May 2012

EDHEC RESEARCH: Heading off course

CompassRevisions to the Mifid directive could increase investor protection rules surrounding ETFs. Felix Goltz, of the Edhec-Risk Institute, investigates.

Exchange-traded funds (ETFs) were not included in the European Markets in Financial Instruments Directive (Mifid), which has been in force since November 2007.

Mifid established a regulatory framework for investment services in financial instruments including pre-trade transparency rules, which require publication of current orders and quotes, and post-trade reporting rules, which require market operators to promptly make public the price, volume and time of all trades in listed shares, even when taking place outside a regulated market.

As ETFs were not included, this means that there is little data available about over-the-counter (OTC) trading of ETFs in Europe.

Under Mifid “appropriateness” rules, firms providing investment advice or individual portfolio management need to have a reasonable basis for believing that a transaction to be recommended for a client meets their investment objectives, does not entail investment risks that would not be financially bearable by the client, and that the client has the necessary experience and knowledge to understand the risks involved. For other investment services, the firm need only determine the client has the experience and knowledge to understand risks.

The rules do not apply when providing execution-only services or when just receiving and transmitting client orders, as long as certain conditions are met. The service also has to be provided at the initiative of the client, and the client has been clearly informed that the firm is not required to assess suitability.

Self-directed investors are thus allowed to gain direct access, via execution-only platforms, to a variety of instruments without undergoing the suitability and appropriateness tests of Mifid. Ucits ETFs can be accessed this way but also non-listed Ucits and non-Ucits products, whether listed or not. All Ucits are thus deemed non-complex.

But, there are concerns with respect to the applicability of Mifid when investment firms or credit institutions issue and sell their own securities without providing investment advice. However, the wider issue on retail investor protection may be that Mifid covers only a fraction of the financial investment products offered in Europe – insurers are regulated by the Insurance Mediation Directive and structured term deposits are outside the purview of Mifid.

On 20 October, 2011, the commission presented a proposed revision of Mifid rules via a directive and a regulation (unlike a directive, which needs to be transposed into the law of each Member State, a regulation is directly applicable).

The proposed directive’s scope is extended from investment firms and credit institutions, which are currently caught by Mifid, to include data providers. Insurance companies continue to be exempted. It also clarifies rules for the provision of services by third-country firms.

The proposal extends the transparency regime to all trading venues for shares and certain equity-like instruments, including ETFs. It alters the right by Member States to exempt institutions from Mifid, extends Mifid requirements to the advised and non-advised sale of structured deposits by credit institutions, and confirms that Mifid also applies to investment firms and credit institutions selling their own securities.

It strengthens investor-protection, notably by requiring firms to disclose whether investment advice is provided on an independent basis or if it is based on a broad or on a more restricted analysis of the market. When the investment advice is independent, third-party inducements are prohibited. Such inducements are also prohibited for all firms when providing portfolio management. Cross-selling practices are subjected to controls and disclosures.

Last, the proposed directive provides clarification on instruments that can be traded via execution-only services. Prohibited are shares in non-Ucits collective investment undertakings, along with shares, bonds and money market instruments embedding a derivative or a structure that makes it difficult for the client to understand the risk, and structured Ucits. The revised proposals prohibit the provision of leverage in the context of execution-only services.

Structured Ucits are defined as “Ucits which provide investors, at predetermined dates, with algorithm-based payoffs linked to the performance, or to the realisation of price changes, or other conditions, of financial assets, indices or reference portfolios or similar features”.

While Ucits other than structured Ucits are explicitly mentioned as authorised for distribution via execution-only platforms, the introductory part of the proposal states that since execution-only services entail “a relevant reduction of clients' protections”, it is appropriate to exclude the possibility to provide these services in conjunction with the provision of leverage.

While this is language that has been used to describe structured Ucits, it may leave some scope for interpretation over whether the use of derivatives by Ucits would render them unfit for execution-only distribution in general and whether synthetic-replication Ucits would be excluded.

It is important the proposal does not create a complex Ucits category but considers structured Ucits to be a priority complex.

It is surprising to see so much regulatory interest being concentrated on a segment of the European investment management industry that is not only narrow (less than 3% of overall assets) but already the most highly regulated. It appears that the overarching objectives of the regulator (to achieve a level-playing field and a high-level of retail investor protection across the industry) would be better staying on the initially charted course of harmonising regulation to generalise the high standards of protection afforded by Ucits and Mifid to all packaged retail investment products and the institutions and individuals involved in their distribution.

Felix Goltz is head of applied research at the Edhec-Risk Institute

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