November 2017

DISTRIBUTION: Day of the MiFID

MiFID_II_deadlineMiFID II comes into force in two months’ time. Catherine Lafferty asks how prepared the funds industry is to meet the target market requirements.

The clock is ticking and the countdown is on. By January 3, MiFID II will come into force and fund manufacturers will be required to specify “at a sufficiently granular level” the “target market” for each financial product they sell and identify the kinds of client for whose needs, characteristics and objectives the product is suitable.

Further, they will have to provide that information along with the target market’s risk profile to distributors so that they too understand the product.

They will have to provide information on charges and costs, their distribution channels and strategy, likely performance, conflicts of interest and relevant stress tests. They will also have to review their products regularly after they are sold to see that they remain suitable for client needs, characteristics and objectives of the target market rule. In short, there must be no possibility of selling hedge funds to grannies.

It is an eminently reasonable intention, but there are areas of unease about the target market framework.

A key concern is about the consistency of understanding on how to populate the target market aspect of the ‘MiFID Template’, an industry initiative to try to solve MiFID reporting consistently across the industry and geographies. 

Worthwhile work is underway through bodies such as the UK’s Tax Incentivised Savings Association (TISA), according to Steve Bennett, founder of Good Conduct Consulting and adviser to Door Funds. But with little time remaining, opinions differ significantly about how to populate the template consistently, for instance with regards to its categories for investor knowledge and experience. 

Some jurisdictions are promoting the view that all Ucits should be categorised as compatible with what the template calls “basic investors” – that is, mass retail – but fund managers aver that this is not how supervision teams within regulators across Europe see things. 

Bennett says: “There may not be many funds that aren’t compatible with basic investors, but that there can be exceptions must be acknowledged. The framework has been designed to cater for this. The basic investor category is for products that are non-complex and easy to understand, whereas the informed investor category is for products which require investors to have more knowledge and/or experience to make an informed investment decision.” 

The intended effect is that distributors should be more thoughtful about selling funds that are compatible with informed investors, considering whether these funds should be included in things like best-buy lists.

What is not intended is for distributors to restrict distribution or cease listing these funds. This would deprive informed investors of access to some good funds and may result in some fund managers compromising their categorisation under commercial pressure, an outcome that would defeat the purpose of the framework and expose them to regulatory risk.

Distributor oversight
Another concern still hovering over the funds industry about MiFID II – which is the revision of the earlier Markets in Financial Instruments Directive – is the lack of consensus across Europe about what is required for oversight of distributors by fund manufacturers. 

Distributors, as MiFID firms, will be obliged to report illegal sales to both clients and product providers irrespective of whether the providers are MiFID firms. It is therefore difficult to see that fund managers can be completely exempt from any oversight responsibility, because if they receive such reporting, they will have to act on it.

This links right back to the first concern. Careful thought is required in defining what constitutes a “negative target market”, Bennett stresses. 

“In my view, target market should only be negative where the product is truly incompatible with the needs, objectives or profile of the end investor in all reasonably foreseeable circumstances. 

“A too conservative view of negative target market will lead to distributors either having to develop a significant reporting capability – and fund managers developing the capability to receive and analyse such responses - or some funds will not be sold, as the overhead for distributors is simply too high,” he says.

A second concern raised by distributors is the risk of civil liability in some jurisdictions if they sell funds to investors that are not in the positive target market, even if justifiable.

Although a proportionately defined target market should lead to few negative target market exceptions, it is still clear that a framework for reporting is required, Bennett says.

UK industry body TISA has landed on a pragmatic compromise based on transaction reporting and consistency. It has proposed a template for transaction reporting that focuses on just two fields – client type and distribution strategy – from the target market section of the European MiFID Template. 

Progress towards the impending MiFID II target market requirements is much discussed. Most manufacturers are starting to include data designating the target market in their product development life-cycle – and the good news is that many asset managers are confident most of their product ranges are suitable for retail investors.

But Greg Glass, director at fund management consultancy Alpha FMC, points out that it only takes one product that is not suitable for the manufacturer to incur a complex data management reporting liability: “If products are bundled, such as a fund-of-funds, then the appropriateness of the bundle needs to be considered in total, and the entity manufacturing the bundled product can in some cases become product manufacturer and needs to make a designation of the target market.”

Bodies including TISA have co-ordinated an industry standard for the exchange of data that requires distributors to provide information to fund manufacturers and highlight any product that has been wrongly sold to a retail investor. The industry is in the process of implementing these specifications and most asset managers intend to report on an exception basis.

But on the issue of identifying and remedying breaches, there has been little reported discussion about how any remediation might be delivered. In practice, this will require substantial communication and data exchange between various parties in the distribution chain.

Meeting the MiFID II requirement is dependent on a chain of co-operation between fund manufacturers and distributors. Fund managers insist they are prepared to meet their MiFID II target market requirements, but some raise questions about the level of co-operation between fund managers and their distributors.

Rob Swan, head of UK business development at technology firm Calastone, believes fund managers are better prepared than distributors and that they are preparing their target market data to pass down. But he says that depending on the country, distributors range from ready to nowhere near.

“Some distributors already pass data, so it is not a big leap. Others have never passed data and so the work required is immense and something even now they are not prepared for.”

He adds: “As an example, I was in Germany this week meeting distributors. Some of them told me that they were not going to pass any data on behalf of MiFID until they were legally bound to!”

Pragmatic approach
Some feel that the ability – or simply willingness – of a distributor to pass on market information should be part of a fund manufacturer’s due diligence when embarking on a distribution relationship.

Bennett believes ongoing distributor due diligence processes, such as those that have been in operation in Luxembourg for years, should be extended to cover target market. 

He says it is a pragmatic approach to addressing distributor target market oversight for many less complicated products. The alternative is a data-driven solution based on sales data.

Bennett says providing specific information on customers would be too great a burden on distributors and should not form part of due diligence. Instead, due diligence should focus on providing information on the distributor’s processes for taking account of the fund manager’s target market assessment. 

However, while standards are developing around due diligence, the process remains a manual, bilateral process, which means distributors are having to complete many questionnaires covering much the same information. This may contribute to the low initial response rate experienced by many fund managers and intermediaries.

MiFID II’s requirement that funds are sold to appropriate target markets is an important additional protection for retail investors. Time will tell how easy it is to achieve in practice.

©2017 funds europe