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Markets in Financial Instruments Directive II Implementation – Consultation Paper III 16/16

27th October 2016

Overview

The FCA recently published a third consultation paper regarding the UK implementation of the Markets in Financial Instruments Directive (MiFID) II. MiFID was applied to the UK from November 2007, but is now being revised to improve the functioning of financial markets in light of the financial crisis and to strengthen investor protection.

The third consultation paper seeks to expand on the proposals from the previous two consultation papers and outline how the UK will implement the directive. The FCA reiterates that firms should continue to follow the obligations derived from EU law and continue preparation for the implementation of MiFID II in early 2018. Despite the recent vote to leave the EU, the UK is still a full member of the European Union and all the rights and obligations of EU membership remain in force. Until the conclusion of exit negotiations, the UK government will continue to negotiate, implement, and apply EU legislation.

One of the key aims of MiFID II is strengthening investor protection. This is in line with the FCA’s operational objective of ensuring an appropriate degree of protection for consumers. The regulator considers that the new framework of conduct rules in MiFID II will reinforce and strengthen the retail and wholesale conduct work it has been doing. Its implementation should help to ensure that markets work well for consumers, which directly supports the FCA’s statutory objective.

The consultation paper comprises two parts, with Part I expanding on conduct of business changes, whilst Part II covers areas which were not outlined in previous consultation papers. This regulatory bulletin will outline all the key changes proposed within both parts of the paper, and provide guidance on the appropriate next steps to take.

Who does the consultation affect?

The proposals detailed within the consultation paper will be particularly relevant to:

• Banks
• Investment firms
• Interdealer brokers
• Stockbrokers
• Investment advisers
• Corporate finance firms and venture capital firms
• Investment managers, including individual and collective portfolio managers
• Financial advisers
• Local authorities

Part I – Conduct of Business

Chapter 2. Inducements, including adviser charging

Relevant to:

• Firms conducting MiFID or equivalent third country business, and firms conducting non-MiFID business (including Article 3 firms).

Introduction

MiFID II enhances the existing inducements standards. For both independent advisers and portfolio managers (discretionary investment managers), it bans the receipt and retention of all monetary and non-monetary benefits from third parties, other than ‘minor non-monetary benefits’, when dealing with retail and professional clients. ‘Minor non-monetary benefits’ are described as:

‘reasonable and proportionate and of such a scale that they are unlikely to influence the investment firm’s behaviour in any way that is detrimental to the interests of the relevant client’ (this will also be reflected in the adviser charging rules’

MiFID II also sets out new implementing provisions. These focus on:

• acceptable minor non-monetary benefits relating to independent advice and portfolio management,
• what benefits can be considered under the MiFID II inducement rule for other investment services to be designed to enhance the quality of the service to clients, and
• record-keeping and disclosure requirements for inducements.

Proposals

• Separating the core inducement rules for MiFID, equivalent third country and Article 3 firm business (into a new COBS 2.3A) from other non-MiFID designated investment business (in COBS 2.3).
• For firms providing independent investment advice and portfolio management services to professional clients, transposing (but not extending) MiFID II’s inducements ban
• For firms providing investment advice and portfolio management services to retail clients, MiFID II’s inducement ban will be extended in three ways:
o firstly, it will extend to restricted advice as well as independent advice
o secondly, to prohibit the acceptance of commission and benefits rather than their acceptance and retention
o thirdly, to amend the adviser charging rules by applying the ban to the business of providing advice rather than only to inducements provided in relation to the provision of a particular personal recommendation to a client
• Subjecting Article 3 firms to same inducement requirements as MiFID firms.

Implications for firms

Independent investment advice
These proposals will see MiFID II rules (extended to ban rebating) applied to firms that offer either independent or restricted advice to retail clients. The FCA propose amending the adviser charging rules to apply the MiFID II provisions relating to minor non-monetary benefits to business within the scope of these rules. The regulator also plans to clarify that the commission ban in COBS 6.1A/6.1B should be understood as applying to the firm’s wider business of providing advice, so that an activity does not need to relate directly to the provision of a personal recommendation for these provisions to apply.

Furthermore, MiFID II rules apply equally to retail and professional clients.

Portfolio management

Firms that manage portfolios can still accept fees, commission or monetary benefits in relation to services provided to professional clients, provided they are rebated to the client. This does not apply to retail clients. In regards to non-monetary benefits, these can only be accepted if they are minor or constitute research that follows Article 13 of MiFID II.

