With 3 January 2018 fast approaching, we consider four of the key challenges that will be faced by the fund management industry over the next few months in order to implement MiFID II on time. Whilst the industry is still waiting for final rules in the UK, much of the detail is now known and implementation projects should be accelerated to ensure that requisite changes are made and bedded in to allow timely compliance.
Whilst many fund managers fall outside the direct remit of MiFID II, we highlight here some aspects of it which will be applicable. The rules will also be applicable to any MiFID firms in the fund industry, such as advisers/arrangers to an offshore structure. It is worth noting that the FCA has historically gold-plated lots of European rules and may well extend scope as regards MiFID II as well.
1. Inducements and investment research
A much talked about subject of MiFID II for the fund management industry has been the rules requiring a separation of research fees and dealing commission. It is clear that it is still an issue that is being grappled with so the below provides an overview of the options available.
The current regime
The FCA’s rules on the use of dealing commission are set out in COBS 11.6 and build upon the general rule on inducements. COBS 11.6 prevents investment managers from using dealing commissions paid to brokers to execute orders in equities or equity‑related derivatives to acquire any additional goods or services in return for those charges where they are passed onto their customers’ funds.
The rules provide a limited exemption to this ban, to allow investment managers to acquire third party goods and services in return for execution charges paid by their clients if they are either directly related to the execution of trades, or amount to the provision of substantive research. Those additional goods and services must also reasonably assist the investment manager in the provision of its services to customers and must not impair a firm’s duty to act in the best interests of its customers. Investment managers must also make prior and periodic disclosures to their customers of any dealing commission arrangements they have in place.
MiFID II prohibits firms that provide portfolio management services from receiving any inducements in relation to these services to clients, except for minor non-monetary benefits. The level 2 measures, which provide the detail on the high-level inducements rule, have been through several iterations over the last two years. In April 2016, the fund management industry finally received some much needed clarity on how managers could receive research from third parties in a way that does not contravene the inducement rules.
Whilst the delegated directive adopts ESMA’s original proposal, that the receipt of research by a manager should be treated as an inducement – principally a non-monetary benefit, the level 2 measures also provide that research can be received if it is paid for either:
- directly by the manager out of its own resources (whether funded itself or by increasing the annual management charge if this is a realistic option); or
- from a separate research payment account (RPA), which meets detailed conditions.
A key element of this debate has been whether the industry can continue to use Commission Sharing Agreements (CSAs). A defining feature of the CSA is that a single commission payment is made with the execution and research charge components being paid side-by-side in a pre-agreed split. During negotiations with ESMA, the industry believed the CSA would no longer be compatible with the new rules but the text of the delegated directive appears to allow the CSA to be used as part of the RPA. The text acknowledges that the amount that will fund an RPA can be collected using a transaction-based research charge, provided that it is separate from the transactions commission. While this provision appears to permit the continued usage, the manager must identify the research charge in advance and its use will be subject to stringent quality assessment criteria, transparency and reporting obligations. Additionally, to be compatible with the RPA requirements, existing CSAs will require amendment and/ or renegotiation in a number of respects.
Detailed requirements will apply if a firm wishes to make use of RPAs, instead of paying for research from its own resources:
- the RPA must be funded by a specific charge to the client (whether separately from other charges or together with commission);
- the manager must implement a policy for valuing research, allocating its value between portfolios, and assessing a research budget, using quality criteria, an audit trail and senior management oversight;
- the manager must regularly assess the quality of the research purchased based on robust quality criteria and its ability to contribute to better investment decisions;
- the manager will be held responsible for the RPA, although a degree of delegation is possible, which may be helpful in ensuring that the manager does not have to treat cash held in the RPA as client money under the FCA rules; and
- the manager will need to seek the client’s express agreement to the use of the RPA as well as be subject to detailed up-front and on-going disclosure requirements.
In its consultation paper, the FCA noted that the MiFID II regime will be wider than the scope of the current COBS 11.6 (which only applies to third party benefits received by managers in relation to executing orders on behalf of their customers in equities or equity‑related derivatives) in that it also applies broadly to any material third party benefits received by a firm providing portfolio management services involving any MiFID financial instrument.
Do these rules apply to fund managers?
