EU Retail Investment Services The regulatory onslaught quickens

ESMA recently released its Final Report on the EU Commission mandate relating to retail investor protection (the "Report"). The Report primarily serves as a forecast of the regulatory direction of travel, with ESMA making recommendations to the EU Commission on where it should be given a new or increased mandate to regulate retail investment services. However, the Report also takes the opportunity to engage in some regulating by the back door, highlighting how existing MiFID II obligations around clients' best interests, the "clear, fair, not misleading" rule and product governance should be "interpreted" in light of recent technological and marketing developments in the retail investment market.

In short: expectations are increasing at pace.

While ESMA's recommendations do not go as far as the UK in suggesting the imposition of a consumer duty, they are in the same ballpark, and arguably are wider ranging in the areas they cover (so wider if not deeper). We have highlighted some of the key observations and recommendations below.

Machine readability and disclosure requirements

ESMA gets off to an uncontroversial and slightly technical start, recommending introducing a requirement for regulatory disclosures to clients required under MiFID to be machine readable, to cater to the needs of a changing retail market. Machine readable disclosures are seen to benefit portfolio management apps, robo advisors, comparison websites, pensions dashboards etc. by allowing greater integration.Separately, ESMA believes that the discretionary power of Member States to choose the format to make certain disclosures under Article 24(5) MiFID is not conducive to creating a single market for financial products and services. As a result, ESMA advises that a standard EU format for disclosures should be developed, particularly in relation to costs and charges.

Query: is this another KID coming?!

ESMA also recommends amending the best execution and conflicts disclosures so that these do not need to be addressed directly to clients, provided they are freely available on a firm's website.

Marketing communications

ESMA acknowledges the importance of marketing information and specifically calls out "anchoring bias", which is the phenomenon whereby people are over reliant on the first piece of information they receive. This is similar in theme to the FCA and "behvioural economics". ESMA also makes clear that it views younger, less experienced investors as "particularly vulnerable", noting that they are especially targeted by social media – both in the sense of engaging with social media influencers but also through the receipt of private messages sent on social networks. Again, vulnerability is a priority topic for FCA.

As a result, ESMA advises that new guidance (such as ESMA Guidelines) should be issued to complement and integrate existing rules in this area. Such guidance is proposed to cover when/where marketing communications shall be considered unfair. As part of this proposal, ESMA also draws attention to its Q&As issued in respect of marketing communications for CFDs and other speculative products – stating that it believes sections of those Q&As could be broadened so that they are applicable to all products. In particular, ESMA advise that the following practices are not compliant with MiFID II requirements and should be explicitly called out as such:

• selectively presenting in e-mails, on websites or social media only the potential returns of products (in favourable scenarios) without presenting in an equally prominent manner risks, costs, and mandatory warnings;
• website content or information presented in languages that are not official languages of the country where the services are to be provided, or presented in the official language(s) of the countries where the services are to be provided but that are based on translations of insufficient quality;
• information spread over multiple different webpages or documents in such a way as to complicate its readability and comprehensibility (one example of this practice is firms attempting to hide risks and costs of the products by directing (potential) clients through various hyperlinks);
• suggesting complex products are suitable or appropriate for all investors, or suggesting an investor can become experienced through limited training provided a by a firm/website; and
• stating or implying that a firm is authorised by an NCA in one jurisdiction when it reality it is authorised elsewhere and relying on passporting to operate in that jurisdiction.

ESMA also acknowledges the difficulty in monitoring new forms of marketing communications, especially the use of social media influencers. It states that firms' control functions and senior management must be more deeply engaged in ensuring the compliance of these communications, noting that the principles it sets out apply to third parties (e.g. influencers) as well as regulated firms, although responsibility for marketing communications remains with the regulated firm. In light of this, ESMA advises that new guidelines should be introduced to clarify that:

• mandatory controls should be performed by compliance on the content of marketing communications and periodic reporting provided as MI to management bodies;
• these controls should include verifying that marketing communications (such as social media posts) are actually issued in the same form as approved;
• all such processes and controls should be documented by firms; and
• the firm has to ensure a proper record keeping process including social media posts by third parties whether paid or incentivised through non-monetary compensation through the firm, even if those (social) media posts encompass statements that are only online for a limited amount of time or can only be accessed by a group behind a log-in or invitation-only.