General inducement rule

The existing requirements remain largely unchanged. Greater detail is provided relating to the benefits that are considered to enhance the quality of service provided to clients. The new COBS 2.3A will reiterate the FCA’s position that Payment For Order Flow creates a clear conflict of interest between the clients of the firm and the firm itself, such that these arrangements are unlikely to be compatible with the inducements rule, and also risks compromising compliance with best execution rules.

Chapter 3. Inducements and research

Relevant to:

• Firms conducting MiFID or equivalent third country business which receive research, in particular portfolio managers and independent investment advisers, and collective portfolio managers currently subject to FCA dealing commission rules.
• Providers of research, including investment banks, brokers and independent research providers.

Introduction

Article 13 of the MiFID II delegated directive states that research received from third parties shall not be regarded as an inducement for an investment firm if it is received in return for either of the following:

a) direct payments by the investment firm out of its own resources, or
b) payments from a separate research payment account controlled by the investment firm, provided a number of conditions relating to the operation of the account are met.

In order to comply with option (b.) and operate an acceptable Research Payment Account (RPA) model, a firm must ensure that:

• the RPA can only be funded by a specific research charge to the client,
• they set and regularly assesses a research budget,
• they are held responsible for the account, and
• they regularly assess the quality of research purchased based on robust quality criteria and its ability to contribute to better investment decisions.

Article 13(9) applies a new requirement to investment firms who provide both execution services and research goods and services to other investment firms (eg investment banks and other brokers). It includes an obligation that investment firms providing execution services must identify separate charges that only reflect the cost of executing the transaction, while the provision of each other benefit or service must be subject to a separately identifiable charge. The supply of, and charges for, those benefits or services shall not be influenced by or be conditioned by levels of payment for execution services.

Proposals

• The FCA will transpose the new requirement in Article 13(9) into a new section COBS 2.3C. This would apply to investment firms which offer execution of orders and other goods and services to other investment firms.
• Creating a new rule in COBS 18.5, and also in proposed new sections COBS 18.5A and 18.5B . This will restrict small authorised UK AIFMs and residual CIS operators, full-scope UK AIFMs and incoming EEA AIFM branches, and UCITS management companies respectively from receiving inducements related to executing transactions on behalf of the fund(s) they manage unless they comply with the new COBS 2.3A or COBS 2.3B.

Implications for firms

MiFID portfolio managers, independent advisors and collective portfolio managers will need to change their policies, systems and controls if they currently receive research from third parties relating to these services to clients, and they wish to continue to receive it. In order to charge clients for research and use a research payment account (RPA), they will need to meet the requirements in Article 13 of the MiFID II delegated directive. If they choose to pay for research directly, they will need to be able to evidence this and show that it is not reflected in any execution costs and charges or other fees paid to brokers.

If an investment manager does currently accept execution-related benefits that are not research, then they would need to either:

• cease accepting them in relation to their investment management services to clients if they are material in nature,
• demonstrate that they are a minor non-monetary benefit (although this is likely to be very limited in scope), or
• pay for services with the firm’s own money. The latter approach is consistent with the fact that execution-related services are likely to be necessary to providing the general service of portfolio management and so should be treated as a core cost of business for the firm.

Firms who provide both execution and research services will have to identify separate charges for their services. Brokers are no longer able to charge a bundled execution rate which the portfolio manager agrees and passes on to their clients as trading costs, in return for unpriced research goods and services provided as a benefit to the manager.

Chapter 4. Client categorisation

Relevant to:

• Firms conducting MiFID or equivalent third country business, and firms conducting non-MiFID business, local authorities and other public sector bodies.

Proposals

Only a national government or a public body dealing with public debt at national level can be categorised as a per se ECP (Eligible Counterparty).

Firms will be required to apply the following tests and procedural steps when opting-up local authority clients to professional client status:

• Qualitative test – adequate assessment of expertise, experience and knowledge of the client
• Re-calibrated quantitative test. Criteria in paragraph (a) and the criteria in either paragraph (b) or (c) must be satisfied:
a) Size of client’s financial instrument portfolio, defined as including cash deposits and financial instruments, exceeds £15,000,000
b) The client has carried out transactions, in significant size, on the relevant market at an average frequency of 10 per quarter over the previous four quarters
c) The client works or has worked in the financial sector for at least one year in a professional position, which requires knowledge of the transactions or services envisaged

The FCA also clarifies that the retail categorisation will apply to local authorities who act as pension fund administrators in the same way as it will to those acting in their main capacity, i.e. as treasury managers. However, firms will have to categorise the local authority separately depending on the capacity in which it is acting.

These requirements will also be extended to non-MiFID scope business including business conducted by Article 3 firms.

