31 Jul 2017

The countdown clock towards implementation of the revised Markets in Financial Instruments Directive and Regulation package (MiFID 2) has been running for quite some time. The battery has run low on several occasions, and has sometimes even appeared to stop, leading to the EU needing to postpone the transposition and effective dates of the changes.However, the batteries that both the EU and UK authorities have found in the past year are super-charged and we have seen a plethora of legislation, guidance, consultations and rules. As we write this article [this article was written in late June], we expect the final push from the UK regulators, so that all domestic legislation and rules are in place to meet the 3 July deadline, with measures taking effect by 3 January 2018.

So how does MiFID 2, a beast of EU legislation, affect British IFAs, the vast majority of whom have no clients outside of the UK? The answer is "a lot". In this article, Emma Radmore and Andrew Barber look at the key new rules MiFID 2 brings, and how changes to UK legislation and Financial Conduct Authority (FCA) rules affect IFAs.

What actually is MiFID 2?

MiFID 2 is the generic name for a complex web of legislation which comprises two EU Directives and three Regulations, backed up with a raft of technical standards, and guidance from the European Securities and Markets Authority (ESMA). The measures adopted by Regulation are directly applicable in Member States. To implement the other standards, and to embellish on the requirements, national legislation and supervisory requirements is set down by the competent authorities in each Member State.

The UK implementation package runs to thousands of pages of consultation, and will result in significant changes to some rules.

What does MiFID 2 do?

The current MiFID dates back to 2004 (and has been in force with few updates since late 2007). So it not only pre-dated the financial crisis, but also did not contemplate many business models and technologies that have become commonplace. So it was in dire need of an update and, in drafting the new provisions, the EU legislators took the opportunity to beef up several existing requirements.

Of most interest to financial advisers are the provisions that enhance the quality of authorisation and conduct of investment firms, by imposing greater prudential requirements in terms of management bodies, systems and controls, and greater investor protection requirements, in terms of categorisation of and disclosures to clients, product governance and treating customers fairly.

What about firms that have a purely UK client base?

Many IFAs may think (or hope) that MiFID 2 will not really affect them, as they are purely UK businesses with a client base also solely in the UK.

Unfortunately, this is not the case. Any firm that meets the MiFID definition of "investment firm" must comply with all MiFID (and MiFID 2) requirements, even if it is a purely domestic business. Many IFAs in the UK, though, are currently what is known as "article 3 exempt" firms. This is, essentially, a status available to firms that carry on only a limited range of MiFID activities – and enables them to choose whether to be treated as an "investment firm" or not. 

Under MiFID 2, "article 3" or "exempt investment" firms must meet all the following criteria:

  • Not be allowed to hold client money or assets, and therefore cannot owe their clients' money
  • Limit their business to "arranging" and "advising" on certain investments only – they cannot, for example, execute deals for their clients or provide discretionary management services
  • In the course of that business, transmit orders only to regulated investment firms or credit institutions (or their third-country equivalents), authorised UCITS or other regulated funds, or listed investment companies with variable capital (such as investment trusts).

Any firm that cannot operate within these constraints will need to be an "investment firm." Many firms that do not wish to be limited in their order transmission will be "investment firms" but will be categorised as "exempt CAD firms". These are firms whose permissions are also restricted to providing investment advice and/or receiving and transmitting orders, without holding client money or securities or providing custody services. But exempt CAD firms may transmit orders to a wider range of persons than those listed in Article 3 and can provide services in relation to derivatives that are not transferable securities. Their status means they can benefit from a favourable capital requirements treatment, as they were traditionally exempt from the Capital Adequacy Directive (the forerunner of CRD IV).

Any firm providing, for example, dealing or discretionary management services will fall within both MiFID 2 and CRD IV, and its capital will in principle be higher, with a base requirement depending on the precise activities it carries out.

IFAs should by now have assessed their businesses to check they are correctly categorised. Any firm needing to vary its permissions (to switch from being an article 3 firm to a MiFID firm, should have applied to FCA to do so by 3 July 2017, in order to be sure FCA will have determined the application by January).

Consequences of being an article 3 firm

Unfortunately, being an article 3 firm and choosing to be exempt from MiFID does not mean that less onerous rules can apply as a matter of course. MiFID 2 includes a requirement that Member States cannot be seen to favour firms that are not MiFID firms. So FCA is bound to apply rules that are "at least analogous" to the relevant MiFID 2 requirements in many cases.

In addition to changes to legislation, for which Treasury is responsible, FCA has to date published one discussion and five consultation papers on MiFID 2 implementation and, as at the date of writing this article, only one feedback statement. From the consultations, there are, as a result of the "at least analogous" requirement, likely to be only a few significant differences in how FCA will treat MiFID firms and Article 3 firms in respect of the key conduct of business and systems and controls rules. However, particularly in relation to the Conduct of Business Sourcebook (COBS), FCA has in the main divided each chapter into a main chapter and a chapter for MiFID firms. These latter chapters usually, but not always, apply also to Article 3 firms – but firms need to check in each case which rules they must follow.

Among the key rules that are expected to treat Article 3 firms in the same way as MiFID firms are those on:

  • client categorisation, agreements and disclosure requirements
  • inducements, including adviser charging
  • independence and suitability
  • product governance (insofar as firms distribute products which are MiFID 2 financial instruments)
  • knowledge and competence.

Rules where FCA is planning to apply some discretion include

  • recording of telephone conversations and electronic communications (taping): FCA's original proposal was to apply a taping regime to Article 3 firms but, in an update at the end of March, FCA indicated it would allow retail financial advisers to comply with the requirement by either taping all relevant phone calls or taking a written note of them. This is likely to be of critical importance to IFAs.
  • appropriateness: FCA proposes to continue to apply the existing rules to Article 3 firms
  • systems and controls rules: many of these will apply as guidance, rather than rules, but certain key requirements, such as those on conflicts of interest, will apply as rule.

The Brexit effect – or lack of it

Does Brexit matter? Actually, no, it doesn't. For one thing, if nothing else about Brexit has been clear, the Government and regulators have been adamant that, until the moment the UK leaves the EU, it is a member, and as such will comply with all relevant laws. As a jurisdiction which has traditionally implemented EU measures on time, it has always been the plan to implement MiFID 2 on time, and for firms operating in the UK to be compliant by the deadline.  Whatever happens with the negotiations, the UK will still be a member of the EU on 3 January 2018, so firms must comply with the changes to UK laws and regulations. So there is no time to waste!

What should firms be doing?

All IFAs, whether they are article 3 firms or MiFID investment firms, should by now have reviewed the proposed changes to FCA rules, and carried out a RAG analysis to assess where their business is most impacted.  They should by now have a plan and timetable for making appropriate changes, including to allow enough time to make all appropriate notifications to clients and have MiFID 2-compliance customer documentation in place by 3 January 2018.

First written and published for Financial Adviser