Lecture 9: Principles of Investment Service Regulation and Investor Protection - PDF

Lecture 9 Principles of investment service regulation and investor protection Diego Valiante, Ph.D. Opinions e...

Lecture 9 Principles of investment service regulation and investor protection Diego Valiante, Ph.D. Opinions expressed are strictly personal and cannot be LEIF Master Programme attributed in any way to the European Commission.  Agenda General investment service provision framework – Principles and regulatory objectives Investor protection in investment services CoB rules – KYC and KYP rules – Investment advice (case study) – Transparency to clients – Best Execution Key organisational requirements © Valiante Diego - 2  General EU framework for the provision of investment services © Valiante Diego - 3  ‘Core’ investment services (section A, Annex I, MiFID II) (1) Reception and transmission of orders in relation to one or more financial instruments; (2) Execution of orders on behalf of clients (execution only services); (3) Dealing on own account; (4) (Individual) Portfolio management; (5) Investment advice; (6) Underwriting of financial instruments and/or placing of financial instruments on a firm commitment basis; (7) Placing of financial instruments without a firm commitment basis; (8) Operation of an MTF; (9) Operation of an OTF. ✓ 3, 8 and 9 are investment activities or market operations ✓ 6 and 7 are mainly services at issuance © Valiante Diego - 4  Financial instruments (section C, Annex I, MiFID II) (1) Transferable securities; (2) Money-market instruments; (3) Units in collective investment undertakings; (4) Options, futures, swaps, forward rate agreements and any other derivative contracts relating to securities, currencies, interest rates or yields, emission allowances or other derivatives instruments, financial indices or financial measures which may be settled physically or in cash; (5) Options, futures, swaps, forwards and any other derivative contracts relating to commodities that must be settled in cash or may be settled in cash at the option of one of the parties other than by reason of default or other termination event; (6) Options, futures, swaps, and any other derivative contract relating to commodities that can be physically settled provided that they are traded on a regulated market, a MTF, or an OTF, except for wholesale energy products traded on an OTF that must be physically settled; (7) Options, futures, swaps, forwards and any other derivative contracts relating to commodities, that can be physically settled not otherwise mentioned in point 6 of this Section and not being for commercial purposes, which have the characteristics of other derivative financial instruments; (8) Derivative instruments for the transfer of credit risk; (9) Financial contracts for differences; (10) Options, futures, swaps, forward rate agreements and any other derivative contracts relating to climatic variables, freight rates or inflation rates or other official economic statistics that must be settled in cash or may be settled in cash at the option of one of the parties other than by reason of default or other termination event, as well as any other derivative contracts relating to assets, rights, obligations, indices and measures not otherwise mentioned in this Section, which have the characteristics of other derivative financial instruments, having regard to whether, inter alia, they are traded on a regulated market, OTF, or an MTF; (11) Emission allowances consisting of any units recognised for compliance with the requirements of Directive 2003/87/EC (Emissions Trading Scheme). © Valiante Diego - 5  Post-2008 crisis regulatory framework for investment services © Valiante Diego - 6  Post-crisis investment service provision 1. Lack of surveillance over investment firms and own employees (incl. Internal controls) – Governance and Board of Directors’ accountability (e.g. black box) – Static execution policies that has reduced passing-on of benefits of competition in the trading venues space to end investors – Low data quality (incl. data standardisation and duplications in regulatory reporting) – Unfair commercial practices (mainly bundling) 2. Weak supervisory convergence among NCAs (e.g. ESMA powers) 3. Formalistic attention to (retail) investors – Overreliance on the caveat emptor principle, which shifts responsibility to investors to assess whether the product/service is what was expected, relying only on transparency tools 4. Low quality of distribution channels for investment products (several ‘misselling’ cases) 5. Poor handling of messaging capacity by trading venues, which led to several technological glitches © Valiante Diego - 7  MiFID at the core of investment services post-crisis reforms The Markets in Financial Instruments Directive II and Regulation (MiFID/MiFIR) regulates investment services and market transparency. UCITS REMIT AIFMD