Implications for firms

Firms will have to re-categorise their ECP clients who have been opted-up from elective professional client status, due to elective professional clients no longer being able to opt-up to ECP status. Firms will also need to amend their opting-up processes for ECPs to comply with the procedural notification requirements (i.e. in the case of per se professional clients only.

The new quantitative criteria will also require firms to review the categorisation of their existing local authority. The broader impacts will also need to be considered as certain clients could lose their professional classification, which would impact firms that do not have the relevant permissions to service retail clients.

Chapter 5. Disclosure requirements

Relevant to:

• Firms conducting MiFID or equivalent third country business, and firms conducting non-MiFID business (including article 3 firms).

Proposals

Fair, clear and not misleading information requirements (MiFID II Delegated Regulation Article 44)

For firms doing MiFID business, the FCA propose to introduce a revised COBS 4.2.1R to require that firms must communicate with ECPs in a way that is fair, clear and not misleading, taking account of the nature of the eligible counterparty and its business. Additionally, in regard to MiFID investment firms’ communications with clients, a new COBS 4.5A is being proposed.

For firms doing non-MiFID business ( including Article 3 firms), the requirement will not be imposed to communicate with ECPs in a way that is fair, clear and not misleading, taking account of the nature of the ECP and its business. The existing requirement in Principle 7 of the Principles for Business will continue.

General requirements for information to clients, and financial promotions (MiFID II Delegated Regulation Article 46)

For firms carrying on MiFID business, the FCA proposes new information requirements will be introduced which pertain to communication with all clients. The new COBS 2.2A will apply to communications with all clients (including ECPs). This will require disclosure to clients of the following information in good time:

• Information on the investment firm and its services
• The financial instruments and proposed investment strategies
• Execution venues
• All costs and related charges
• Guidance on risk warnings for investment strategies
• Whether the financial instrument is for a professional or retail client

For firms doing non MiFID business, the current rules on timing and disclosure of information contained in COBS will be updated so they only apply in relation to non-MiFID business, and when firms communicate with retail clients.

For firms doing MiFID business, the FCA also propose to amend COBS 4.7.1R to ensure the information required by MiFID II is included in direct offer financial promotions when received by all client types. Whereas for firms doing non MiFID business, the proposed changes to COBS 4.7.1R will only apply to direct offer financial promotions received by retail clients.

Information about the investment firm and its services for clients (MiFID II Delegated Regulation Article 47)

For firms doing MiFID business, a proposed new chapter, COBS 6.1-A. will be added. Provisions in this new chapter will reproduce the applicable provisions in the MiFID II delegated regulation, which lists the general information that must be disclosed to all clients, including the additional information that must be given when firms provide portfolio management services.

The FCA proposes to amend the existing provisions in COBS 6.1 so they only apply to firms in relation to non MiFID business.

Information about financial instruments (MiFID II Delegated Regulation Article 48)

For firms doing MiFID business, the FCA proposes to introduce a new COBS 14.3A, which will list the information firms must give about the specific investment, including details of the nature of the investment and its associated risks.

The FCA rules currently require firms to provide clients with a description of the nature and risks of designated investments. It is proposed that these be amended, to ensure they apply only in relation to non-MiFID business.

Information about safeguarding client instruments and funds (MiFID II Delegated Regulation Article 49)

The FCA proposes that firms provide clients with information pertaining to the safeguarding of client financial instruments or client funds.

For firms doing non-MiFID business, the existing safeguarding disclosure rule in COBS 6.1.7R will be amended, so it applies to firms when they hold financial instruments or clients funds for retail clients.

Information on costs and associated charges (MiFID II Delegated Regulation Article 50)

For firms doing MiFID business, new rules in COBS 2.2A, and COBS 6.1-A.2.8 EU will require them to provide aggregated and on-going information on all costs and associated charges which go beyond what is currently required. For MiFID investment firms and Article 3 firms, certain information relating to costs and charges will be required. This information will include; the costs of advice, the cost of the instrument recommended or marketed, how the client will pay for it, and the cost of third-party payments.

The new provisions require that all costs and charges, including those in connection with the investment service and the financial instrument, which are not caused by the occurrence of underlying market risk, are aggregated. This aggregated information must be provided to the client regularly, or at least annually.

The disclosure requirements have now changed, with firms having to make point-of sale disclosures in good time. It must be noted that the previous provisions of occasional exceptions regarding distance communications or use of telephones no longer apply. Furthermore, when there is an on-going relationship, post-sale disclosure must be made at least annually.