The FCA is consulting on whether to apply the research and inducements requirements in MiFID II to MiFID-exempt UK authorised firms carrying out investment management of collective investment schemes, which includes:
- UCITS management companies;
- full‑scope UK AIFMs;
- small authorised AIFMs and residual collective investment scheme (CIS) operators; and
- incoming EEA AIFM branches.
These firms are currently subject to COBS 11.6, under application provisions set out in COBS 18.5. The FCA is proposing a similar approach in substance based on the new MiFID II inducements and research standards.
2. Best execution
The best execution provisions under the current MiFID regime and COBS 11.2 require firms to take “all reasonable steps” to obtain the best possible results for clients and to establish, implement and monitor effective arrangements for best execution, including an order execution policy. The new MiFID II best execution rules will be included in the FCA Handbook in a new COBS 11.2A chapter and copy out the delegated regulation on point even though it is directly applicable in the UK. The rules will add to the current regime by increasing the compliance threshold to “all sufficient steps“, and by seeking to improve transparency for clients, in particular, by requiring further disclosures.
One of the major changes in MiFID II is that MiFID firms (including adviser/arrangers in a fund structure) will need to publish an annual report (in differing formats for retail and professional clients) containing:
- a list of the top five execution venues they have used for each class or sub-class of financial instrument in the preceding year;
- a separate report of the top five execution venues for any securities financing transactions; and
- a summary of the outcomes which have been achieved (which must give enough meaningful information for clients to be able to effectively evaluate the firm’s execution practices).
Firms must determine the top five execution venues in terms of trading volumes based on executed client orders, and publish details of the percentage of orders which were passive or aggressive. The summary of outcomes should include a number of points, for example the importance given to factors such as price and speed, a description of any conflicts of interest, and how order execution differs according to client categorisation.
Where a firm only uses one execution venue, it will be required to show, using execution quality data or internal analysis, that this consistently delivers the best possible results which are as good as the results which could reasonably be expected if alternative venues had also been used.
The deadline for each report is 30 April following the end of the period to which the report relates, with the first report to be provided by 30 April 2018.
Do these rules apply to fund managers?
Importantly for fund managers, the FCA’s consultation paper proposed that the requirement to publish this annual report will also be extended to full scope UK AIFMs where they execute on execution venues (e.g. a regulated market, multilateral trading facility or market maker). If your firm is a full scope AIFM, complying with the new reporting requirements is likely to have a significant impact on your business (including where you are using only one execution venue). In addition to the existing order execution policy requirement which has been refined to ensure that firms provide clear and sufficient details, you will need to consider now whether you have sufficient systems and processes in place to be able to capture the data prescribed by the technical standards and publish that data on your website in template form as prescribed by the standards. You will also be expected to be aware of new execution venues and to take into account changes in the market regarding execution services. The FCA is also considering whether to extend the other best execution changes under MiFID II to full scope AIFMs, so you should look out for any further FCA publications on this issue.
The FCA has decided not to extend the new MiFID II best execution rules to small authorised AIFMs of unauthorised AIFs or operators of residual CISs. They currently may be able in any case to exempt themselves from best execution requirements where they only deal with professional clients (and the fund documents specify the obligations are dis-applied). However, if your firm is a small authorised AIFM, you should note that the FCA is planning to consult on whether any of the new MiFID II best execution provisions should be applied to small authorised AIFMs in the future. If you will be making the transition to becoming a full scope AIFM, you will also need to take steps in good time to ensure that you will immediately be able to comply with the new best execution regime.
3. Transaction reporting
One of the most time-consuming and expensive areas of overhaul from the current regime comes in the form of stricter requirements on trade and transaction reporting. According to a recent article in the Financial Times: “Europe’s largest asset managers are expected to spend an average of €10.3m each to make sure they comply with MiFID II — and additional reporting requirements are expected to account for a large chunk of that.”
The scope and depth of what is required to be reported will increase significantly, with the number of fields within the reports increasing from 23 to 65 fields.
Currently, transaction reporting applies only to MiFID firms that execute transactions in financial instruments admitted to trading on EU regulated markets. For UK firms, the FCA gold-plated the MiFID requirements by applying the reporting obligation to OTC derivatives that have EU listed financial instruments as an underlier. The Markets in Financial Investments Regulation (EU 600/2014) (MiFIR), increases the scope so that it will apply to all transactions in financial instruments that are admitted to trading on regulated EU trading venues and any financial instruments (listed or OTC) where the underlying is a financial instrument that is admitted to trading on such an EU trading venue. The reference to ‘trading venue’ will extend the obligation beyond regulated markets to multilateral trading facilities and organised trading facilities. The timing remains the same, with reports required within one business day of the trade date.
