The Markets in Financial Instruments Directive (MiFID II), which applies from January 3, 2018, aims to increase competitiveness by creating a single market for investment services in the European Union (EU), and harmonize protection for investors in financial instruments.
To achieve these objectives, MiFID II introduces a ban on inducements for investment firms that provide independent advice and portfolio management services. These modifications are raising challenges for asset managers.
The changes echo those implemented in the United Kingdom (UK) through the Retail Distribution Review (RDR) in 2013 when commissions on products were abolished and replaced by fees. The rationale, at that time, was that a fee-based system would give financial advisers greater incentive to choose the products and investments that best covered client needs, rather than those that paid the best commission.
Regulators hope that the ban on inducements will encourage asset managers to focus more on their clients' needs
Revenue and research funding
Asset managers will be subject to similar requirements following the implementation of MiFID II's ban on inducements paid to independent investment advisers and measures relating to discretionary investment advice. Regulators hope that the ban on inducements will encourage asset managers to focus more on their clients' needs but it is unclear how it might affect asset managers’ business models and profitability.
In Australia, research undertaken by the Australian Securities and Investments Commission (ASIC) found that the most significant challenges for investment advisers following the ban on inducements introduced in 2013 related to the requirements to provide fee disclosure statements, the necessary adviser training and the updates to their internal systems. According to a report issued by Deloitte:1 “The current revenues of independent investment advisers are likely to fall due to the ban on inducements. Either this results in losses at those incumbent firms or a change in the operating model to increase the top line and recover lost revenues by charging more fees to clients or reducing the expense base while investing in new technologies to meet the changing regulations."
Asset managers may have to reconsider their fee structures, product pricing and product development strategies. They will also have to revisit how they fund their research – already a thorny issue – as MiFID II requires clear separation of research and trading costs to increase transparency of fees.
“The way in which many asset managers currently pay for research will be significantly impacted," says Imogen Garner, a Partner at the London offices of law firm Norton Rose Fulbright LLP3. “In the UK, we have had rules on asset managers using dealing commissions to buy research in the equities markets for some time, but now MiFID II is creating a Europe-wide regime that is broader in scope and covers fixed income products as well. Managers will have to decide whether to pay for research out of their own funds, or use a client-funded research payment account – and they may have to set up specific new operational structures to meet the new requirements."
MiFID II may have a profound effect on market infrastructure. The growth of alternative venues for trading financial instruments has increased competition, but it has also increased fragmentation as more bonds and derivatives are traded outside organized venues.
MiFID II may have a profound effect on market infrastructure
The expansion of the scope of regulated trading venues and systematic internalizers to overcome these challenges should benefit asset managers who improve their risk management practices and pricing accuracy. However, it also imposes additional responsibilities. “MiFID II expands the scope of the transaction reporting requirements and captures an increased number of transaction types, data points and instruments," states law firm Travers Smith2. “More activities are considered to constitute 'execution' of a transaction, and so may give rise to a reporting obligation.”
Travers Smith further notes that “under MiFID II, more investment managers are expected to report more transactions directly; a manager may only rely on a third-party broker to report transactions on the firm's behalf if a bilateral reporting agreement is in place requiring the firm to provide timely information. The practical difficulties in concluding agreements with individual brokers and the sensitivities of some firms about sharing confidential information mean that many firms who previously relied on the 'EU broker exemption' will now need to undertake transaction reporting in-house”.
Imogen Garner of Norton Rose adds: “Already transactions are reported to regulators, but the requirements are going to be expanded in scope, and they'll become more burdensome with more transaction types, data points and instruments captured. There'll also be reduced scope for asset managers to rely on brokers to transaction report for them compared to today. They'll have to engage with their brokers in the coming months to gauge the potential impact."
Garner also notes that “some asset managers are very much informed about the detail of these changes but others are in danger of underestimating the amount of work that needs to be done".
In particular, asset managers based in the UK may be required to have alternative plans in place depending upon the terms of the UK’s proposed withdrawal from the EU because the applicability of MiFID II and other EU Directives may ultimately be modified.
- Deloitte (2016) - MIFID II: What will be its impact on the investment fund distribution landscape
- Telephone interview
- Travers Smith (April 30, 2015) - Financial Services and Markets: MiFID II – A Short Introduction for Asset Managers