For non-MiFID business, the new rules do not apply. The existing rules on the provision of information about costs and charges, and the timing of disclosure will be retained.

Costs and charges in relation to UCITS and PRIIPs (MiFID II Delegated Regulation Article 51)

For firms doing MiFID business, the FCA propose to introduce a new COBS 14.3A.8EU.Under this provision firms that distribute units in a UCITS scheme or PRIIPs will need to provide clients with more information regarding other costs and charges related to the product purchase. This includes the costs and charges relating to their provision of investment services in relation to that product.

Comprehensible information (MiFID II Article 24(5))

For firms doing MiFID business, the FCA propose to introduce a new rule in COBS 2.2A.5R. Firms will need to provide clients with information in a comprehensible form, which allows them to understand the nature and risks of the investment service and of the financial instrument being offered, thus enabling them to make informed investment decisions.

The provision of information regarding a firm’s services and investments is planned to only apply to firms carrying on non-MiFID business.

Cross-selling/Bundled products or services (MiFID II Article 24(11))

In relation to MiFID business, when offering bundled products or services, a firm must alert the client to the possibility of purchasing the components separately, and provide details of the costs and charges for each component.

If the risks of bundling the components differ from when they are separate, the firm must provide a description of these risk differences. This will be transposed into a new rule in COBS 6.1-A2. There are no proposed rule changes for non-MiFID business.

Periodic Reports (MiFID II Article 25(6))

Firms doing MiFID business must provide clients with adequate reports in a durable medium, which include periodic communications that consider the type and complexity of the financial instrument involved and the nature of the service provided. These should include, where applicable, the costs associated with the transactions and services undertaken on behalf of the client. This will be included in a new rule, COBS 16A.1.2R.

In another new rule, COBS 2.2A.3R(3), firms are required to provide clients with information on costs at least annually during the lifetime of the investment.

Reporting obligations in respect of execution of orders other than for portfolio management ((MiFID II Delegated Regulation Article 59)

For firms doing MiFID business, a new COBS 16A.2.1 EU will be introduced, which details the content and timing of the essential information that firms, having carried out an order other than for portfolio management, must give clients post-sale.

For firms doing non-MiFID business, or business relating to UCITS schemes or EEA UCITS schemes, the existing rules in COBS 16.2 regarding reporting obligations will apply.

Reporting obligations in respect of portfolio management (MiFID II Delegated Regulation Article 60)

For firms doing MiFID business, a new COBS 16A.3.1 EU will be introduced which details firms’ reporting obligations when managing obligations.

Firms conducting non-MiFID business will need to provide a statement every six months, rather than every three months. Some firms might also be able to obtain an exemption if they have an adequate online system that contains up-to-date statements, and they have evidence that clients have accessed it at least once during the previous quarter. This will be reflected through amendments to COBS 16.3.1R, 16.3.2R and 16.3.3R.

Reporting obligations in respect of eligible counterparties (MiFID II Delegated Regulation Article 61)

For firms doing MiFID business, the FCA propose to create a new COBS 16A.5.1EU. This will clarify that the provisions in COBS 6.1-A EU COBS 16A.2.1 EU (see above) apply in respect of ECPs, unless firms enter into agreements with the ECPs to determine the content and timing of reporting (which may be different from the requirements in relation to retail and professional clients).

Additional reporting obligations for portfolio management or contingent liability transactions (MiFID II Delegated Regulation Article 62)

For firms doing MiFID business, the FCA propose to introduce a new COBS 16A.3.3 EU . This rule will require firms to report when a client’s managed portfolio, or position in leveraged financial instruments or contingent liability transactions, depreciates by 10%, and thereafter at multiples of 10%. For portfolio management, a contingent liability transaction should involve any actual or potential liability for the client that exceeds the cost of acquiring the instrument.
For firms doing non-MiFID business, the provisions in COBS 16.3.6R will apply as they do currently.

Statements of client financial instrument or client funds (MiFID II Delegated Regulation Article 63)

For firms doing MiFID business, a new rule, COBS 16A.4.1 EU, is proposed. This will require firms to satisfy disclosure requirements detailed in Article 63(2)(d) to (f) and give clients statements that contain more information about the assets held than is currently required.

For firms doing non-MiFID business, the rules in COBS 16.4 will continue to apply.These cover the timing and content of statements of client designated investments or client funds that must be provided. In addition, the FCA are proposing to introduce an exemption to allow firms to avoid providing such a statement if they have an adequate online system that contains up-to-date statements, and they have evidence that clients have accessed it at least once during the previous quarter.