TD and CSDR PD MiFID/R MAR PRIPs CRD EMIR TO NOTE: MiFID does not apply to insurance companies (among others), but the Insurance Distribution Directive (IDD) mirrors (not perfectly) key MiFID requirements. © Valiante Diego - 8  A Directive and a Regulation MiFID 2 (Directive) – Market structure (RMs-MTFs-OTFs) – Exemptions (e.g. commodity derivatives) – Investor protection Execution quality Client categorisation Investment advice – SMEs regime – Organisational requirements – Third country regime (branch) – Data consolidation (APAs, CTPs) – Corporate governance (directors) – Supervisory powers (position limits and management; algo trading) – Sanctions MiFIR (Regulation) – Transparency (trade and transaction reporting) – Open access – Trading of OTC derivatives – Supervisory powers (bans and coordination role for ESMA) – Third country firms without branch © Valiante Diego - 9  Key principles and regulatory tools Single market for wholesale financial services High Level Principles Integrated securities and derivatives market European Passport Investor Protection Orderly Markets and Market Efficiency Financial Stability Basic Principles Organisational Conduct of Business Market Access and Requirements Rules and Market Integrity Transparency Source: Valiante (2011), MiFID 2 Task Force Report © Valiante Diego - 10  Regulatory tools When it comes to the strategies to regulate the provision of investment services, there are four main regulatory tools that are generally adopted: 1. Organisational rules (i.e. general impositions on how the provision of the service should be organized, including entry rules; e.g. capital requirements) 2. Product/transparency rules (i.e. requirements concerning the characteristics and modality of production and price transparency of a given financial product; e.g. UCITS) 3. Conduct of Business (COB) rules (i.e. a wide-ranging set of requirements to steer the financial intermediaries’ conduct towards clients) 4. Enforcement mechanisms (strong deterrence; big administrative sanctions, at least a maximum of EUR 5mn for natural persons and or of up to 10% of total annual turnover, art. 70 MiFID 2) © Valiante Diego - 11  Investor protection in investment services © Valiante Diego - 12  The ‘shingle’ theory and fiduciary duties It is presumed that a broker-dealer that hangs out a shingle and solicits customers makes an implied representation of fair dealing. (Loss & Seligman, Fundamentals of Securities Regulation, 1995) Theory based on the ‘hanging out’ doctrine developed by U.S. Courts (mainly in administrative proceedings brought by the SEC), but later codified into law When there is “Confidence, trust and influence” (Frankel 1983) – Credence nature of financial services. – “Trust”, “experience” and “dependability” (Mullainathan et al. 2018) “like doctors” relationship, which lead to fees way above costs, chronic underperformance, exploitation of investors’ biases and so less effective arbitrage that destabilises financial markets (Gennaioli et al 2012). Financial services provider is an agent of the client/investor. The fiduciary relationship exposes a beneficiary/principal to two distinct types of wrongdoing (Cooter and Freedman 1991): 1. The fiduciary agent may misappropriate the principal’s asset or some of its value (negligence); and 2. The fiduciary agent may neglect the asset’s management (failure to perform). © Valiante Diego - 13  Fiduciary duty theory Key fiduciary duties that have emerged over the years: 1. Broker’s duty of disclosure (informed consent by the client, disclosure of ‘adverse interest’) because of trust and confidence by the investor → Hughes v. SEC, 174 F.2d 969, 974-76 (D.C. Cir. 1949) 2. Duty of fair dealing as broker-dealers impliedly represent that they will deal fairly with their customers, and, therefore, unfair dealing is a breach of this implied representation and a violation of the antifraud provisions. → Kahn v SEC, 297 F.2d 112, 115 (2d Cir. 1961) 3. Duty to offer suitable products and according to specific criteria, such as the investment objectives or the ability to bear losses. (MiFID 2) Why giving a fiduciary duty and not simply a contractual remedy or greater transparency only (caveat emptor)? 