On 3 July 2017, just hours before MiFID II’s transposition deadline passed, the FCA published its Markets in Financial Instruments Directive II Implementation – Policy Statement II (PS17/14). In this document, the FCA sets out its final position on the conduct of business rules, many of which will significantly impact the way your firm carries out its commercial activities. It follows PS17/5 published in March, which covered market structure and organisational requirements. PS17/14 runs to some 1068 pages (including the final amended text for the FCA Handbook).
In this article, we attempt to boil this down to the most significant changes to the applicability of MiFID II to certain categories of firms, and run through the most important clarifications to the rules themselves. We plan to follow this up in coming weeks with further in-depth analyses of specific MiFID II topics, including paying for research and transaction reporting.
This article – the latest in ACA Compliance (Europe)’s series MiFID II: understanding and practical preparation – explains what the changes are, how they might impact on firms and offers guidance on the steps firms can and should be taking now in order to ensure they remain compliant post-January 2018.
Collective Portfolio Managers (“CPM”) – AIFMs (hedge) and UCITS managers
The FCA has decided that the enhanced Best Execution rules will not apply to UK AIFMs, including the requirement to publish the top 5 execution venues for each class of financial instrument (under RTS 28). This exemption applies to both full-scope and small AIFMs, and also includes CPMI firms (AIFMs with MiFID top-up permissions). UCITS management companies will, however, remain subject to these requirements acknowledging the greater need to protect retail investors in UCITS vehicles.
CPMs – Other AIFMs (Private Equity, Venture Capital and Real Estate)
Managers of these strategies have been taken out of the Paying for Research regime, with the FCA accepting the argument that such firms are not susceptible to inducements incurred in a dealing commission context. Managers trading in non-listed instruments are also taken out of the obligation to tape-record relevant conversations.
MiFID II investment firms (buy side)
Some MiFID investment managers (as well as CPMs) will benefit from the FCA’s comparatively narrow interpretation of the tape-recording regime, with only calls directly relating to, or intended to result in, the execution of a transaction deemed to be in scope.
MiFID II investment firms (sell side)
Brokers dealing with 3rd country managers (those based outside the EU) will not be required to price research separately from execution and other services provided to such firms.
The main points of interest:
Inducements and paying for research
The longest and probably most eagerly awaited chapter in the Policy Statement has several useful points of clarification on the new paying for research regime.
Who is caught?As highlighted above, the FCA is going ahead with the proposal to extend the research rules to all forms of CPMs. However, there is also a significant carve-out for firms whose core investment policy does not involve financial instruments held by a depositary or in non-listed companies (e.g. private equity, venture capital and real estate managers). This is because they are considered to use research services in a way that does not render them susceptible to inducement risks (e.g. infrequent assignments, separately negotiated). Applying the rules across all firms using execution and research services will, the FCA believes, lead to a more efficient and effective asset management industry.
Execution services: the FCA accepts that certain activities are inherent to execution services, such as working large orders and taking trades on risk. Hence, they may be paid for by execution commissions (but not out of an RPA). Usefully, firms can accept delegated transaction reporting and post-trade reporting as part of the execution service provided to clients, provided it does not influence best execution and is offered as a standard term of business by the broker (i.e. it is selectively provided for free to some firms but not to others). The FCA also provides examples of services that it considers are not related to the execution of an order: the provision of 3rd party analytic tools, order management systems or RPA administration services.
Operating a Research Payment Account (“RPA”):once the charge has been paid into the RPA, the monies belong to the investment manager (including when delegating RPA administration to a 3rd party), and must be appropriately ring-fenced. In terms of sweeping research charges into the RPA, the FCA has accepted the argument that this can be done periodically, but lays down a maximum of 30 days from any transaction (albeit stating their preference that the transfers are more frequent). It also confirms that multiple RPAs are permitted by the rules although the FCA believes that a single RPA may be more efficient.
RPA funding and payment mechanisms:the FCA states its view that it is possible to combine different approaches to pay for research, including both research commissions and direct charges to fund the RPA (which may serve well for firms operating multi-strategy funds), as well as direct payments by the manager. However, it warns that complexity must not be used as a cloak to dilute other MiFID II obligations such as best execution and managing conflicts of interest. It also will not allow “payment netting” (the practise of offsetting research payments against commissions) since (it believes) this has the potential to recede to a bundled model.
Budgeting for and valuing research: whilst not requiring managers to establish fixed, ex ante research budgets in relation to specific providers, the FCA does require firms to formulate a “clear methodology” to establish what they expect to pay for services before they are consumed. It also makes it clear that firms must carry out regular ex post assessments of research quality, to be used to inform future procurement decisions and agreements with providers. We anticipate that both these requirements will typically be addressed through a new Paying for Research Policy which will form part of the firm’s compliance framework.