Retention of records to show reports sent (MiFID II Delegated Regulation Article 72)

For firms doing MiFID business, the FCA propose to add new provisions to SYSC 9. The new record-keeping requirements are more detailed; they require firms doing MiFID business to keep records for a period of five years and, where requested by the FCA, for a period of up to seven years.

For non MiFID business, the rules in COBS 16.2.7R and COBS 16.3.11R which require firms to retain records for three years will continue to apply.

Chapter 6. Independence

Relevant to:

• Firms conducting MiFID or equivalent third country business and firms conducting non-MiFID business (including Article 3 firms) which provide personal recommendations to either retail or professional clients.

Proposals

The FCA proposes to implement the MiFID II independence standard for personal recommendations to retail clients in the UK for both MiFID financial instruments and structured deposits and for non-MiFID retail investment products (such as insurance-based investments and personal pensions). For professional clients, and where relevant, retail clients outside the UK (who are currently not covered by the RDR independence standard), the FCA proposes to apply only what is required by MiFID II.

Implications for firms

No significant implications are expected. Some firms which provide both independent and non-independent or ‘restricted’ advice (on MiFID financial instruments) need to consider any changes they should make to comply with MiFID’s organisational requirements. This is particularly the case in relation to MiFID’s prohibition on individual advisers providing both independent and non-independent advice.

How firms describe themselves

A firm providing independent advice to retail clients which is narrower in scope than all RIPs, financial instruments and structured deposits may include the word ‘independent’ in its name as long as its marketing materials are sufficiently clear as to the nature of the service provided by the firm.

Chapter 7. Suitability

Relevant to:

• Firms conducting MiFID or equivalent third country business and Article 3 firms which provide personal recommendations to either retail or professional clients
• Consumers and consumer organisations

Proposals

MiFID II makes the following additional requirements in regards to suitability provisions:

• Assess suitability of overall package where advice is provided on a package of bundled products or services
• Firm remains responsible for suitability assessment provided through an automated or part-automated system
• Ensure information collected about clients is reliable
• Ensure information about a client is up-to-date if the firm is providing ongoing advice or discretionary management services
• Conduct periodic suitability reports for discretionary management
• Have in place a policy for deciding who the suitability assessment should relate to, where the client is (a) a legal person; (b) a group of two or more natural persons, or (c) one or more natural persons represented by another natural person
• If the services or investment is not suitable for the client, then no personal recommendations should be made or decisions to trade be taken
• When advice or discretionary management involves switching investments, the firm should collect information on existing investments, so that the costs and benefits of the switch can be analysed
• When a service of periodic suitability assessment and reports is provided, the following reports can be limited to any changes

The new MiFID II requirements are mostly set out in MiFID II delegated regulation. Article 3 firms will be subjected to full provision of the new COBS 9A.

Implications for firms

Firms will have to reassess their suitability policy and procedures due to those enhanced requirements.

Chapter 8. Appropriateness

Proposals

• A clear distinction between non complex and complex products with greater emphasis being placed on the intricacy of product appropriateness assessment where products or services are highly complex
• Article 25(4) of MiFID II enables a MiFID business firm to provide a limited range of investment services (execution or reception and transmission of orders) to a client without having to assess the appropriateness of the investment product for the client as long as certain conditions are met. One of those conditions is that the investment product should be ‘non-complex’
• Non-UCITS Retail Schemes (NURS) and investment trusts are neither automatically non-complex nor automatically complex. NURS need to be assessed against the criteria in the MiFID II delegated regulation. When firms apply these criteria, they should adopt a cautious approach if there is any doubt as to whether a financial instrument is non-complex

Implications for Firms

• Firms will need to carry out the appropriateness test for all products to be ‘complex’
• Examples of complex products are, structured deposits where the credit institution has the unilateral right to terminate the agreement before them or units in a structured UCITS
• When offering bundled products and services, they will need to consider the appropriateness of the overall bundle
• They will also need to record the results of a test, including, when a warning has been given but the client wishes to proceed with the transaction, and whether they decided to carry out the client’s request
• Firms currently offering products through direct offer financial promotions may be particularly affected by the widening of the scope of complex products
• It is unlikely that a firm offering products through a direct offer financial promotion will be able to meet the appropriateness test, because the obligation to carry out the test is on the firm, and not the client
• Simply collecting information on a client’s knowledge and experience will not be sufficient
• The FCA are not applying the new requirements to Article 3 firms

Chapter 9. Dealing and managing

Relevant to:

• Firms which execute receive and transmit or place orders for execution, including portfolio managers
• Firms undertaking MiFID or equivalent third country business and firms undertaking non-MiFID business (including Article 3 firms as well as managers of collective investment undertakings)

MiFID II requirements on best execution- This includes client order handling, record keeping of client orders and decisions to deal, transactions limit order display, and personal account dealing.