1. Contracts are ‘incomplete’ Specification costs (contingencies) Monitoring costs Enforcement costs (high costs) 2. Need for pre-contractual commitment Reputational market? © Valiante Diego - 14  Why do we need investor protection? Investment firm-client relationship Two dimensions: – Macro (capital allocation) and – Micro (market efficiency) Understanding of risk/reward – Nature of the product/service (credence good) – Retaining private information (conflicts of interests) – Bounded rationality (e.g. frame) – Lack of financial education/knowledge – Unforeseeable risks (uncertainty) Market power – Competitive incentives of a firm to cross-subsidise between informed and uninformed investors through the sale practices © Valiante Diego - 15  Why do we need investor protection? Examples of drivers of the market failures from previous lectures: – Information asymmetry – Switching costs due to ‘sunk’ costs (lock-in effects) Transaction costs (e.g. Docs, fees, etc) Uncertainty costs (experience or credence attribute) Psychological costs (mutual or personal trust) – Cognitive biases Prospect Theory (risk-taking and losses) But also more aggressive (and potentially unfair) commercial practices, such as (Valiante and Renda 2009): – Unsolicited offers (e.g. so-called “pressure selling” [such as repeated visits to consumers] or “inertia selling” [supplying products not requested and ask for payment]); – Churning (“excessive buying and selling of securities in your account by your broker, for the purpose of generating commissions and without regard to your investment objectives” [SEC def.]); – Steering (especially used in the mortgages market, consisting of stressing the credit risk of a potential borrower to steer him\her to higher cost loans; intentional misjudgement of the intermediary). © Valiante Diego - 16  Key regulatory strategies Entry rules (authorization and passporting) Greater transparency (beyond ‘caveat emptor’ approach) – Standardised disclosure documents – Conflicts of interest disclosure Safeguards (organizational rules) – Prudential requirements – Insurance compensation – Remuneration structure Conduct rules (fiduciary duty) – Client classification – Conflict of interests management – Best execution – Suitability and appropriateness test – ‘Nudging’ consumers (libertarian paternalism) Adjustments to ‘choice’ architecture Default rules (bias sensitive; e.g. default enrolment in pension scheme that allows to opt out to reduce the status quo bias) © Valiante Diego - 17  Two general ‘fiduciary’ clauses in MiFID (art. 24, MiFID II) Investment Firm - Client Organisational Requirements Conduct-of-business rules ‘Best interests of clients’ ‘Fair, clear, not misleading (art. (art. 19.1) 24.1) information’ (art.19.2) General Clauses (art. 24.3) Conflicts of interest Information to Best execution Suitability & clients Appropriateness © Valiante Diego - 18  Conduct of Business (CoB) rules © Valiante Diego - 19  Conduct of Business (CoB) Rules CoB rules try to govern this fiduciary relationship by creating safeguards against three potential risks of liability: 1. Liability for fraud (when deceit occurs; e.g. market manipulation) 2. Liability for carelessness (negligence or lack of care; e.g. weak internal controls) Duty of best execution 3. Liability for disloyalty (intermediary-client relationship; e.g. inducements from third parties) There are two main tools used to enforce the fiduciary relationship: 1. Know-your-customer (KYC) rules 2. Know-your-product (KYP) rules Under MiFID, moreover, the rules of conduct that the investment firm must comply with are calibrated depending on: 1. The category to which the client belongs to (client categorisation) 2. The type of investment service being provided © Valiante Diego - 20  KYC, client categorisation and KYP rules © Valiante Diego - 21  KYC rules (1) – Appropriateness test 1. Know-your-customer rules: a. Appropriateness test (for execution-only services, i.e. reception and transmission of orders and execution on behalf, in complex products [art. 25.4, MiFID II]) This test is not needed for those services provided in conjunction with non-complex products, such as shares, plain vanilla bonds, money market instruments. Source: PWC © Valiante Diego - 22  KYC rules (2) – Suitability test b. Suitability test (for investment advice and portfolio management) “The duty of suitability rejects the prevailing paradigma of caveat emptor and forces providers [lenders] to internalise the harm that they cause when they exploit information asymmetries to the detriment of customers.” (Engel and McCoy, 2002) Three criteria to ‘satisfy’ the suitability test (see table). 1. Understanding of the risks 2. Ability to bear these risks 3. Alignment with the client’s investment objectives Source: PWC © Valiante Diego - 23  KYC rules (3) – Suitability test If the assessment is negative? – For investment advice → advice against transaction – For portfolio management → no transaction – The client can have a separate agreement for order execution, despite negative assessment If the assessment is positive? – Assess whether “equivalent” investment services or financial instrument can meet client’s interests (art. 53.9 Del Reg) “search for the most suitable product” → backstop to churning risks For investment advice, a suitability report should be provided (incl. advice given, how it meets the client’s objectives and personal circumstances, etc) To be reviewed annually (where applicable) © Valiante Diego - 24  KYC rules (4) – Appropriateness and suitability Source: PWC © Valiante Diego - 25  Reliance on information disclosure by the client Information disclosure by the client discharges the intermediary’s responsibility, unless 1. it was aware that the information was outdated, inaccurate or incomplete (‘passive alertness’ in art. 55.3 Del Reg). 