an order to a particular venue would be expected to list the intermediary firm providing that service for the purposes of the report to be published under Article 65(6) of the Delegated Regulation (which is consistent with the RTS 28 report). In these instances, the investment firm would be considered as giving a specific instruction to the intermediary providing DEA regarding the choice of the execution venue. Correspondingly, the intermediary providing DEA service would still have an obligation to include trades executed via such access arrangements in its RTS 28 reports, although these trades could be classified as “directed orders” given the venue on which orders are executed is specified by the client (as set out in Article 2(c) of RTS 28). This differs from a situation where the intermediating broker retains discretion over some parameters of the execution of the order, particularly, the venue destination, including where a broker’s smart order router determines where an order is executed.

While transactions are intermediated by the broker providing the DEA service, ESMA also recognises that the objective of the report to be published under Article 65(6) of the Delegated Regulation is to help clients understand the execution practices of investment firms transmitting or placing orders via DEA services and directing the choice of execution venues (as outlined above), and this objective is best served by the provision of information about the execution venues orders are routed to (where the investment firm is exercising discretion over the choice of execution venue). In order to ensure that the report provides a complete picture of the investment firm’s order routing arrangements, ESMA considers that the investment firms should also disclose the identity of the main venues it commonly selects via DEA arrangements and the existence of any close links and specific arrangements with such execution venues, in its summary of execution quality (which, as required by Article 65(6), must be consistent with the information to be provided in accordance with Article 3(3) of RTS 28).

Recording of telephone conversations and electronic communications

Question 13

What is the applicable scope of the record keeping requirements set out in Article 16(7) of MiFID II in terms of products and services?

Answer 13 – Conversations intended to result in the provision of the services listed in Annex I, Section A of MiFID II must also be recorded

The requirements set out in Article 16(7) of MiFID II and the related Article 76 of the MiFID II Delegated Regulation apply “at least” to the provision of services (1), (2) and (3) included in Annex I, Section A of MiFID II.

Article 16(7) only requires the recording of communications in relation to the client order services mentioned above. However, the second subparagraph of Article 16(7) also requires those conversations and communications that are “intended to result in” the provision of these services to be recorded. In practice, other investment services like investment advice (paragraph (5) of Annex I, Section A) may be provided at the point when there is an intention to provide a client order services. In this case, the content of the advisory service would need to be recorded, as it would de facto be in scope of Article 16(7) of MiFID II.

ESMA notes that Members States may also decide to extend the requirements further to other MiFID services, or non-MiFID services and products.

Post-sale reporting

Question 8

Article 62(2) of the MiFID II Delegated Regulation states “…Reporting under this paragraph should be on an instrument-by-instrument basis, unless otherwise agreed with the client…What kind of flexibility could be allowed by such an agreement with clients?

Answer 8 – Clients must give their consent to assess the 10% depreciation on an aggregated basis

Under Article 62(2) the MiFID II Delegated Regulation, investment firms should have the possibility to agree with their clients on the possibility to assess the 10 % depreciation on a aggregated basis, for example:

  • on the overall value of the portfolio, as required under Article 62(1) the MiFID II Delegated Regulation;
  • on the global value of all leveraged financial instruments or contingent liability transactions in the client’s portfolio.

In any case, the client should give his/her express consent to assess the 10% depreciation on an aggregated basis and the client should have the capacity to terminate it at any time.

Question 9

When reporting to clients information required under Articles 62(1) and 62(2) of the MiFID II Delegated Regulation, can firms agree with clients to assess the depreciation of the overall value of the client’s portfolio, or of leveraged financial instruments or contingent liability 62 transactions included in a client’s account, on a threshold higher than the “10% and thereafter at multiples of 10%”?

Answer 9 – Non permissible for firms to assess the depreciation on a threshold higher

No. The requirements set out in Article 62 of the MiFID II Delegated Regulation do not allow firms to agree with clients to assess the depreciation on a threshold higher (e.g. 15%) than that set out in Article 62 of the MiFID II Delegated Regulation.