MiFID II does not materially change the current regime. It increases the compliance threshold and details the content of specific disclosures to be made to clients. The new framework moves from a higher-level set of rules to a more prescriptive one, with well-defined organisational and reporting requirements.

MiFID II also introduces two new Regulatory Technical Standards (RTS 27and RTS 28). These set out new reporting requirements for execution venues and investment firms executing client orders with the aim of improving investor protection and transparency over execution quality.

Four new recitals in MiFID II and its delegated regulation that would serve as useful guidance for firms in understanding their best execution:

• Recital 24 of MiFID II clarifies that when firms deal on matched principal basis (back-to-back trading) executing orders on behalf of clients, it is equivalent to dealing on own account and is subject to the best execution provisions
• Recital 107 of the MiFID II delegated regulation; investment firms should compare and analyse relevant data published by execution venues in order to obtain the best possible results for their clients (Article 27(3) of MiFID II)
• Recitals 100 and 108 of the MiFID II delegated regulation; firms may select a single venue for execution of client orders only where they are able to show that this venue consistently delivers the best possible results that are at least as good as the results they would expect from using alternative entities for execution
• Recital 99 of the MiFID II delegated regulation; when applying the best execution criteria for professional clients firms’ order execution policy should take into account the particular characteristics of SFTs and it should list separately execution venues used for SFTs

Application of MiFID II best execution rules to non MiFID business (Article 3 firms and managers of collective investment undertakings)

Proposals

• Extension of the MiFID II best execution rules to non-MiFID business with retention of certain modifications to take into account the specific business models of certain firms
• Extension of the MiFID II best execution requirements to financial advisers exempt from MiFID II under Article 3. However they intend to moderate the new requirements by exempting them from reporting under RTS 28
• The levelling up of best execution rules to MiFID II standards for UCITS management companies subject to some modifications to tailor the provisions for collective portfolio management
• The levelling up of best execution rules to MiFID II standards for small authorised UK AIFMs
• Where the best execution provisions apply to small authorised and residual CIS operators, the FCA propose to apply similar modifications to the best execution provision to those that will apply for UCITS management companies. This will be done in COBS 18.5
• Enhancement of the existing best execution obligations for full scope UK AIFMs and incoming EEA AIFM branches although in substance the requirements remain largely the same (these are currently set out in COBS 18.5.4AR)

The FCA intend to keep the current disapplication of best execution obligations for non-MiFID corporate finance business and non-MiFID energy and oil market activities as well as the concessionary regime currently applying to trading of commodity and exotic derivatives instruments (which is not energy and oil market business) by non-MiFID firms.

Lastly, consistent with the FCA’s general approach to third country firms, the regulator will apply the MiFID II best execution provisions to third country branches as rules.

Implications for firms

Firms will be expected to update their existing execution arrangements, execution policies and monitoring procedures. The FCA expects that the main impact MiFID II will have on firms will arise from the reporting requirements under RTS 27 and RTS 28.

Raising best execution standard

MiFID II introduces a modification to the best execution high level provision from ‘all reasonable steps’ to ‘all sufficient steps’. This will not necessarily involve the strengthening of the firms’ systems and controls and require that they reassess whether their execution policies and arrangements deliver the improved outcomes in line with the higher MiFID II standard.

Changes to disclosure requirements

The MiFID II provisions make direct references to the conflicts of interest and inducements rules, and explicitly state that investment firms shall not receive any remuneration, discount or non-monetary benefit for routing client orders to a particular trading venue that infringes these rules.

The regulator has previously set out their position in TR14/13 and in the Guidance on the practice of payment for order flow (FG12/13).

MiFID II also provides that firms need to include their own costs for the purposes of selecting execution venues and the best possible results for retail clients shall be determined in term of total consideration.

The execution policy must also include a clear and prominent warning that any precise instructions from the client could prevent the firm from taking the steps needed to obtain the best result.

MiFID II requires firms executing client orders outside a trading venue to include in their order execution policy information about the implications of this mode of execution.

Changes to execution arrangements and practices

When executing orders or taking decisions to deal in OTC products including bespoke
instruments, firms will be required to check the fairness of the price that they are proposing to
the client, by gathering market data and where possible by comparing against similar products.

Firms will need to regularly assess the market landscape to determine whether or not there are alternative venues that they could use. This must be supported by the quarterly execution quality data to be published by execution venues under RTS 27.

