»New regulations result in many obligations: let our expert teams navigate you safely through the related focus areas«

Thomas Hungerkamp, Partner LPA

MIFID II

The MiFID II Directive is producing more extensive regulatory measures than ever before. We use our know-how and expertise to bring them under control – in a plan tailored to your business model.

A summary of our services for MiFID II

MiFID II and its regulatory backdrop

The legislative texts of MiFID II (Markets in Financial Instruments Directive II) and MiFIR (Markets in Financial Instruments Regulation) that came into force on 2 July 2014 aim to counter flaws and weaknesses in the European financial market that were revealed during the financial crisis, with the objectives of greater stability and transparency and increased protection for the investor.

All companies providing investment services within the European Union are affected by the amendments, including, for example, banks and insurance companies, asset managers, stock exchanges, and fund providers.

MiFID II: what are the new features?

In addition to the legislative texts of MiFID II and MiFIR (Level I) and the implementing acts of the European Commission (Level II), the European Securities and Markets Authority (ESMA) regularly publishes opinions on the new legislative texts (Level III). These guidelines, opinions and Q&As aim to support banks and financial service providers in their efforts to comply with MiFID II / MiFIR requirements.

The main amending measures introduced by MiFID II affect the following core areas:

  • Client-oriented securities operations (with a focus on providing retail investors with comprehensive protection)
  • Trade and derivative operations, including the relevant market infrastructure (trading/execution venues)
  • Overarching governance of the relevant service providers and market players

The legislator has also tightened the options for imposing sanctions in the case of breaches of supervisory law.

MiFID II: background and origin

The MiFIR has been officially applicable in all member states of the European Union since 3 January 2018. The respective national competent authorities were to transpose the provisions of MiFID II into national law by 3 July 2017, and these too have been applicable since 3 January 2018. MiFID II was transposed into German legislation as part of the “Second Act Amending Financial Market Regulations” (Zweites Finanzmarktnovellierungsgesetz) that saw changes made in particular to the German Securities Trading Act (Wertpapierhandelsgesetz) but also to other laws, such as the country’s Stock Exchange Act (Börsengesetz) and Banking Act (Kreditwesengesetz).

The preceding directive, MiFID I, was introduced more than ten years ago as a basic legal framework governing trading with financial instruments. Compared to MiFID I, however, its successor, MiFID II, has much greater regulatory scope, particularly in terms of the numerous implementing acts. The motivation for MiFID II and the changes it introduced was the 2007 global financial crisis, followed shortly afterwards by the euro crisis. But technology-driven changes in market infrastructure and a greater awareness of and demand for comprehensive investor protection can also be seen as key drivers of the reforms.

The role of the ESMA in implementing MiFID II / MiFIR

Alongside the EU Commission, Council and Parliament, the European Securities and Markets Authority (ESMA) has played a pivotal role in designing and implementing the regulatory frameworks of both MiFID II and MiFIR. The ESMA was founded in 2011 with the following objectives in mind:

  • Investor protection: safeguarding the needs of clients; strengthening their rights and recognising their responsibilities
  • Regulated markets: promoting the integrity, transparency, efficiency, and orderly functioning of the financial markets to guarantee a stable market infrastructure
  • Financial stability: strengthening the financial system so that it can absorb external shocks; promoting economic growth

The ESMA is also responsible for coordinating and supervising the national competent authorities, such as Germany’s own Financial Supervisory Authority (BaFin). In addition to the legislative texts of MiFID II and MiFIR (Level I) and the implementing acts of the European Commission (Level II), the ESMA regularly publishes opinions on the new laws (Level III). These guidelines, opinions and Q&As aim to assist banks and financial service providers in their efforts to comply with MiFID II / MiFIR requirements.

Core areas affected

The main amending measures introduced by MiFID II affect the following core areas:

  • Client-oriented investment operations (with a focus on providing private investors with comprehensive protection)
  • Trade and derivative operations including the relevant market infrastructure (trading/execution venues, pre- and post-trade transparency, reporting)
  • Overarching product governance of the relevant service providers and market players, together with precautions to avoid conflicts of interest

The legislator has also tightened the options for imposing sanctions in the case of breaches of supervisory law.

Virtually all companies providing investment services within the European Union are affected by the amendments, including, for example, banks and insurance companies, asset managers, stock exchanges, and fund providers.

Product governance

In addition to the relevant measures aimed at reforming the market infrastructure and increasing transparency in trading, significant improvements in investor protection have also been a priority. In this regard, one of the most important MiFID II regulations has introduced comprehensive rules on product governance, the aim of which is to recast organisational and conduct-of-business requirements along the entire value chain of a financial instrument. The primary aim here is to make financial products more customer-friendly. To this end, issuers must, for example, use certain criteria to define a target market for their various products. In addition to the client category (retail or professional client), the criteria include clients’ knowledge and experience, their financial situations with a focus on their ability to bear losses, their risk tolerance, and their objectives and fundamental needs.