Information on costs and charges

Question 15

Which methodology should an investment firm use when calculating the ‘costs related to transactions initiated in the course of the provision of an investment service’ for its ex-ante cost disclosure?

Answer 15 – Actual incurred costs shall be used as a proxy when calculating expected costs and charges on an ex ante basis

Based on article 50(8) of the MiFID II Delegated Regulation, investment firms shall use actually incurred costs as a proxy when calculating expected costs and charges on an ex-ante basis. Firms should ensure themselves that the incurred costs are a representative proxy for future costs, taking into account any changes that are expected to have a material impact on the transaction related costs and charges, for instance changes in broker tariff structures or significant changes in market liquidity that will affect transaction costs on an ongoing basis.

Where data on actually incurred transaction costs are not available, the investment firm shall make reasonable estimations of these costs, provided that it identifies all expected transaction costs associated with the transaction, and that it clearly discloses to clients the basis on which transaction costs have been estimated. Firms may for instance use the method provided for in paragraphs 21 to 23 of the Annex VI of the PRIIPs RTS.

In accordance with Article 50(8) of the MiFID II Delegated Regulation, investment firms are also required to review ex-ante assumptions based on ex-post experience and make adjustment to these assumptions where necessary.

Question 16

How is Recital 79 of the MiFID II Delegated Regulation “The costs and charges disclosure is underpinned by the principle that every difference between the price of a position for the firm and the respective price for the client should be disclosed, including mark-ups and markdowns.” to be interpreted with regard to the position for the firm?

Answer 16 – The price of a position of the firm is the value of the financial instruments held when firms offer instruments to the client ex-ante or ex-post

When an investment firm holds a financial instrument on its own account before offering it to a client, the price of the financial instrument may change due to market value fluctuations. Based on Article 24(4) MiFID II, any costs and charges that are caused by the occurrence of underlying market risk shall not be included in the aggregated information about costs and charges. Hence, the price of a position of the firm as referred to in Recital 79 of the MiFID II Delegated Regulation should be understood as the current (fair market) value of the financial instrument held by the firm when the firm offers the instrument to the client (ex-ante) or when it sells it to the client (ex-post).

Question 17

How should investment firms identify and disclose mark-ups and structuring costs embedded in the transaction price (Recital 79 of the MiFID II Delegated Regulation)?

Answer 17 – The difference between the price of the position for the firm and the price for the client must be calculated

According to Recital 79 of the MiFID II Delegated Regulation, practices where there is ‘netting’ of costs should not be excluded from the obligation to provide information on costs and charges. As a result, mark-ups and structuring costs that are embedded in the transaction price need to be identified and disclosed to clients by the investment firm. Based on Recital 79, investment firms should identify such costs by calculating the difference between the price of the position for the firm and the price for the client. In case of PRIIPs, ESMA would expect the investment firm to apply the calculation methodology in paragraphs 36 to 46 of Annex VI of the PRIIPS RTS.

Question 18

How should an investment firm assess, in accordance with Article 50(1) paragraph 3 of the MiFID II Delegated Regulation, that an eligible counterparty does not intend to offer the financial instruments to its clients?

Answer 18 –  Procedures to record eligible counterparties’ agreements and intentions must be put in place

Without prejudice to the obligations set out in Article 24(4) MiFID II and the requirement to provide information on all costs and charges to all clients and potential clients, investment firms providing investment services to eligible counterparties shall have the right – in accordance with Article 50 of the MiFID II Delegated Regulation – to agree to a limited application of the detailed requirements set out in Article 50, except when, irrespective of the investment service provided, the financial instruments concerned embed a derivative and the eligible counterparty intends to offer them to its clients.

Investment firms are expected to apply the full cost and charges disclosure regime as the default option, and only to apply the limited flexibility allowed under Article 50(1) as further explained under recital 74 when there is an agreement to do so and the eligible counterparty has indicated that it does not intend to offer the financial instrument to its clients. ESMA expects investment firms to have procedures in place aiming at recording eligible counterparties’ agreement and intention not to offer such financial instruments to their clients.