Reporting requirements

RTS 27 and RTS 28 provisions include requirements for execution venues to regularly publish a report containing detailed information about the quality of the execution achieved in the preceding period. The information on execution quality of execution venues must be published in accordance RTS 27.

RTS 28 requires firms executing orders to publish reports setting out the top five venues they sent orders to in the preceding period, and a summary of their execution quality monitoring. The requirement on firms executing orders will also apply to portfolio managers and receivers and transmitters, who will have to disclose the top five firms or entities to which they sent orders for execution.

Client order Handling

MIFID II does not make any material changes to the client order handling and limit order rules. However, it adds the term ‘trading venue’ alongside ‘regulated market’ to reflect changes in market structure under MiFID II. It clarifies that the choice of venue must be made in line with the firm execution policy.

MiFID II also switches on client order handling provisions for firms when selling or advising clients in relation to structured deposits.

Proposals

They have also proposed to apply MiFID II’s client order handling requirements as rules to third country branches conducting MiFID business, which is consistent with the existing approach.

They intend to keep the current disapplication of these rules for non-MiFID corporate finance business, non-MiFID energy and oil market activities and full scope UK AIFMs and incoming AIFM branches, which remain subject to relevant requirements under AIFMD.

Record keeping of client orders, decisions to deal and transactions

Proposals

New measures now require firms to record more exact details on the client instruction, the security traded and the different parties involved in the execution of the order. Firms will be required to record all necessary order references that will allow their records to be matched to the new transaction reporting requirements applicable to trading venues and the exact sequence of the order execution.

Record keeping requirements to include transactions that are carried out on own account and order processing. It also brings structured deposits into scope for the enhanced record keeping requirements.

The FCA propose to apply the MiFID II record keeping requirements for client orders, decisions to deal, transactions and order processing to some Article 3 firms.

They propose to delete the existing text in COBS 11.5 and copy the text in the MiFID II delegated regulation into a new chapter entitled COBS11.5A.

In particular, they will apply the new provisions to Article 3 firms providing retail investment advice. However, they propose to not apply the requirements to Article 3 firms carrying out corporate finance business; in line with their current position under COBS 18.3.3.

The FCA also propose to apply the MiFID II record keeping requirements of orders and transactions as rules to UK branches of third country firms, who are already subject to the current COBS 11.5 requirements.

They also propose to maintain the current approach that does not apply requirements in COBS 11.5 to full-scope UK AIFMs, incoming EEA AIFM branches or UCITS management companies.

Implications for firms

The FCA recognise that the MiFID II record keeping requirements on client orders, decisions to deal, transactions and order processing are more extensive for those firms affected than the existing requirements under COBS 11.5, since it established a greater number of entries (fields) per transaction report that must be recorded.

Personal account dealing

Personal account dealing rules seek to protect clients against practices by individuals with a firm who have access to confidential information on clients and transaction information, such as front-running.

MiFID II does not introduce any changes in the rules currently governing personal transactions. However it does extend these provisions to investment firms or credit institutions selling or advising clients in relation to structured deposits.

Implications for firms

There should not be any substantive implications for already compliant firms, as this area is fundamentally unchanged under MiFID II.

Chapter 10. Underwriting and placing

Relevant to:

• Firms conducting MiFID or equivalent third country business which carry out underwriting and placing activity

Implications for firms

• New requirements in COBS 11A for underwriting and placing will require firms to establish specific measures to ensure compliance, if they do not already exist
• There will be resource implications, particularly around the new disclosure requirements

Chapter 11. Investment Research

Relevant to:

• Firms undertaking MiFID or equivalent third country business and certain firms undertaking non-MiFID business (including some Article 3 firms) which produce and disseminate investment research and non-independent research
• These will apply as rules to firms conducting equivalent third country business, non-MiFID Energy Market Participants (EMPs) and Oil Market Participants (OMPs) and Article 3 firms carrying out corporate finance business

Proposed Handbook provisions will apply to firms which produce, or arrange for the production of, research that is intended or likely to be subsequently disseminated to clients of the firm or to the public.

Implications for firms

• The new investment research rules are largely unchanged from the existing regime.
• There is a new provision which requires the physical separation of analysts, unless it is not proportionate to do so
• New provision is unlikely to have a material impact on the way compliant firms manage conflicts of interest

Chapter 12. Other Conduct Issues

Relevant to:

• Firms undertaking non-MiFID designated investment business for retail clients, firms undertaking MiFID or equivalent third country business for both retail and professional clients, and firms undertaking non-MiFID collective portfolio management activities
• Consumers and consumer organisations

Provision of client agreements:

MiFID II enhances a number of the FCA’s current consumer protection provisions. There is now an obligation to enter into a written basic agreement with professional as well as retail clients, and this must be done for each investment service or ancillary service, not just for new clients.