2. Did not take ‘reasonable steps’ to ensure reliability of collected information (art. 53.7 Del Reg), such as Make clients aware of importance of providing accurate and up to date info Questions should be easy to understand and able to capture the necessary information with certain level of accuracy, without relying on self-assessments All tools should be appropriately designed to identify and mitigate limitations Ensuring consistency of client information vs obvious inaccuracies (?) With insufficient information to comply with KYC rules: – No provision of investment advice and portfolio management (art. 53.8 Del Reg) – Warning that no appropriateness test is possible for other investment services (art. 56.2, Del Reg) © Valiante Diego - 26  KYC rules (5) – Client categorisation c. Client categorisation Categorisation must take place before providing the service at the investment service provider’s responsibility! Three main categories: 1. Eligible counterparties (ECPs) 2. Opt-in professional 3. Retail investors © Valiante Diego - 27  KYC rules (6) – Client categorisation 1. Eligible counterparties (ECPs) can waive most business conduct rules (art. 30, MiFID2) – The group includes UCITS, credit institutions, central banks and IFs. (art. 30.2, MiFID2) – For execution on behalf, dealing on own account and reception and transmission of orders – Automatic recognition as ECPs (but they can opt-in to be treated as professional clients) – No appropriateness and suitability assessment, as well as most of the information to clients obligations, best execution and client order handling are not applied (art. 30.1, MiFID2) – ‘Local’ public authorities are not anymore ECP but professional (art. 30.2, MiFID2), if member state doesn’t decide otherwise – Target market identification and compatibility for products sold to ECPs Investment firms can, on request or own initiative: (art. 28, Imp Dir) – Treat a ‘ECP’ as ‘professional/retail’; and – Treat a ‘professional’ as a ‘retail’ client. © Valiante Diego - 28  KYC rules (7) – Client categorisation 2. Financial markets operators (Annex II.I(1), MiFID 2) are automatically recognized as professional clients, as well as ‘large undertakings’ (a balance sheet of 20 mn EUR, net turnover of 40 mn EUR, own funds of 2 mn EUR) – Selected requirements that do not apply to professional investors (for info) No price-cost best execution No summary of order execution policy Different type of communication with provider Less comprehensive information on costs and charges and other relevant operations (e.g. packaged products, leveraged positions) Own account use of assets by provider allowed (no client’s consent) When assessing suitability and appropriateness, provider can assume that PI has knowledge and experience, as well as ability to bear losses for per se PIs. – Professional classification is cross-referred in many other legislations (such as AIFMD, among others) © Valiante Diego - 29  KYC rules (8) – Client categorisation 3. Retail clients as a ‘residual category’ – Can become ‘professional’ (based on experience and quantitative requirements) and viceversa (opt-in) – Investment firm can approve the request to be treated as professional if two of the following criteria are satisfied (Annex II, 2, MiFID II): the client has carried out transactions, in significant size, on the relevant market at an average frequency of 10 per quarter over the previous four quarters, the size of the client’s financial instrument portfolio, defined as including cash deposits and financial instruments exceeds EUR 500 000, the client works or has worked in the financial sector for at least one year in a professional position, which requires knowledge of the transactions or services envisaged. Investment firms must notify clients of their classification © Valiante Diego - 30  Product categorisation © Valiante Diego - 31  KYP rules (1) – Product governance and design 2. Know-your-product rules a. Product governance and design rules (suitability at product design; art. 16.3 MiFID II) for the manufacturer (not all of them; e.g. UCITS & AIFMD funds): 1. Identify target market of end clients for each financial instrument 2. Establish a distribution strategy (targeted client) consistent with the identified target market (with stress testing) – Including selection of distributors that serve those clients 3. Regularly review that the financial instrument remains consistent with the targeted market 4. Make available all appropriate information on the financial instrument and approval process to the distributor (incl. target market etc) Source: KPMG © Valiante Diego - 32  KYP rules (2) – Distribution b. Distributors need to ensure that: – They confirm the existence of a product approval process with coverage of their target market – They should take reasonable steps to obtain all relevant information about the product if the manufacturer not captured under MiFID – They can also use public information if clear, reliable and produced to meet regulatory requirements (like prospectus, transparency documents, UCITS KID etc) – They review if their distribution strategy is consistent with the identified target market and, if not, reconsider the target market and/or update the product governance arrangements © Valiante Diego - 33  KYP rules (3) – Product intervention powers c. MiFIR also introduced product intervention powers, i.e. the possibility for the Member State (coordinated by ESMA through opinions and ’comply or explain’ by national authorities) to ban or restrict (e.g. prohibition of certain features or extra information obligations): 1. Marketing, distribution or sale of investment products or of investment products with certain features 2. A type of financial activity or practice – Conditions » ‘Concrete and identifiable’ problem (e.g. significant threat to stability or investor protection or impact on underlying markets) » No discriminatory effect » Intervention should be proportionate and only if existing regulation and supervision is not sufficient to address the risk – Temporary ban by the ESAs too (initially 6 months), but renewable twice and proper analysis afterwards (to be renewed). » Same conditions, plus no adequate national measures, no risk of regulatory arbitrage » E.g. binary options © Valiante Diego - 34  The market for investment advice (case study) © Valiante Diego - 35  The market for investment advice “‘investment advice’ means the provision of personal recommendations to a client, either upon its request or at the initiative of the investment firm, in respect of one or more transactions relating to financial instruments” (art. 4.1.4, MiFID II; art. 9, Del Reg) 1. Recommendation, made to a person in his capacity as an investor or potential investor (or agent) Presented as suitable for that person, or based on a consideration of the circumstances of that person 2. to take one of the following sets of steps in respect of a particular financial instrument: (buy, sell, subscribe for, exchange, redeem, hold or underwrite, exercise a right or not exercise such right…) 3. Considered a personal recommendation if it is NOT issued exclusively “to the public” Self-standing investment service (licensing includes execution on behalf and reception and transmission of orders) © Valiante Diego - 36  5 tests to determine investment advice 1. Recommendation? – Implicit/explicit opinion or statement of facts and figures 2. Transaction in a financial instrument? – Specific financial instrument (including advice not to buy), not about choice between types of financial instruments 3. Personalised? – Based on perception of the client, e.g. collection of specific information and absence of disclaimer like “this is not investment advice” 4. To the public? – Lots of grey areas (what about email to a group of clients?) 5. To an investor or a potential investor? – Focusing on anyone’s wealth and not about strategic or entrepreneurial activities (that is corporate finance advice) © Valiante Diego - 37  Many aspects to be considered © Valiante Diego - 38  The market for investment advice (FCA survey) Most advisers (mostly ‘non-independent’)... – do not understand risks involved in products – do not collect sufficient information from clients – follow poor recording practices – do not disclose inducements and conflicts of interest* Some advisers... – generate ambiguity and confusion in investors about the process of advice and their own responsibility Most clients… – not asked for ability to deal with investment risk (ability to bear losses) How can investment advice be optimally regulated? © Valiante Diego - 39  The advisor’s remuneration ‘Inducements’ are “fees, commissions or any monetary or non-monetary benefits paid or provided by any third party or a person acting on behalf of a third party in relation to the provision of the service to clients” (art. 24.7(b), MiFID II) General rule → inducements are prohibited for all financial services as contrary to duty of loyalty, except: – Fees paid by or on account of the client – Fees paid by or on account of a third party, but only if: 1. Designed to enhance the quality of the relevant service to the client 2. Proper fees that are necessary for the provision of the investment service and cannot give rise to conflicts (by their nature, such as settlement and exchange fees) 3. Received and transferred to the client. But different regime (with MiFID II) for ‘independent advice’ and portfolio management: – Full ban on inducements, except Minor non-monetary benefits if disclosed to clients, enhancing quality and of minor scale and nature (e.g. research?) 