In an increasing hard-line approach on this type of marketing, ESMA describes it as "aggressive" and suggests a clarification to Article 69 MiFID to allows NCAs and/or ESMA to take effective action against the marketing of high risk/complex products more swiftly.

Again, FCA has taken similar action and the ASA has also recently rolled out new rules. In short: social media marketing is high risk and subject to material NCA interest.

ESMA notes that the input it received was that aggressive marketing practices were observed especially by CFD providers, zero commission brokers and non-regulated crypto providers – giving a further indication of who these measures are predominantly directed at.

"Vital" information

Linked to its observations on marketing, ESMA draws attention to the information overload (query: ESMA is often the cause of this overload!) it perceives to apply to retail customers and proposes to address this by "layering" information, with "vital" information forming the first layer. ESMA proposes that vital information be disclosed in all marketing communications.

While ESMA recognises that it is not easy to determine what is vital information, it suggests it might include:

• key product features and objectives (including on the possibility of capital loss or conditions for early exit);
• risk information; and
• total costs/fees.

ESMA's recommendation is that vital information should be prominently disclosed in all marketing communications to clients "even when these are in the form of extremely brief social media messages".

Query: does this indirectly ban certain marketing?

PRIIPs and MiFID disclosure alignment

ESMA considers that the MiFID II ex-ante costs and charges requirements should be clarified, bringing them in line with the approach as required under PRIIPs.

When providing ex-ante information on costs and charges, a firm should provide the information for a holding period of one year assuming that the client will sell the financial instrument after the first year. For this first year, firms should assume a net performance of zero. For products with a maturity of less than one year, the ex-ante information on costs and charges should be shown for the maturity of the relevant product, also assuming a net performance of zero.

Query: This appears overly complex to us and in danger of creating problems they are seeking to solve!

Digital disclosures

ESMA has also carried out an assessment of digital disclosures. One of the key points which can be drawn from this is that ESMA appears to be moving towards a customer-outcome approach, similar to that which we have seen proposed under the UK's consumer duty. ESMA implies that disclosures are not sufficient, stating that "merely providing (potential) clients with the required disclosure information does not mean that the clients are able to process all information to make the best possible decision" – noting that customers often click through disclosure notices without reading them.

ESMA reiterates that firms should ensure that disclosures should be drafted/formatted in a way which is suitable for the target market of the financial product, noting that the effectiveness of disclosures can benefit from the application of product governance requirements. By way of (a somewhat condescending) example, ESMA advises that when dealing with younger clients, the use of illustrations, cartoons, animations and other media can be used to tailor the user experience to the target market regarding financial disclosures. IS this a joke...?!

In further homage to the UK consumer duty proposals, there is a suggestion that ESMA may require firms to use their customer data to specifically target behaviour. ESMA states that data on the time customers spend reading disclosures, time spent making investment decisions and data derived from customers' cookies could be used by firms to inform clients (e.g. through pop ups) when they are about to engage in behaviour that may not be in their best interests.

As a more general comment, ESMA's recommendation is to use layering and navigation menus to help customers more around financial and risk disclosures more easily. In addition, ESMA point out that firms' terms of business are often long and it may be prudent for firms to provide their terms of business (which are a contractual document) separately from regulatory disclosures and risk warnings so as to reduce information overload on customers.

Another significant proposal is that ESMA be permitted to issue guidance requiring firms to monitor the effectiveness of disclosures and risk warnings, and take action where they identify that these are not read by customers.

If ESMA receives its mandate in this area, we can expect far more onerous obligations on firms. The idea of targeting disclosures at clients based on bespoke data around engagement with similar disclosures and risk warnings is clearly a marked step change from current norms.