• A description of the services, and where relevant the nature and extent of the investment advice, to be provided
• For portfolio management services- the types of financial instruments that may be purchased and sold and the types of transactions that may be undertaken on behalf of the client, as well as any instruments or transactions that are prohibited
• A description of the main features of any safeguarding services to be provided

Part II – Other matters

Chapter 13. Product Governance

Relevant to:

• Firms undertaking MiFID or equivalent third country business, and firms undertaking non-MiFID business which are involved in the manufacture or distribution of MiFID products
• Consumers and consumer organisations

MiFID II will bring about product governance requirements for manufacturers and distributors.

Implications for firms

The new rules and guidance will replace broadly equivalent existing guidance in the RPPD
There are certain aspects of the MiFID II product governance provisions that go beyond the RPPD, as outlined below.

For firms involved in the manufacture of products:

• Product design, including product charges, should meet the needs of the target market and the firm should identify groups for whom the product is unlikely to be suitable
• Firms should consider the impact of new products on the orderly functioning of the market
• The distribution strategy should meet the needs of the target market
• Firms working together to develop a single product should have a written agreement setting out their share of these responsibilities
• The compliance function at the firm should monitor product governance and firm management boards should have effective control and oversight over the process

For firms involved in the distribution of products:

• Before distributing product, firms should consider for which target market it is likely to be suitable and any groups for whom it is unlikely to suitable
• The distribution strategy should meet the needs of the target market
• Products should be reviewed regularly to confirm they remain consistent with the target market’s needs and make changes to the distribution strategy or other processes if they identify problems
• The firm’s compliance function should monitor product governance firms management boards should have effective control and oversight over the process
• Firms working together to distribute a single product should share information with other firms in the chain

Chapter 14. Knowledge and competence requirements

Relevant to:

• Firms undertaking MiFID or equivalent third country business which provide investment advice and information to clients on services and financial instruments

Article 25(1) of MiFID II requires firms engaged in MiFID business to ensure, and be in a position
to demonstrate to the FCA, that individuals giving investment advice or information about financial instruments or investment or ancillary services to clients possess the necessary knowledge and competence to fulfil their investor protection obligations.

Proposals

The FCA proposes making amendments to TC to give effect to the ESMA guideline requirements that employees must have a:
• Minimum of six months appropriate experience (as well as an appropriate qualification) before they can be considered eligible to work unsupervised
• Maximum time period of four years in which to acquire appropriate knowledge and competence under supervision

Implications for Firms

The guidelines introduce more detailed knowledge and competence requirements for firms not subject to the TC sourcebook. In particular, the guidelines are relevant to those who provide investment advice to professional clients and employees that give information to retail and professional clients.

Chapter 15. Recording of telephone conversations and electronic communications (taping)

Relevant to:

• Firms conducting MiFID or equivalent third country business, Article 3 firms and non-MiFID Investment managers

Introduction

MiFID II introduces for the first time an EU wide minimum harmonising requirement on firms to record telephone conversations and electronic communications when providing specific client
order services that relate to the reception, transmission and execution of orders, or dealing on
own account.

However, the FCA remain open, particularly for smaller financial advisers, to considering whether an alternative and more cost efficient approach could help achieve a similar level of consumer protection as taping.

Proposals

Application of the MiFID II taping regime to a wider range of activities than those required by the directive, namely:

• The service of portfolio management, including removing the current qualified exemption for discretionary investment managers
• Corporate finance business
• Energy market activity or oil market activity
• The activities of collective portfolio managers (full-scope UK AIFMs, small authorised UK AIFMs and residual CIS operators, incoming EEA AIFM branches and UCITS management companies branches and UCITS management companies

The retention period is longer than the existing regime (six months). MiFID II requires records to be stored for five years, with the option for the FCA to extend the requirement to seven years in specific cases.

Next-steps

The FCA will be receiving comments and feedback to the consultation paper until 4 January 2017, except for Chapter 16 where responses must be submitted by 31 October 2016. The FCA will then review the feedback and make any relevant changes to their proposals and will publish their rules in a Policy Statement in the first half of 2017. A further consultation paper will then be published, which will focus on the other FCA /handbook changes required to implement MiFID II.

As always, if you have any queries please don’t hesitate to contact one of the CPA Audit team.

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