The EU’s biggest financial rule book shake-up in a decade has just landed. This week I sum up what it means for private investors and their advisors.

For the latest Winter Issue of Confidant, I spoke to Penny Rooney, Partner and Director of Compliance, to find out what MiFID II means for Killik & Co clients.

Why MiFID II?

This is the second EU Directive of its type and I strongly suspect that it won’t be the last! 10 years ago, in 2007, the first version (MiFID), represented the EU’s attempt to harmonise financial markets regulation across the whole of Europe. Then we had the financial crisis, which rather exposed the flaws in the existing rulebook – markets were not as stable as they should have been and were too open to manipulation. Persuading 27 countries to agree on how to move forward hasn’t been easy, which is why it’s taken a decade to get to where we are. Investor protection is a key part of these new rules – making sure that people know what they are buying and how much it’s going to cost them and then ensuring that they receive regular position and performance updates.

How has this business been affected?

Our clients will notice a number of differences between the “old” and “new” regimes. Here are three of the bigger ones;

Suitability

We have always had an obligation to assess suitability: MiFID II reinforces the importance of this, extends it, and also puts a bigger onus on us to keep it up to date. So, for example, there are still certain key things that we have to ascertain and evidence before we can offer a product or service, such as whether we think a client can handle the risk associated with a particular investment and bear any potential losses. In order to assess that, the rules say you have to consider a number of factors; the extent of a client’s regular income and its source, any regular financial commitments and what other assets they hold in the form of cash, investments, property or pensions.

Further, whereas under MiFID we only compiled a suitability report for certain products and services, MiFID II requires that every piece of advice is accompanied by one. That even includes advice not to do anything. For example, an Investment Manager might say to you, “Your portfolio looks absolutely fine and I don’t think you should make any changes.” That now qualifies as advice and we need to follow up with a report effectively confirming our mutual agreement that you don’t need to act.

We also have an obligation to report every transaction we undertake for a client to the regulator at the end of each day. To do that, we need a unique identifier code for every individual or entity that we deal with. For a British national, that identifier will typically be a national insurance number. For a national of another EU member state, it might be an identity card or tax number. When it comes to companies and trusts we need a legal entity identifier. Without this information, we can’t process trades and nor can anyone else. The logic behind all of this is that, at any point, the regulator can now join up all of the transactions being undertaken by, or on behalf of, a client even if they are routed via multiple third parties and jurisdictions. This comprehensive reporting trail will help them to spot market manipulation, or at least that’s the theory.

Under MiFID II we will also have to actively and regularly monitor a client’s circumstances and check that our records are up to date. We will need to know if, for example, a client sells a major asset, or has another child, or retires. All of these events could influence how we manage their assets and shape our recommendations.

I accept that for some clients, this new regime could feel a bit intrusive. However, the new requirements should also help us to improve the quality of the advice and investment management we can offer. Needless to say, we never share suitability information with anybody else. That works both ways, of course, which means that every new client has to go through our suitability process even if they have already been through something similar with another firm.

Reporting frequency

There are several changes in this area.

One of the simplest is that whereas custody statements used to be produced annually, now they need to be provided quarterly.

Others are less straightforward. For example, there is a new requirement to inform discretionary clients every time their portfolio suffers a drop of 10% or more on a quarterly basis. That’s because the EU sees the world very much from a single product perspective, where if that’s all you held, a 10% drop may be significant.  Whereas in the context of a wider diversified portfolio, a short-term fluctuation may be of little or no concern, but under MiFID II it needs to be flagged. And although historically, a client would have expected to hear from their Investment Manager anyway when markets were a bit choppy and portfolios were down, this new rule tries to make that systematic. The danger is that these formal 10% notifications could make people jittery, especially if they receive more than one in succession – it’s an example of where a well-intentioned rule in the context of a single product holding could be completely counterproductive in our space. That is something we will need to manage with clients.

New rules also mean more paperwork. That’s why we would urge all clients to use our online client portal, MyKillik so that far less has to be sent by post and we can get important documents out much faster (as well as reduce the threat of identity theft). MyKillik will also speed up trade execution where certain MiFID II disclosures now need to be made before we can act.

Enhanced disclosure

This impacts in several ways, perhaps the biggest of which is how we communicate our charges. We have always had to show these to clients up front, however now we need to do it in a way that regulators believe will maximise clarity and ease of understanding. We will also be giving more weight to the difference between a client’s first-year and ongoing costs. Moreover, when a client decides to change service, we will be issuing detailed cost illustrations. At the end of the year, another new report will then land – an annual disclosure of how much clients have paid in costs over the full year. The regulators hope that this will make comparing one firm with another easier. In practice, you have to be sure you are comparing apples with apples when it comes to specific portfolios. We will continue to encourage clients to have an open discussion with their Investment Manager about the service they are on and whether they feel they are getting the best value from it.

What have been the biggest challenges in implementing the new rules?

The financial services industry in the rest of Europe is really quite different from the UK’s. We don’t work on the assumption that someone will just walk in the door and buy a single product “off the shelf” – we are much more about broad relationships and long-term portfolio advice and management. With their origins in a more European, one-off sales culture, MiFID II’s rules have required some careful interpretation and generated a few headaches.

Meanwhile, as Paul Killik highlighted in the Autumn Issue of Confidant, some new rules may unhelpfully restrict the choice available to retail investors. For example, anyone creating and marketing a product, such as a fund, is now responsible for ensuring that it gets into the hands of the people that they intended it for further down the distribution chain. That actually makes quite a lot of sense from a single fund perspective. The problem is that the rules also appear to apply to all sorts of other instruments as well, such as equities and bonds, where the chain is much longer and the intermediaries involved may be far more widely dispersed. We can only hope that issuers don’t start limiting access to suitable products for retail clients simply to avoid the regulatory risk.

How will Brexit impact MiFID II?

It won’t, at least not until we formally leave the EU and we have made the necessary amendments to our own regulation that would enable us to change the rules. The extent to which we then make revisions will depend on the type of agreement we reach when it comes to providing financial services throughout Europe. If we want to continue to be a UK-regulated firm, that also services clients in France for example, then we’ll be expected to apply a broadly equivalent set of rules, even if not MiFID II’s verbatim. That said, outside the EU we will have greater flexibility to interpret and adapt the regulations to our marketplace, as opposed to pondering rules designed for a one-size-fits-all European one.

Are there any other big regulatory changes looming in 2018?

General Data Protection Regulation (GDPR) also lands this year, in May. That’s no bad thing as our UK Data Protection Act 1998 has not kept pace with the way data is distributed and used in an age of social media, the internet and mobile phones. The new rules focus on making sure people know who holds their personal data, why, how long they keep it, what they use it for, who they might pass it on to and how they keep it secure. Meeting the new requirements will be a huge challenge for some organisations as GDPR affects any firm, in any sector, if it handles personal data. The good news is that many financial services firms have had to stay well ahead on data management and protection to meet existing regulatory requirements. I am therefore quietly hopeful that our clients won’t see too much further change in this space in 2018.