Question 19

Which specific limitations to the cost transparency regime may professional clients and eligible counterparties agree on?

Answer 19 – Limitation on the cumulative effect of costs on return, indication of the currency involved, and the provision of the applicable conversion rates and costs

Article 50(1) of the MiFID II Delegated Regulation allows – in certain situations described in paragraphs 2 and 3 thereof – for a limited application of some of the detailed requirements set out in Article 50. The more limited application which needs to be agreed by the two parties should however never lead to disapplying the obligations imposed on investment firms pursuant to Article 24(4) MiFID II.

ESMA emphasizes that Article 24(4) MiFID II requires that the information provided to clients, amongst others, includes information on all costs and charges, including information relating to both investment and ancillary services, the financial instrument recommended or marketed to the client and any third-party payments. In addition, the information shall be aggregated and where the client so requests, an itemised breakdown shall be provided. The information about costs and charges shall be provided to the client in good time before the investment service is provided and, where applicable, on a regular basis, at least annually.

Recital 74 provides examples of detailed requirements which could be the object of such limited applications under Article 50 of the Delegated Regulation. For instance, the investment firm could agree, at the request of the client, to not provide the illustration showing the cumulative effect of costs on return, not provide an indication of the currency involved and not provide the applicable conversion rates and costs where any part of the total costs and charges is expressed in foreign currency.

Question 20

How should the cost disclosure be made regarding the respective figures that are to be disclosed in aggregated and itemized form (see Question 13) in case the respective costs or charges are zero?

Answer 20 – “zero” should be explicitly shown

The firm should explicitly show a “zero” for the individual figure that is to be disclosed. As one of the purposes of the cost disclosure regime is comparability of products and services, it is important that clients receive explicit figures for every item to be disclosed, even if it is zero. The firm should therefore not leave out a cost component which value is zero as this might lead to misinterpretations.

Question 21

At what date should investment firms send their first annual ex-post information to their clients?

Answer 21 – Information to be provided no later than one year after the date on which the ongoing relationship has started

When investment firms are required to provide their clients annual ex-post information about costs and charges based on article 50(9) of the MiFID II Delegated Regulation, ESMA expects firms to provide such information on the basis of a time period that ends at the latest one year (12 months) after the date on which the ongoing relationship has started and that this information should be provided to clients as soon as possible after the above annual anniversary of the relevant service commencing. Where an existing ongoing relationship between a firm and a client ends during 2018, ESMA expects firms to provide information at that period end. Where part of the reporting period would fall under MiFID I and part under MiFID II regime, investment firms may choose to calculate, on a best effort basis, the costs and charges in line with MiFID II requirements for the entire reporting period or provide this first ex-post report with a breakdown of costs for the two periods and a clear explanation of the basis on which costs have been calculated.

Client categorisation

Question 1

Are investment firms required to inform of their MiFID categorisation all their clients, including those already categorised under MIFID I, or should they just provide such information to new clients or to clients which categorisation has changed under MIFID II?

Answer 1 – Firms must only notify new clients and existing clients who categorisation has changed under MiFID II

ESMA’s view is that under Article 45(1) of the MiFID II Delegated Regulation, firms only have to notify information on their categorisation to:

  • new clients; and
  • clients whose categorisation has changed under MiFID II. Such is the case for instance for certain local public authorities or municipalities which could have been categorised as professional clients under MiFID I and will now be considered as retail clients according to paragraph 1 of section II.1 of Annex II of MiFID II.

NEXT STEPS

The content of the Q&A is aimed at clarifying a number of queries regarding the forthcoming implementation of MiFID II and MiFIR and the implications for investor protection. It must be remembered that the Q&A does not constitute any new policy, however ESMA will periodically review the Q&As to update them where required and to identify if, in a certain area, there is a need to convert some of the material into ESMA Guidelines and recommendations.

If you have any queries please don’t hesitate to contact one of the CPA team.

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