2 and 3 above, plus fees from the client – Independent advice also needs to provide a ’sufficient’ range of products © Valiante Diego - 40  The market for investment advice We can think of two (alternative) approaches to regulate advice Separation with pre-sale services Disclosure only (current) (alternative approach) Hp: investors can recognise Hp: investors cannot recognise ➔ independent advice independent advice Broad definition of advice ➔ Restricted definition of advice (incl. pre-sale services) Few limits on inducements ➔ Banning inducements Full fees/inducements disclosure ➔ Full fees disclosure Source: Valiante & De Manuel 2014 © Valiante Diego - 41  The market for investment advice The current framework is something in the middle. Broad definition with independent vs non-independent (de facto sale service) advice But, for independent advice →’sufficient’ range of products to be advised and ban on monetary inducements (only ‘minor non- monetary benefits’ to enhance quality) to address main conflict of interest (distribution) – other incentives not to behave in the client’s interest were not tackled (e.g. churning) Fee charged on Range of products and Originator (partially) Investor Comprehensive but Comprehensive providers Wide non-independent? and independent Restricted and Restricted but Narrow non-independent Independent? Source: Valiante & De Manuel 2014 © Valiante Diego - 42  Targeted information on investment advice (art. 24 (4) and 52 Del Reg) Before the investment firm provides investment advice, it must inform the client: 1. whether or not the advice is provided on an independent basis; 2. whether the advice is based on a broad or on a more restricted analysis of different types of financial instruments and, in particular, whether the range is limited to financial instruments issued or provided by entities having so close links to pose a risk of impairing the independent basis of the advice provided; 3. whether the investment firm will provide a periodic suitability assessment, and if so, further information on such periodic assessment © Valiante Diego - 43  Other conduct of Business (CoB) rules © Valiante Diego - 44  Transparency to clients Strengthening pre-contractual information ‘Fair, clear and not misleading’ information disclosure (art. 24.3, MiFID2) – Compliant with specific rules (Art. 27.2-8, Imp. Dir.) that allow to obtain: ‘Comparison between financial instruments/investment services’ ‘Past performance of financial instruments/investment services’ ‘Simulated past performance of an instrument’ ‘Future performance’ ‘Tax treatment’ – More extensive information than MiFID I must be provided about the costs and charges Including aggregated information to allow the client to understand the overall cost as well as the cumulative effect on return of the investment Appropriate information shall be provided in good time to clients or potential clients with regard to the investment firm and its services, the financial instruments and proposed investment strategies, execution venues and all costs and related charges. (art. 24.4, MiFID2) © Valiante Diego - 45  Best execution “Member States shall require that investment firms take all sufficient steps to obtain, when executing orders, the best possible result for their clients taking into account price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order.” (art. 27.1, MiFID2; art. 44, Imp D) In terms of services, it applies to – Execution of orders on behalf – Reception and transmission of orders – Portfolio management – OTF and SI operations For all financial instruments, excluding spot FX instruments © Valiante Diego - 46  Best execution It is a loosen definition, but: – “Nevertheless, where there is a specific instruction from the client the investment firm shall execute the order following the specific instruction.” (art. 27.1, MiFID2) – “Where an investment firm executes an order on behalf of a retail client, the best possible result shall be determined in terms of the total consideration, representing the price of the financial instrument and the costs relating to execution” (art. 27.1, MiFID2) The specific reference to retail client became necessary because, BE became a box ticking exercise with MiFID I. – Execution policies were too long and not regularly updated ‘when a significant new execution venue emerges’ (FSA, 2006) © Valiante Diego - 47  Best execution Execution quality data (art. 27(3)(6), MiFID II) – A quarterly own quality of execution report which has to be published by all execution venues. It includes failed trades, all costs and average bid-ask spread and other price indicators – Top 5 execution venues for IFs executing clients orders – An annual report about the monitoring of the execution quality of all used execution venues (when executing client orders). © Valiante Diego - 48  Two still unanswered questions 1. Should BE be an obligation of ‘results’ or ‘means’? 