The product governance obligations are directed at both the manufacturers and the distributors of financial instruments and associated services.

In the context of product governance, MiFID II has assigned new tasks to the compliance function, in particular. In the future, it will be obliged to oversee the development and regular review of product governance arrangements and to identify in timely fashion any risks that might lead to non-compliance with the product governance process.

Conflicts of interest

Aside from the obligations arising from product governance, explicit rules on the handling and management of conflicts of interest aim to bring about significant improvements in investor protection. Under MiFID II, therefore, investment firms will be required to identify potential conflicts of interest in all investment services (including ancillary services), and to make effective arrangements to avoid such conflicts so that clients’ interests are not impaired. To this end, in conjunction with product governance, the corresponding articles 16(3) and 24(2) of MiFID II have been elaborated with supporting guidelines from the ESMA (ESMA35-43-620), according to which all financial instruments (shares and bonds as well as more complex products such as derivatives) are now subject to product governance. What is more, the regulations apply to all relevant investment services, even to execution-only transactions, irrespective of whether the products are distributed on the primary or the secondary market.

Rules on product governance coupled with the principles of avoiding conflicts of interest mean that product manufacturers must therefore comply with a wide range of obligations during the product’s life-cycle:

  • Prior to actual distribution, a target market must be defined for the designed product and a distribution strategy determined.
  • The product must be stress-tested and evaluated (using different scenario analyses under negative market conditions).
  • Conflicts of interest must be avoided through appropriate organisational arrangements.
  • Product manufacturers must provide distributors with suitable information to enable the latter to comply with their own obligations, e.g. that of critically examining the target market defined by the product manufacturer.
  • During the life-cycle of the product, the financial instrument and the target market must be regularly examined, updated and, if necessary, adjusted.

The obligations incumbent on distributors apply only during the life-cycle of the product or service:

  • Before a financial instrument is distributed, the product range must be approved and the distribution strategy defined. During this process, it must be ensured that the target market is aligned with the corresponding distribution strategy and that both are compatible with clients’ needs.
  • Distributors must also ensure that their distribution strategy is consistent with the target market.
  • Corresponding organisational measures must be put in place in order to comply with product governance requirements.
  • Product governance arrangements must be regularly reviewed (monitoring).
  • Distributors must exchange information with the manufacturers whose financial instruments they are distributing.

MiFID II: how we can help you implement the new requirements

During implementation of the new requirements under MiFID II / MiFIR, our experts can provide assistance in the following key areas:

    • Classification of clients: in order to satisfy the requirements in terms of investor protection, all the clients of an affected financial institution must be classified as retail clients, professional clients, or eligible counterparties.
      • Retail clients: these are all clients who are not classified as either professional clients or eligible counterparties. According to the legal interpretation, the definition of “retail client” extends beyond natural persons to include even small and medium-sized companies, regardless of their legal structures. Retail clients enjoy the highest level of protection, as all statutory provisions on investor protection apply in full to this category. In particular, comprehensive disclosure obligations, the “best-execution” obligation and disclosure obligations on how client orders are processed all apply here.
      • Professional clients: professional clients are clients with enough experience and knowledge of financial markets to take investment decisions on their own and to evaluate the associated risks. Professional clients are therefore likely to be financial counterparties such as investment firms and banks, as well as non-financial companies that meet certain criteria.
      • Eligible counterparties: this client category is a subset of the professional client and boasts extensive knowledge of and experience in financial transactions. As such, this category enjoys only very limited regulatory protection.
    • Distribution and closure of interest-rate and currency derivatives: MiFID II is having a profound effect on the distribution process of banks. Requirements in terms of cost transparency, suitability, documentation of advisory meetings, and staff qualifications mean expanded review, documentation and transparency obligations for client contacts. These have significant implications in terms of how a bank provides its clients with investment advice.
    • Product governance (“suitability” and “appropriateness”): the aim of product governance is to ensure that manufacturers and distributors target only suitable clients when selling products. To comply with this requirement, investment companies in the future will be obliged to make far-reaching arrangements: requirements such as defining target markets and providing sales information on every single financial instrument aim to ensure that clients purchase only those instruments that match their needs and objectives. A client’s knowledge and experience, anticipated investment horizon, and loss-bearing ability must be aligned with the product’s characteristics and declared suitable and appropriate.

Suitability is based on whether the specific business is compatible with the investor’s objectives, whether the investor understands the risks inherent in the investment, and whether the investor can bear the financial risks of that investment (suitability test).

Appropriateness is based on whether the client has the knowledge and experience to adequately assess the risks arising from the investment in the financial instrument. Investment firms will therefore need to query clients about their knowledge of and experience in individual asset classes in order to properly assess the appropriateness of the desired investment (appropriateness test).

