MiFID for asset managers

A look back at the steps asset managers should be taking now

It would be difficult to not have noticed that the financial services industry has stopped simply talking and has started to implement the Markets in Financial Instruments Directive II (“MiFID II”). MiFID II will replace the current MiFID (“MiFID I”) as the framework legislation that regulates a significant proportion of firms providing investment services and activities in the EU including many asset managers. In this article we set out some of the key issues that asset managers should be considering.

Background

MiFID II comprises a regulation (MiFIR) and a directive (the MiFID II Directive), collectively known as MiFID II, as well as regulatory technical standards and EU guidance that runs to thousands of pages. In addition, each member state must implement MiFID II and so there are different interpretations and gold-plating in each jurisdiction. MiFID II is a significant change as it substantially alters and expands many of the current MiFID I obligations. “MiFID investment firms” – those authorised and regulated under MiFID need to undertake a significant amount of work to ensure compliance. MiFID II will come into effect from 3 January 2018.

MiFID II will have a substantial impact on the asset management industry regardless of whether a firm is regulated under MiFID, AIFMD or UCITS (or a combination). While not directly applicable to the latter two types of firm there is significant gold-plating by regulators (including the FCA) to ensure many rules apply equally to AIFMs or UCITS management companies. It is also likely that firms and market operators will require changes to arrangements to ensure that they can comply with their own obligations thus indirectly affecting asset managers.

Whilst final rules (and national implementation of these rules) are still being finalised there are some key areas where asset managers must start working towards implementation. We have highlighted below certain areas where asset managers will be required to build new systems, controls, processes and / or policies. In many cases asset managers will need to engage with their counterparties and third party providers.

Product governance

MiFID II introduces new obligations for firms to have appropriate systems and controls for the design, marketing and ongoing management of “products”. Under MiFID II, an asset manager may be viewed the “manufacturer” of a product that it manages. The manufacturer is responsible for:

• ensuring that the product is designed to meet the needs of an identified target market;
• the strategy for distribution is compatible with the identified target market; and
• taking reasonable steps to ensure that the financial instrument is distributed to the identified target market.

These manufacturer obligations will require asset managers to have a product approval process to specify an appropriate target market and ensure relevant risks are identified. This includes product testing, including assessing the risk of poor outcomes and the circumstances that these might occur (such as during a period of market deterioration or commercial unviability of the fund).

Most European distributors such as placement agents (and also many asset managers themselves) are MiFID firms and so are under obligations to understand the products they distribute, assess the product’s compatibility with an identified target market and are required to distribute products only when in the best interests of the client (investors). This means distributors will need to put in place effective arrangements to obtain from the asset manager any necessary information about products.

The rules take into account proportionality, so for simpler products the assessment of the target market is less granular. Likewise, for asset managers that provide products only to professional investors this will require limited work. However, if complex funds are sold to natural persons through distribution channels a more detailed assessment will need to be undertaken. A related, but separate piece of legislation, Packaged Retail and Insurance-based Investment Products KID Regulation (“PRIIPS”), is also coming into effect on 3 January 2018. This will require asset managers to provide a pre-contractual disclosure document (a key information document or KID) to retail persons prior to the retail investor making an investment in the fund.

ACTION:  Asset managers might start considering the necessary approval committees and ensure that they can justify their product governance arrangements as appropriate

Research unbundling / prohibition on inducements

Under the MiFID II inducements regime, asset managers will be prohibited from receiving “free” or “bundled” research (with some very limited exceptions). Instead, MiFID II requires asset managers to purchase research and execution services separately (and for sell-side institutions to unbundle their execution and research charges). This will require decisions by asset managers on their research strategy and commercial negotiations with research providers. Asset managers should consider what research they are willing to purchase.

There are (broadly) two models for purchasing research, either (i) direct payments by the asset manager out of its own resources (profit and loss model) or (ii) payments from a separate research payment account (“RPA”) controlled by the investment firm. For an RPA, a number of conditions relating to the operation of the account must be met (for instance the RPA can only be funded by a specific research charge to the client and requires appropriate disclosures to clients). Setting up the RPA will require new systems and controls for asset managers.

ACTION:   A key consideration for asset managers over the forthcoming months will be the research they are willing to pay for and how they want to fund it. Implementing internal systems and procedures for RPAs will require discussions with the sell-side.

Transaction reporting

There are potentially significant developments in an asset manager’s transaction reporting obligations under MiFID. Whereas currently the buy-side does not (generally) transaction report (rather the broker does) – this will no longer be possible under MiFID II.

This is a key area for asset managers who must assess the extent to which they will execute transactions (i.e. when they undertake reception and transmission, execution or making an investment decision). Asset managers will need to have IT systems that can generate and submit relevant reports as well as detailed information from clients. While other MiFID firms will have been subject to the current (less onerous) MiFID transaction reporting obligations this is likely to be a new obligation for asset managers and will require significant effort to build systems.

Helpfully, the FCA has stated that they will exclude AIFMs from this obligation entirely (including those with top up permissions).

ACTION:  For affected firms building appropriate IT systems will be substantive and take months. It is recommended that firms engage with counterparties and providers as soon as possible.

Costs and charges

MiFID II introduces more detailed cost and charges disclosures for asset managers. The regime is also extended to professionals and eligible counterparties (albeit with some opt outs available). There is now detailed post-sale information to be provided.

ACTION:  For asset managers without a retail base there is again a requirement for new systems and controls. Firms should be identifying how they will provide adequate disclosure on a timely basis.

Looking to the future - AIFMD 2

As noted, it is likely that many of these rules will be “copied” into AIFMD 2 in the future. ESMA has made it clear that the research rules and product governance rules should be applied to AIFMs and so in jurisdictions where there is no gold-plating this is likely to change. There are many other obligations in MiFID II such as telephone taping, client reporting, and costs and charges that may be implemented into AIFMD 2.

Insights

• Asset managers will be required to comply with new rules on a number of areas.
• Some of these changes, such as new transaction reporting rules, require substantial systems build.
• Firms not authorised under MiFID such as AIFMs may also be affected by gold-plating or by counterparties requiring changes to business terms.