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MiFID II: Inducements in Action

 

The MiFID II revisions on inducements present a raft of new strategic and operational challenges for financial institutions and advisors. What are they and how can firms react to them most effectively? 

As framed by the current MiFID regulations, inducements are perceived as potentially preventing firms from acting in their clients’ best interests. MiFID II, which comes into force in January 2018, aims to further strengthen investor protection and to make financial markets operations more efficient and transparent. As part of this new round of regulatory rollout, there will be important changes to inducements rules. These, in turn, will require adjustments to financial firms’ strategy and operations.

What are inducements?

Inducements, as defined in the regulation, comprise feesͥ, commission and non-monetary benefits received by firms from third parties, in relation to services or products provided to the firms’ clients. To avoid conflicts of interest between a firm and its clients, MiFID, in principle, bans receiving direct or indirect inducements from parties other than clients, unless certain conditions are fulfilled.

New rules, new layers of nuance

Under MiFID II, further refinements will be enforced. This is largely because the European Commission and the European Securities and Market Authority (ESMA) identified that firms do not implement the current rules effectively. The updated regulatory framework now defines separate rules for independent advisors / portfolio managers and for non-independent advisors.

MiFID II guidelines at a glance

Quality enhancement

MiFID II also provides guidance on quality enhancement. In practice, an inducement is held to enhance the quality of a service provided to a client when the following - non-exhaustive - conditions are met:

  1. A higher level of service is provided. Situations where this higher level will apply include:
    1. Access is made available to a wider range of suitable financial instruments, including an appropriate number of instruments from third party products providers, with no close links to the firm;
    2. Non-independent advice is combined with either 1) an offer to provide ongoing advice to the client (at least annually) or 2) another ongoing service that is likely to be of value to the client (e.g. advice about asset allocation);
    3. Service is paired with an added value tool (e.g. a monitoring tool) or with periodic performance reports.

       

  2. Tangible benefit for clients. An inducement cannot directly benefit the recipient firm, its shareholders or employees, without there also being a tangible benefit to the client concerned.

     

  3. Ongoing benefit for clients. An inducement is justified by the provision of an ongoing benefit to the client concerned.

Investment research

The subject of investment research generated significant debate during the ESMA consultation on MiFID II. Arguably, any investment research received by firms from third party brokers should be considered as a form of inducement.

ESMA acknowledges that such research could conflict with a firms duty to act in the best interest of its clients. It also recognizes that investment research plays an important role in the decision-making process, both for firms selling financial products and clients buying those products. As result of ESMAs deliberations, there is now a requirement to properly classify investment research activities.

In practice, MiFID II determines that for investment research not to be considered an inducement, it must be:

  • Directly paid for by firms, or;
  • Paid for by clients, from a separate and client-specific research payment account that is strictly controlled by the firm and used only for the purposes specified.  

In addition, firms must also continuously assess the quality of any research they purchase.

Strategic and operational implications

New fee structure. Firms are evaluating their products, to assess whether their offer portfolio remains aligned with their market and commercial strategies. Many considered that moneys received from activities falling into the category of inducements formed part of their regular income or fee structure. In the light of the new regulation, firms are reviewing what proportion of their profitability could be impacted. As an outcome of the review process, some financial products could become less attractive and dropped altogether. The changes also impact third party providers. They will need to define a different pricing strategy with distributors.

Timely disclosure. Whether they retain them or pass them on to clients, firms need to communicate the details prior to and after (and at least once each year) the execution of any transactions involving inducements. This situation creates an operational challenge. Not only do operational processes need to be adjusted (e.g. front-office), but also systems and reporting activities must be updated.

Policy set-up. Before making any decisions on strategic and operational impacts of changing rules, firms need to put in place a policy on inducements. This should establish a clear and shared corporate understanding of, first, what represents an inducement and, second, how an inducement should be handled internally. This is particularly important for large firms operating from multiple locations. The more complex and widespread the operations, the greater the need will be to allocate sufficient resources for harmonizing MiFID II with local regulation.

Implementation challenges. During implementation, it is important to keep in mind that inducements and investment research are interrelated with other MiFID II areas, including client reporting and cost and charges. Client reporting, for example, requires a degree of disclosure of cost and charges (ex-ante and ex-post transaction execution), as well as reporting to clients at prescribed intervals. This makes it vital to properly define and then integrate inducements and investment research into internal systems, so that reports disclosed to clients provide adequate labeling and correct details.

Are you MiFID II compliant?

Firms serious about becoming MiFID II compliant by January 2018 must now ask themselves a series of questions. The responses will identify whether the main aspects of inducements regulation are being covered. They will also help direct strategic and operational efforts going forward. The key questions are:

  1. Corporate policy. Do we have in place a compliant corporate policy on how inducements should be treated?
  2. Fee income status and structure. Which of the fees we receive will remain valid? Does the fee structure need to be changed?
  3. Disclosure and reporting. Are inducements disclosed to clients before execution? And are we generating regular and compliant ex-post reports?
  4. Service quality benchmarking. Are we documenting precisely how the quality of our services is being enhanced?
  5. Systemic compliance capability. Do our systems need to be adjusted to respond to regulation on inducements?

There are now just a few weeks left to test and deploy new operational approaches (formal compliance will start on 3 January 2018). And there are crucial choices to make around the specific MiFID II activities to address in 2018.

How ready is the industry?

Most financial institutions are not 100 percent ready and will not be by 3 January 2018.

Some banks are focusing on the most immediate aspects of compliance. For example, certain institutions have concentrated on making their own products MiFID II compliant while leaving action on third party products for later.

In many cases, initial compliance will be achieved through manual or tactical solutions. However, throughout 2018, the pressing need for strategic and automated solutions will remain. In addition, operations and technology infrastructure of financial firms will need to be monitored for accuracy of the newly implemented functionalities. For instance, firms would need to verify that new reports contain the mandatory fields and are sent out in timely manner.

Inevitably, compliance activity will ‘spill over’ into 2018, but it is imperative to act now. The regulator will acknowledge genuine work in progress, if it is clearly moving towards full compliance.

ͥ Fees that are necessary for the provision of financial services and activities are excluded (e.g. custody cost, settlement and exchange fees, regulatory levies, legal fees).

 

About the Author

Angel Baca

Angel Baca is a Consultant with the risk and regulatory compliance practice at Capco, based in Frankfurt. He specializes in regulatory compliance implementation projects with particular focus on business transformation, investment assessment and risk management.

 

 
 
 

The content and opinions posted on this blog and any corresponding comments are the personal opinions of the original authors, not those of Capco.