Trial periods: The FCA accepts the arguments that trial periods for research form an important part of lowering barriers to entry for new providers. However, it lays down that such trials may only last for a maximum of three months and may not be repeated for a further 12 months.
RPA administration costs: administering an RPA is considered a discrete service and therefore firms will have to pay for this out of their own resources and not out of the RPA itself.
Rebating monetary benefits to Professional Clients: The FCA will not be extending MiFID II’s ban on receiving and rebating monetary benefits to services provided to Professional Clients, although it suggests that firms may want to consider applying consistent standards across their whole business.
Acceptable minor non-monetary benefits:the FCA highlights the MiFID II framework for acceptable minor non-monetary benefits which permits only hospitality “of a reasonable de minimis value, such as food and drink during a business meeting, conference, seminar or other training events”, and transcribes this language into COBS 2.3A. This signals a much tighter perimeter for hospitality than is currently the norm in many parts of the investment management industry and we understand that sell-side firms are also moving in the same direction.
Reporting services: as noted above, post-trade delegated reporting may be considered as part of the overall execution service provided.
Scope: AIFMs will not be subject to MiFID II’s reporting requirements under RTS 28 (top 5 execution venues) and the other enhancements to the best execution regime. The FCA warns, however, that it will reconsider this position if it detects evidence of poor outcomes as a result of this carve-out. AIFMs will, of course, continue to be subject to the AIFMD best execution requirements.
UCITS management companies: UCITS management companies will be subject to MiFID II’s Best Execution regime. For the avoidance of doubt, MiFID investment managers which manage UCITS funds under delegation will also be subject to these requirements.
Recording of telephones and electronic communications
Clarification on which conversations must be recorded: whilst confirming the scrapping of the previous exemption for discretionary investment managers, the FCA provides some useful guidance in narrowing the scope of conversations relating to the reception, transmission and execution of orders that must be recorded. The FCA states that “it is not our intention to require all conversations or other electronic communications to be caught by the taping requirement.” The focus of recording should be on the transactional side of portfolio management – where transactions take place or are intended to take place. The FCA also notes that any monitoring of recordings should be “risk-based and proportionate”. Taken together, the FCA’s positions on recording should allay fears of an onerous and broadly interpreted set of obligations which could disproportionately hurt smaller managers.
Non-listed instruments: The FCA further clarifies that conversations relating to financial instruments not linked to trading on a trading venue should not be taped, thus providing a helpful carve-out for managers with private debt and equity strategies, as well as venture capital and corporate finance firms providing advice on structure, strategy and general research.
MiFID and eligible complainants: the FCA confirms a potentially confusing overlap between two regimes - MiFID II complaints, which will apply to all retail, professional and eligible counterparty business; and the Financial Ombudsman Service (“FOS”) concept of “eligible complainants” which will still apply. The FCA plans, however, to amend the way they report data so that it distinguishes between FOS eligible complainants and others.
Local authority clients: the FCA has reconsidered the criteria for local authorities to be able to opt up to professional client status. The quantitative test for portfolio size is reduced from £15m to £10m; a 4th qualitative criteria is added (two out of four must be met), namely that the local authority receives investment services within the UK’s local government pension scheme (“LGPS”). They also clarify that the qualitative criteria (expertise, experience and knowledge) can be applied to a group of persons at the local authority rather than a single individual.
Information and reporting to clients
Scope: the FCA confirms that it will not be extending the “fair, clear and not misleading” requirements of MiFID II to eligible counterparty business. Nor will it be extending the requirements regarding costs and charges disclosure to non-MiFID business. It has also declined to provide a standardised format for point of sale or post-sale costs, instead encouraging the emergence of an industry-led approach.
- Proportionality principle: the FCA confirms that the new PROD section of the FCA Handbook which sets out the new rules for manufacturers and distributors of financial products will apply to all portfolio managers. Firms must comply with the new rules in a way that is proportionate and appropriate to their businesses, taking into account the nature of the instrument or services and the target market.
Apart from a subsidiary consultation also initiated last week, PS17/14 represents the FCA’s last major body of work in implementing the MiFID II reforms. We anticipate further guidance from the FCA emerging from its industry working groups, as well as more Q&As from the EU regulator ESMA. However, these are likely to amount to clarifications rather than substantive changes of direction. Firms must therefore proceed with implementation of MiFID II on the basis of what we know now, rather than holding out for situation-specific clarity.