Social media and influencers

ESMA's comments clearly reflect their alarm at the rising influence of social media and influencers in financial services. ESMA states that social media addresses investors who tend to be more financially illiterate and that such investors need to be protected from "addictive gamification".

As expected, the events surrounding the surge in value of Gamestop ("Gamification" see further below) is at the top of the agenda – ESMA name check this event specifically, noting that it demonstrated investors can use social media to coordinate strategies which can lead to not only high volatility but even threaten financial stability.

On influencers, ESMA is aware of their increasing use and indicates that it considers that so-called "finfluencers" rarely post in an objective and/or neutral manner, nor are they typically experienced or knowledgeable of finance matters more generally.

As a result, ESMA recommends that the European Commission provide it with a mandate to develop guidelines to regulate the use of social media by regulated firms. Additionally, ESMA is recommending it be provided the power to enforce risk warnings (as currently in force for CFDs) on other high-risk products more easily, and advises that they should be imposed on relevant social media posts and messages too, reminding firms social media posts remain in scope of current rules.

Customer journey and gamification

ESMA acknowledges that firms use "nudging" techniques to drive customers to certain behavioural choices, some of which can have negative consumer outcomes. However, ESMA also notes that the same behavioural tendencies can be used to improve consumer outcomes – highlighting specifically "sludges" and "cooling-off" periods which can be used to slow down clients as they move through the customer journey. ESMA underlines the importance for firms of ensuring that their customer journey and choice environment makes it easier for investors to make sensible investments and decisions in line with product governance requirements.

Although ESMA notes that Article 24 MiFID II already requires firms to act in the best interests of clients, it concludes that it should be given a mandate to further develop requirements for firms to use digital techniques and tools in their sales process in a manner which advantages the client.

Gamification is another issue specifically addressed by ESMA. It highlights the issue of gamification in retail services and points out that it is difficult for firms to demonstrate adherence to their product governance obligations if they are "nudging" clients towards products which are inappropriate or unsuitable for specific clients. ESMA suggests that where firms carry out this kind of nudging, a suitability assessment may be required to ensure that clients are being pointed in the direction of the right types of financial instrument for them. This cannot be correct in law... but it is clear what ESMA thinks. It further clarified that gamification tactics, such as push notifications, form part of distribution strategies and so fall within the remit of the existing product governance regime.

ESMA takes an even stronger tone on gamification when it comes to its recommendations, stating that firms' product governance arrangements should clearly set out the various aspects of its distribution strategy (including gamification tactics used) but that ESMA believes gamification techniques which are intended to nudge retail clients to undue risk taking and/or which result in addictive behaviour are never in the best interests of clients and therefore breach existing MiFID II requirements.

Payment for order flow (PFOF)

Again pointing to Gamestop, ESMA uses this case as an example of zero-commission brokers and PFOF being thrust into the limelight before concluding that it considers it unlikely that PFOF is compatible with MiFID II and the delegated acts due to the conflict of interest between firms and their clients, caused by the incentive for the firm to choose the third party offering the highest payment rather than the best possible outcome for its clients.

However, ESMA then appears to row itself back slightly, saying that although it has serious investor protection concerns around PFOF, it could not conclude that PFOF is "entirely incompatible" with MiFID II but that nevertheless it considers that it is in most cases unlikely to be compatible. This is likely due to the current disagreements in Europe about the role of PFOF in the EU – a point reflected by ESMA's admission that the responses it received on PFOF were "quite divergent".

ESMA concludes by recommending that the EU Commission ban PFOF across the EU, bringing the position into convergence with that of the UK

Zero commission brokers

ESMA stresses that zero commission brokers should provide clients with information on costs and charges, noting that they have consistently been recognised as carrying out overly aggressive marketing and advertising.

EMSA also notes that securities lending in relation to retail clients' financial instruments increases the risk incurred by retail clients and stringent MiFID II requirements apply in such cases – and that such practices "might require further analysis".