MiFID II: Fragmented EU Distribution Rules Bubble Up Again

A lot of water has passed under the bridge since the Markets In Financial Instruments Directive (MiFID II) was implemented at the start of 2018. The sheer scale and scope of MiFID II implementation sent shockwaves across the EU’s capital markets, and further afield as its extraterritorial impacts like research unbundling took hold globally. MiFID remains high on the agenda of most asset managers operating in Europe. There are a number of MIFID related consultations currently under review such as integration of ESG factors and the third country equivalence regime.  In fact, just last week, the European Securities and Markets Association (ESMA) also issued a reminder of their MIFID II obligations relating to retail investors, amid increased transactional volumes created by the COVID-19 crisis.   

Just two years on from its go live date, EU policymakers have reopened the book on MiFID II with a wide-ranging public consultation focused on specific areas and garnering industry feedback on how those areas have functioned thus far. The consultation poses 94 questions across a gamut of areas including research unbundling, trading requirements, and more — topics we will certainly revisit in time. 

One area that demands closer scrutiny now, however, relates to the sales, marketing, and distribution requirements of MiFID II. Once again, this consultation is likely to flag that there remains much to be done in terms of rule harmonization before a truly pan-EU digital funds marketplace comes into being. 

Fragmentation

Upon its implementation, MiFID II imposed stringent criteria on the types of products that could (and could not) be sold to EU investors through its product governance rules. MiFID II’s suitability assessments, defined target market, and so called “Know Your Distributor” rules set a high and complex bar for the sale of financial products across the EU. Fragmented distribution regulations have long been a thorn in the side of regulators and asset managers alike – MiFID II is no different. Indeed, European Securities Markets Authority (ESMA) have previously assessed barriers to cross border distribution of UCITS and Alternative Investment Fund Manager Directive (AIFMD) funds with a view to imposing a more harmonized ruleset, a topic which ESMA returns to as one area of focus within this MiFID review. While there are some specifics like simplification of the product governance rules and a heightened focus on inducement rules, once more, the broader issue of cross-border distribution barriers will likely to be the area of keenest focus once more. 

Despite more than a decade of rule revisions and consultation, the EU cross-border market is still rife with “gold plated” national requirements. These requirements   create rule fragmentation which fly directly in the face of pan-EU regulations such as MiFID, UCITS, and PRIIPS. As such, asset managers, distributors, and their funds can often be subject to multiple layers of regulation when they sell product on a cross-border basis. Such rules often include additional documents, marketing restrictions, or appointment of local agents which must be adhered to on top of the EU wide rules. Fragmentation and duplication result in additional barriers as complexity, confusion, and ultimately costs increase, while investor access, understanding, and participation in funds decrease. 

No More Paper?

Another consequence of the national level gold plating rule is the reduced opportunity to conduct a digital sales strategy. Given COVID-19 lockdowns and a natural reduction in face-to-face meetings for the foreseeable future, this is not a moot point. The EU funds marketplace is still largely reliant on physical face-to-face meetings and interactions between investors and their banks, brokers, and financial advisors. To foster increased financial inclusion and participation, there has been a long-held industry desire to move to a more digital method of marketing communication, sales, and engagement with investors. The current pandemic makes that imperative even more important. 

A digital sales strategy is highly predicated on providing standard uniform documents and data to online investors wherever they reside.

Another key focus area will be is the move away from paper to digital documents. Currently, investors must be provided certain disclosure documents via a “durable medium.”  The current default durable medium is paper. Amid a general push toward sustainability, the industry has been strongly advocating for a shift to online digital documents. What’s more, there is a general desire among those in the industry to move towards a digitally calibrated funds sales model, which requires a ruleset that accommodates and encourages the adoption of virtual advice, online accounts, and mobile apps to deliver investors the required information. This move would align with   EU policymakers’ own ESG/sustainability and digital economy policy goals. Rule harmonization across EU member states is a key cornerstone of a digital economy and is an area that ESMA are sure to review closely in this consultation and beyond. 

Inducement Ban?

The other focal point of the consultation relates to inducements. Inducements under MiFID II are any fees, commissions, or non-monetary benefits that may be accrued by product providers and their distributors for sales of products. There are rules in place to ensure that incentives to promote and sell particular products are appropriate to the investors needs and free from conflicts of interest.

Such inducements continue to play a central role in pan-European distribution. There is still a large swathe of EU investors who access funds through their bank or insurer rather than directly through an independent financial advisor. There is an ongoing debate about the requirement for a simplified and harmonized cost disclosure regime which spans MiFID, UCITS and other areas like PRIIPS. Today, it is onerous for investors to easily identify and compare inducements such as commissions paid to distributors against overall product costs under the various regimes. 

Additionally, the definition of “inducement” is not aligned across the respective EU rulesets (UCITS, MIFID, PRIIPS etc).  There is a complexity to the MiFID rule regarding quality enhancement and best interest tests as well as which products are deemed independent. Simplification and certainty of definition would be a leap forward as currently it is hard to decipher what does and doesn’t represent an inducement.  

The prospect of an outright ban on inducements across the entire EU is raised once more in the consultation. The UK and the Netherlands are two markets who have previously imposed outright bans on inducements. An outright ban, however, was initially resisted in MiFID II and is likely to be once more. Using the cases of the UK, outright inducement bans such as imposed in UK’s Retail Distribution Review (RDR) do not improve investor access to investment advice and may result in an advice gap whereby investors (usually those with smaller portfolios whom would benefit from such advice) are either unable to access it (because it is no longer economic for advisers to service the market) or unable or unwilling to pay for it. Thus, outright inducement bans reduce participation in financial products which runs counter to the regulatory goal. There are also many EU markets who simply do not have a deep independent financial advisory market, leaving some investors with no choice if they can’t access services through their bank or insurer. 

Bottom line

What is clear is that the industry must ensure that investors maintain access to a broad range of suitable products at the right price. Retention of a diverse range of distribution models from full to partial advice through to execution-only is optimal for investors. Retention of inducements is possible if regulators maintain other requirements such as suitability assessments, managing conflicts, and enhancing transparency of inducements. 

 After just two years of going live, this behemoth regulation is once more open to change. Here we have outlined the impacts to asset managers in terms of sales and distribution.  However, since the thorny issues of research unbundling and creation of an EU consolidated tape are also up for debate, it seems like once more MiFID II is high on the asset management agenda for 2020.