2. Price as a ‘default rule’ for everyone (like in the US)? Source: Equiduct (January 2010 on the 1,000 + most liquid stocks – Europe) © Valiante Diego - 49  The investment ‘life-cycle’ Source: De Manuel & Valiante, 2014. © Valiante Diego - 50  Key organisational requirements © Valiante Diego - 51  Accountability and governance Responsibility of senior management (Art. 9, Impl. Dir.; art. 9.3, MiFID2) – Periodical assessment of the effectiveness of policies, arrangement and procedures – Receiving on a frequent basis written reports – ‘Define, approve and oversee’ strategies, offered products/services, personnel Taking into account ‘nature, scale and complexity of its business’ Corporate governance rules (Rec. 5, MiFID2) – ‘Minimum standards’ (reputation and experience; art. 9, 48, MiFID2) – Time commitment. No more nomination than: a. 1 executive directorship with 2 non-executive, or b. 4 non-executive directorships Same group counts one and waivers from competent authority – Nomination committee to assess compliance – ESMA RTSs to define details (such as ‘sufficient time’) © Valiante Diego - 52  Order handling and conflicts of interest Client order handling system (art. 28.1, MiFID2) – ‘Prompt, fair, and expeditious execution of client orders’ – Conditions not to disclose limit orders Safeguard of clients’ ownership rights and depositing (art. 16.8, MiFID2) – Segregation if there is no client’s consent for own account use All reasonable steps to identify conflicts of interest (art. 23, MiFID2) – Firms need to identify, prevent and disclose conflicts of interest! – 3 types of conflicts (F/C, C/C and infra-group) – If unable to prevent → ‘caveat emptor’ Prevent through: – Internal committee, policies, refrain to act and barriers © Valiante Diego - 53  Record-keeping and cross-selling (for info) Record-keeping obligations – 5 years – ‘Relevant data’ defined by ESMA (e.g. identification number) – Telephone call recording (durable medium) Cross-selling practices – Affecting investors’ mobility – Unbundling pre and post-trade data (art. 11, MiFIR) – Disclosure to clients of such practices (art. 24.7, MiFID2) Disclosure if available ‘unbundled’ © Valiante Diego - 54  Other organisational requirements (for info) Compliance officer (art. 6, Imp Dir) – Objectivity, and independent remuneration. Personal transactions (art. 16.2, MiFID2, art. 11, 12, Imp. Dir.) – E.g. acting outside scope of activities Notification of ‘intended holdings’ acquisition or sale (art. 11, MiFID2) – 20%, 30%, 50% (to see if the investment firm is a ‘subsidiary’) Tied agents (acting on behalf of the investment firm) – No handling of money or financial instruments (art. 29.2, MiFID2) – ‘Appropriate’ commercial and professional knowledge – Operation in other member states as a ‘branch’ (if no objections from host member state authority within 3 months) © Valiante Diego - 55  To recap on retail investor protection under MiFID 2 MiFID requirements (conduct of business and conflicts of interest rules) are extended to the sale of structured deposits. Safekeeping of assets (clients’ asset segregation) rules are strengthened The power of member states to exempt certain investment firms from given rules is reduced. Senior management is explicitly given the responsibility to approve the policy governing the services and products offered by the firm. The quality of best execution is monitored by imposing transparency obligations on firms and venues, so leaning gradually towards an obligation of results. MiFID aims to improve investment advice by requiring firms to disclose if the advice is independent, considering a broad range of instruments, strengthening ongoing suitability and banning all monetary inducements (for independent one) Monetary inducements are banned for portfolio management services too. © Valiante Diego - 56  Recommended readings Armour J., D. Awrey, P. Davies, L. Enriques, J. N. Gordon, C. Mayer and J. Payne, Principles of Financial Regulation, OUP (Chapter 11 and 12) Niamh Moloney, Eilís Ferran, and Jennifer Payne (2015) The Oxford Handbook of Financial Regulation (Chapter 18) Valiante D. and M. De Manuel (2014), A Life Cycle Approach to Investor Protection, ECMI Working paper, available at https://www.ceps.eu/publications/life-cycle-approach-investor- protection Additional readings – Roberta S. Karmel, "Is the Shingle Theory Dead," Washington and Lee Law Review 52, no. 4 (1995): 1271-1298 – Spindler G. (2011), “Behavioural Finance and Investor Protection Regulations”, Journal of Consumer Policy, 34:315 – Valiante, D., & Lannoo, K. (2011). MiFID 2.0: Casting New Light on Europe's Capital Markets. Brussels: Centre for European Policy Studies. (Chapter 6) available at https://www.ceps.eu/publications/mifid-20- casting-new-light-europe%E2%80%99s-capital-markets © Valiante Diego - 57  Diego Valiante LEIF Master Programme [email protected] www.unibo.it