Whilst MiFID II does not change the categories of client, nor the various monetary thresholds and experience levels that eligible counterparties and professional clients are required to meet, there have been some fundamental changes to how municipalities and local public authorities are able to be classified. From 3 January 2018, they are no longer permitted to be eligible counterparties or per se professional clients. Unless the FCA changes its current qualitative and quantitative criteria for electing to be a professional investor, Local Government Pension Schemes (LGPS) may only be able to be classified as ‘retail’, clients, which would impose significant limitations in terms of the sorts of tools and investments available to them.
Current UK regime
Under the existing regime for MiFID business, a local authority may be categorised as a per se professional client if it meets the existing MiFID test for large undertakings. Where a client, such as a local authority, does not fall within one of the categories of client considered to be professional per se, it is by default categorised as a retail client. As a retail client, it has the ability to request to be treated as an elective professional client where it meets the specific ‘opt-up’ criteria. For non-MiFID business, local authorities are categorised as per se professional clients, subject to no restrictions.
MiFID II changes
Recital 104 states that municipalities and local public authorities should be excluded from the lists of eligible counterparties and professional clients, but such clients can still request treatment as professional clients provided they meet the qualitative and quantitative tests in Annex II. In addition, a new provision in Annex II, Section II.1 states that Member States may adopt specific criteria for the assessment of the expertise and knowledge of municipalities and local public authorities requesting re-categorisation to professional client, which criteria can be alternative or additional to those listed in the Annex. MiFID II does not provide a definition of ‘local public authority’ nor does it make any other amendments to Annex II as regards the client classification of pension funds.
UK implementation of MiFID II
According to the FCA, the changes under MiFID II mean that it is no longer possible to treat local authorities as per se professional clients on the basis of meeting the large undertakings test. According to its consultation paper from September 2016 (CP16/29), the FCA proposes to exercise its discretion to introduce either additional or alternative quantitative opt‑up criteria for local authorities. Under its proposals, firms would be required to apply certain qualitative and quantitative tests (as outlined below) and procedural steps when opting‑up local authority clients to professional client status.
In CP16/29, the FCA also proposed to clarify that the retail categorisation will apply to local authorities that 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, under the new proposals, firms will be required to categorise the local authority separately depending on the capacity in which it is acting (i.e. either as treasury manager or a pension fund administrator), and apply the opt‑up criteria separately to each business line.
Process for electing to be a professional investor
The FCA’s proposed process has two criteria (qualitative and quantitative requirements) in addition to the procedural requirements which the relevant funds that make up LGPS would need to demonstrate to each investment manager:
- to meet the qualitative criteria, the investment manager will need to be confident that the LGPS funds have the necessary “… expertise, experience and knowledge such that the LGPS funds are capable of making their own investment decisions and understanding the risks involved.“
- to meet the quantitative criteria, the LGPS funds will be required to meet the first condition below and either the second or third:
- the size of their financial instrument portfolios (including cash and financial instruments) must exceed £15m;
- the relevant funds must have carried out transactions, in significant size, on the relevant market at an average frequency of 10 per quarter over the previous four quarters;
- the fund must work or have worked in the financial sector for at least one year in a professional position which requires knowledge of the transactions and services envisaged.
Application to LGPS funds
The FCA’s handbook will amend the qualitative test set out above where the client is an entity by requiring the test to be performed in relation to the person authorised to carry out the transaction. However, this construct is not readily applicable for local authority pension schemes where the decisions are usually made by a committee, after taking appropriate advice and then implemented by an officer based on these instructions.
LGPS funds are unlikely to have any issue with the first limb of the quantitative test given most pensions funds are substantially larger than the threshold. The second limb is unlikely to apply to pension funds as they transact infrequently – a high volume of transaction could actually be a cause for concern. As a result, eligibility for elective professional status will depend on meeting the experience criteria laid down in the third limb. As currently drafted, this limb is unworkable for local authorities – whilst they can have “knowledge of the transactions and services envisaged“, they are not individuals who “work or have worked in the financial sector“.
Practical implications of these client classification changes
Unless the qualitative and quantitative tests are revised to reflect the nature and structure of LGPS funds, those funds will be classified as retail clients. It is likely that that classification would have a significant impact, with the following consequences possibly arising:
- a curtailment on the ability to use advanced portfolio management tools like liability and currency hedging;
- an inability to access the full range of investment products and services (as some managers only work with professional clients);
- an increase in costs as a result of the increased regulatory requirements and reduced range of options; and
- a reduced ability to invest in illiquid assets, for example, infrastructure.
Even if the LGPS funds are classified as elective professionals, this will still have an impact, on the basis that managers will not be able presume that the funds possess market knowledge and experience comparable to a per se professional client. Additionally, unlike a per se professional, it cannot be assumed that an elective professional client has the ability to financially bear any related investment risks consistent with his investment objectives if the service provided is investment advice.