  • Client disclosures: in the future, clients are to receive comprehensive information on financial products so that they can better understand the characteristics and associated risks. This information includes disclosing all costs associated with the instrument before the business deal is executed. Investment firms must, therefore, explain in clear terms what the total costs of the investment will be and how these costs will affect returns. The costs must be disclosed separately, i.e. divided into actual product costs and costs incurred for ancillary services. Investment firms must also disclose any payments they receive from third parties. Upon request, investment firms must provide clients with a schedule of costs detailing each individual item. In the case of ongoing business relationships, an investment firm must provide its clients with retrospective cost information on an annual basis if the firm recommended or offered the financial instrument in question. All costs incurred must be disclosed individually.
    • With regard to the information sheets investment firms have to send to clients before executing a transaction, there will continue to be product information sheets and, in the field of investment funds, key information documents for investors. Since 1 January 2018, clients buying packaged retail and insurance-based investment products have been provided with key investor information documents (KIIDs) rather than product information sheets.
  • Systematic internalisation (and the legal consequences): although the concept of systematic internalisation (SI) was introduced in MiFID, it was restricted to equity trading. Under MiFID I, therefore, the term “systematic internaliser” referred to “an investment firm which, on an organised, frequent and systematic basis, deals on its own account by executing client orders outside a regulated market or multilateral trading facility (MTF)”. Under MiFID II, expansion of the concept to include organised trading facilities (OTFs) and the notion “on a substantial basis” means that the SI regime is now applicable also to equity instruments (ETFs, certificates, etc.) as well as to non-equity instruments such as derivatives, bonds, and other structured financial instruments. In turn, the benchmark for “on a substantial basis” is either the scale of the OTC trading carried out by the investment firm relative to the total trading of the investment firm in a specific financial instrument, or by the size of the OTC trading carried out by the investment firm in relation to the total trading in the European Union in a specific financial instrument.
  • Transparency reporting and transaction report: MiFID II is extending the pre- and post-trade transparency requirements introduced under MiFID I for equity trading on regulated markets to include equity instruments (ETFs, certificates, etc.) and non-equity instruments such as derivatives, bonds, and other structured financial instruments. In addition, efforts will be made to ensure that bilateral trading of OTC products takes place at OTFs. Under MiFID II, identical pre- and post-trade transparency rules apply to regulated markets (RMs), MTFs and OTFs alike. However, the pre-trade transparency regime applicable to SIs differs from that for the regulated trading venues in that it includes publication of the latest bid/offer prices and the depth of market interest. The post-trade transparency regime requires the timely publication of prices, volumes and times of transaction.
  • Trading obligations and strategies: MiFID II has added OTFs to the defined list of trading venues in order to regulate trading on markets other than RMs and MTFs. Accordingly, derivative financial instruments that are sufficiently standardised must be traded by financial counterparties via regulated markets.
  • Requirements placed on algorithmic trading: under MiFID II / MiFIR, algorithmic trading is defined as trading in financial instruments “where a computer algorithm automatically determines individual parameters of orders such as whether to initiate the order, the timing, price or quantity of the order, or how to manage the order after its submission, with limited or no human intervention”. Investment firms engaging in algorithmic trading are subject to enhanced regulatory scrutiny in the form of certain standards and reporting requirements concerning, in particular, technical infrastructure, risk control and operating capacity, and usage.
  • Best execution (reports and execution principles): under MiFID II, banks are required to publish “top-5 reports” annually on their best execution venues, along with supplementary notes rating the execution quality achieved. MiFID II also requires investment firms to document the “fairness” of a proposed price. To this end, banks are obliged to maintain processes and provide documentation to prove that they are fulfilling their “best execution policy”.

MiFID II: we offer you the following services

In order to take account of the complexity of the regulatory requirements – and to ensure that we protect your resources and implement the individual provisions efficiently in harmony with your existing business models – our experts adopt a modular, tailored plan of action that can be divided into two successive stages.

1. Identify courses of action and make strategic decisions:

  • Run an impact assessment to identify the business segments concerned
  • Analyse the strategies, processes and systems concerned
  • Identify fields of action
  • Plan and define implementation activities

2. Konzeptionierung und Umsetzung:

    • Develop goals and make strategic decisions
    • Design implementation solutions
    • Provide a tool to regularly monitor potential for SI classification
    • Prepare top-5 reports and the necessary client information documents via LPADoc and CAPTANO
    • Provide support in the areas of client classification and product governance (suitability/appropriateness tests, and definition of target markets)
    • Define target markets for all product categories and coordinate these with the competent departments and with Compliance/Legal
    • Provide support when defining distribution strategies for different financial instruments
    • Generate KIDs with the help of LPADoc, and calculate the SRI and

performance scenarios for all products

  • Develop and coordinate product monitoring arrangements
  • Draw up detailed design concepts, plan and implement measures
  • Implement organisational adjustments
  • Implement technical adjustments (including test management)

 

Would you like to know more?

We will be happy to advise you.

Thomas Hungerkamp
Thomas Hungerkamp
Ihr Ansprechpartner für Regulation & Technology

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Thomas Hungerkamp
Thomas Hungerkamp
Ihr Ansprechpartner für Regulation & Technology
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