The current reporting regime contains a carve-out for firms that rely on others to make transaction reports on their behalf. The fund management industry has historically appreciated both the FCA’s generous interpretation of this carve-out and certain regulators in other jurisdictions taking the view that only the entity directly facing the trading venue is required to report. Under MiFID II, the position has been clarified to confirm that the reporting obligation applies to MiFID portfolio managers. As a result, a key focus for the industry over the next few months will be identifying when they can rely on others to report on their behalf.
Where managers transmit orders to EU-regulated brokers for execution, they will continue to be able to rely on the broker to report, provided that they submit certain information to the broker and there is a formal ‘transmission agreement’ in place. These will take time to negotiate and work should, realistically, already be under way. Where the manager executes their own trades or uses non-EU brokers to execute, it will either need to submit reports itself or use an approved reporting mechanism.
As well as a substantial increase in the number of data fields for each report, some of those fields will be problematic – for example, identifying the individuals that originated the decision to trade and who execute it. Managers should therefore not only be assessing how they will report, but also finalising what information they need to report and revising systems to be able to capture all elements required. This should take into account the examples published by ESMA last October as part of their guidelines.
Do these rules apply to fund managers?
The transaction reporting requirements under MiFIR do not apply to EU AIFMs when carrying out portfolio management (and related execution) activities for the AIF for which they act as AIFM. In the first MiFID II consultation paper (15/43), the FCA proposed that AIFMs should be entirely exempt from transaction reporting under MiFIR, even in respect of managed account business. This is contrary to what had been expected as the industry had expected gold-plating in relation to AIFMs, at least in respect of portfolio management activities.
Recording of telephone conversations and electronic communications:
MiFID II introduces extensive rules on recording telephone and electronic communications, which will require particular focus during implementation projects and beyond. The basic principle is that communications and conversations must be recorded if they relate to “transactions concluded when dealing on own account and the provision of client order services that relate to the reception, transmission and execution of client orders”. The obligation applies to conversations and electronic communications relating to transactions that are concluded and also to those which are intended to result in a concluded transaction (even if not ultimately concluded).
In the UK, the FCA has had in place a regime relating to this kind of recording since 2009, which is currently set out in COBS 11.8 and applies also to non-MiFID firms undertaking relevant trading activities. This current regime is similar to what is proposed in MiFID II – COBS 11.8 requires firms to record and keep records of telephone conversations and electronic communications about certain trading activities for six months, alongside discouraging mobile phone use where this prevents such recording.
MiFID II goes further than the current FCA regime in several important areas:
- Internal calls – the delegated regulation confirms that the obligation to record applies not just to conversations between a broker and a third party but also to internal telephone conversations, for example, where an investment manager instructs an internal execution desk to execute an order.
- Retention – the retention period is longer than the FCA’s existing regime of six months. Under MiFID II, records must be stored for five years, with the option for the competent authority to extend the requirement to seven years in specific cases, which the FCA is intending the avail itself of.
- Monitoring – from January 2018, firms will be required to periodically monitor the electronic records and recordings of telephone conversations. Whilst the regime allows for a proportionate and risk based approach, this will be a significant drain on compliance resource.
- Face-to-face conversations – whilst firms can choose the form of written record (e.g. written notes or minutes), provided it is in a durable medium, the obligation to record ‘all relevant information’ when receiving orders during face-to-face conversations will likely require revision to existing practices.
Do these rules apply to fund managers?
In consultation paper 16/29, the FCA proposed to delete COBS 11.8 and replace it with a new chapter in SYSC, with the aim of ensuring that all MiFID organisational requirements are in one place with senior management responsibility aligned. The regulator also proposed to apply the recording regime to a wider range of activities than those required by MiFID II, in order to keep it in line with the current domestic regime. This means that the following will be subject to MiFID II extensions discussed above:
- the service of portfolio management – the FCA will remove the current qualified exemption for discretionary investment managers; and
- the activities of collective portfolio managers (full-scope UK AIFMs, small authorised UK AIFMs and residual CIS operators, incoming EEA AIFM branches and UCITS management companies).